From the data of 501 S&P500 companies, 10 portfolios are constructed.

First 9 portfolios
consist of 50 companies and the last one contains 51. The companies were first ranked as per
their beta in ascending order and the selection was made. First 50 companies were grouped as
portfolio 1, the second lot of 50 companies as portfolio 2 and so on, the order also signifies
the increasing level of risk of these portfolios.

Portfolio The beta of the Return on the Portfolio market-cap

portfolio portfolio
1 0.24 13.99 1,343,508,421,632
2 0.51 8.55 2,376,045,644,800
3 0.49 7.41 1,761,386,125,312
4 0.77 10.47 2,287,635,497,472
5 1.34 18.14 3,301,482,948,608
6 1.19 15.35 2,663,891,216,384
7 1.57 19.76 3,206,674,562,048
8 1.16 23.29 2,068,692,944,896
9 1.25 23.96 1,997,150,715,392
10 1.14 9.83 1,508,040,783,872

Beta of the portfolio Return on the portfolio

1.80 30.00
1.60
25.00
1.40
1.20 20.00
1.00
15.00
0.80
0.60 10.00
0.40
5.00
0.20
- -
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10

Beta of the portfolio Return on the portfolio

 Portfolio market-cap
3,500,000,000,000

3,000,000,000,000

2,500,000,000,000

2,000,000,000,000

1,500,000,000,000

1,000,000,000,000

500,000,000,000

-
1 2 3 4 5 6 7 8 9 10

Portfolio market-cap

It can be understood from the tables and graph that the beta is increasing with a sequence of
portfolios. However, there is a decline after portfolio 7, the reason for the decline is lower
weights associated with ending portfolios in terms of market capitalization. The return
increased at the beginning along with the risk but it dropped significantly in the case of the
last portfolio. This signifies that risk & reward relationship exists but up to a certain limit of
risk, beyond that, the rationale fails.

The regression analysis is done after the preliminary analysis. the regression line describes
the relationship between two variables where one is the dependent variable and other is
independent. In the given case portfolio beta is the independent variable and return is
dependent upon beta. The linear relationship between the two is as follows:

y = 9.1685x + 6.216
Regression Line R² = 0.4334
30.00

25.00
Portfolio Return

20.00

15.00

10.00

5.00

-
Portfolio Beta
Summary Output

Regression Statistics
Multiple R 0.658359335
R Square 0.433437013
Adjusted R Square 0.36261664
Standard Error 4.826729971
Observations 10

ANOVA

df SS MS F Significance F
Regression 1 142.5849835 142.5849835 6.120230563 0.038475199
Residual 8 186.3785777 23.29732222
Total 9 328.9635612

Standard Lower Upper Lower Upper

Coefficients Error t Stat P-value 95% 95% 95.0% 95.0%
Intercept 6.2160 3.8930 1.5967 0.1490 -2.7614 15.1934 -2.7614 15.1934
X Variable 1 9.1685 3.7061 2.4739 0.0385 0.6223 17.7148 0.6223 17.7148

The results show us different statistics about the relationship between these variables. The
correlation between beta and return is 0.6583, it signifies that the relationship is reasonably
strong and directly proportional. It means that if there will be an increase in the risk of the
portfolio, its return will also increase. The coefficient of determination R2 describes the
percentage change in return caused by the beta. If return increase, then it can be said that
43.34% is caused by the beta. The adjusted R2 is a more reliable statistic as it eliminates other
factors that are not affecting the change in return. Adjusted R2 is 0.36, the standard error is
4.82 which is very high. The standard error is as good as standard deviation; it describes the
variability of actual returns from the predicted returns. The standard error of 4.82 signifies
that a predicted 15% return can go as high as 19.82% or as low as 10.18% in actual. Such a
huge range increases risk as it allows the possibility of a good expected portfolio turns bad in
actual. The regression equation is as follows:
 y = 9.1685x + 6.216

9.1685 is the slope of the equation, the value of beta will be multiplied with this figure to
arrive at the value of return where the constant value of 6.216 will be added every time. The
slope signifies the change in return due to the percentage change in the value of beta. The
other tables including ANOVA are used to conduct detailed analysis like T-test and F-test.

The capital asset pricing model (CAPM) ideally gives us an equation to determine the cost of
security. The equation is as follows:

𝑟𝑗 = 𝑟𝑓 +(𝑟𝑚−𝑟𝑓)𝛽𝑗
β = Covariance (Ri , RM ) / Variance (RM )

Where RJ is the weighted average return of the portfolio, rf is the risk-free return, rm is
market return, (rm-rf) is market risk premium and Bj is the beta. The CAPM equation
describes the relationship between the return with respect to beta and market risk premium.
The equation is exactly like a regression equation where the variables can be interpreted as
follows:

𝑟𝑗 = 𝑟𝑓 +(𝑟𝑚−𝑟𝑓)𝛽𝑗
Y = aX + B

Rj = Y

Rf = B

( rm – rf ) = a

Bj = X

However, there arises a confusion that what to consider as X and what an A. In case of
CAPM the return of a portfolio depends upon 2 factors – remarket premium and beta. What
to determine as the independent variable is a question, but the beta is more appropriate
through its identifiable characteristic (Gupta, 2012). The empirical test is to check whether
the market portfolio is efficient for a mean-variance or not. However, theoretically, it is very
difficult to determine. CAPM suggests that there is a positive relationship between beta and
rate of return. As a result of our analysis of portfolio from S&P500 securities which also
indicated a positive relationship between beta and return, it can be concluded that empirical
relevance of CAPM is valid in our case.
In this part of the question, I created 10 portfolios by combining 50 random shares from the
trading index into a single portfolio. For every portfolio, I am taking three considerations
which are total return, beta and market capitalization. Each portfolio includes the average of
their multiple shares in terms of beta and total return whereas the market capitalization is
taken out to be a sum of all the company’s shares. Then, I align the portfolio from the lowest
market capitalization to the highest one and take out the lowest 10 for further analysis as
required in the question. In this order, our first portfolio has the beta value of 0.82 and return
is 34.6% and 10th portfolio has a beta value of 0.97 and return of 6.75% respectively.

The beta of the Return on the

Portfolio Portfolio market-capital
portfolio portfolio
1 0.82 34.06 3,08,83,19,29,856
2 0.94 20.35 4,61,92,84,74,112
3 1.27 16.53 5,59,66,98,69,568
4 1.03 14.19 6,86,28,62,04,928
5 1.01 8.06 8,67,03,01,97,248
6 0.94 5.97 11,16,08,51,49,696
7 1.03 12.53 14,21,93,85,93,792
8 0.94 16.45 19,65,15,96,08,320
9 1.06 18.14 32,94,36,67,24,096
10 0.97 6.75 86,65,82,65,90,720

Correlation Analysis

Further, I applied the correlation analysis on the Beta of the portfolio and Return of the
portfolio in order to understand, if there any relationship between the two variables. Mukaka
(2012), defined correlation as the statistical method which signifies the degree of relationship
between the two variables, the +1 implies strong positive relation and -1 implies a strong
negative relation. Our correlation value came out to be -0.3112 which signifies there is
negative

the relationship between the two variables which are beta and return on the portfolio.

Correlation Matrix
Beta Return
Beta 1
Return -0.3112 1
Regression Analysis

In order to find a significant relationship between the beta and return of the portfolio, I
applied the linear regression analysis on the data. Ludbrook (2010) explains regression
analysis as the tool of providing a deeper understanding of the relationship between the two
variables, out of which one was taken to be as dependent and other independent variables.
Here, I took the portfolio return as dependent and portfolio beta as independent variables in
the analysis.

Regression Statistics
R Square 0.096848697
Standard Error 8.29651963
Observations 10
Significance F 0.381426566

1. R Square-: In the regression analysis, R square signifies the coefficient of

determination, which determines the goodness of fit criteria. It shows out of a number
of observations, how many points are falling on the regression line. Higher the R
square implies the good fit for the model. In my case, the R square is 0.09 which does
not indicate good fit. In other words, only 9% of the dependent variables in the y-axis
(Returns) can determine by independent value on the x-axis (Beta values).
2. Standard error-: It signifies the precision of the analysis. Higher the number in the
standard error, lower the precision in the variables. As the standard error is
8.29651963, the regression equation is uncertain.
3. Observations-: It is the number of observation used in the analysis. In my case, I
used the 10 portfolios for the analysis.
4. Significance F-: It determines how reliable the idea of the analysis conducted on the
variables. If the significance of F is greater than 0.05, then it is suggested to use a
different independent variable. In our case, the significance of F is 0.38 much higher
than the permissible limit of acceptance.

Hence, it can be concluded that the model does not hold any significance or states any
kind of relationship between the beta of the portfolio and the return of the portfolio.

Implications on the validity of CAPM

CAPM stands for the capital asset pricing model which was developed by William Sharpe.
CAPM assumes that even after the diversification some amount of risk is always present.
Therefore, it divides the risk into two parts viz. systematic and unsystematic risk.
Unsystematic risk can be mitigated through diversification whereas systematic cannot be
diversified. CAPM focuses on the systematic risk using beta which is a measure of systematic
risk. CAPM depicts the linear relationship between the beta of portfolios and the portfolio
returns. As per CAPM, the investor expects the market return over the risk-free rate of return
i.e. if the market rate of return is 10% and the risk-free rate is 3% then the investor would
expect a return of 7%. This rate of 7% is known as the market risk premium. Moreover, the
beta of the portfolio should also be considered i.e. if the portfolio is riskier than the market
then in such a case investor should expect a return higher than the market return and vice-
versa. For evaluating the validity of CAPM, I have used the cross-sectional test. Firstly, I
calculated the relation (RM – R0). R0 has been taken to be the rate of 20 years UK treasury
bonds which 1.63% (Bloomberg, 2019). Using Bloomberg’s data, I have arrived at the
following table.

Excess Return on the

Portfolio Beta of the portfolio
portfolio
1 0.82 32.43
2 0.94 18.72
3 1.27 14.90
4 1.03 12.56
5 1.01 6.43
6 0.94 4.34
7 1.03 10.90
8 0.94 14.82
9 1.06 16.51
10 0.97 5.12

Cross Sectional Test

35.00

30.00

25.00
Excess Return

20.00

15.00

10.00

5.00

0.00
0.00 0.20 0.40 0.60 0.80 1.00 1.20 1.40
Portfolio Beta
R² = 0.0968 y = -22.022x + 35.736
According to CAPM, there should be a linear relationship between return and beta of the
portfolio. This implies that higher beta portfolio should give higher returns and the lowest
beta portfolio should give the lowest returns. However, as depicted by the chart and table,
there is a negative relationship between the beta and return of the portfolio. Moreover, the
correlation between the return and beta is -0.3112 which means that the beta and return of the
portfolio are inversely related to each other. However, as per CAPM, there should be a
positive linear relationship between the return and beta. Therefore, it can be said that CAPM
does not hold valid in this case.

In comparison with the results obtained from part (a) of this exercise, it can be said that in
part (a) there is a positive relationship between the beta and the return of the portfolio
whereas in part (b) there is a negative relationship between the two. In part (a) the correlation
between the beta and the return of the portfolio is +0.6583. However, in the case of part (b),
the correlation between beta and return of the portfolio is -0.3112. Thus, it can be said that
CAPM holds valid when I sort the stocks on the basis of beta whereas CAPM does not hold
when it is sorted by the market capitalization of the stocks.
References
Bloomberg, 2019. United Kingdom Rates & Bonds. [Online]
Available at: https://www.bloomberg.com/markets/rates-bonds/government-bonds/uk
[Accessed 04 April 2019].

Gupta, N., 2012. The Size Effect and the Capital Asset Pricing Model. [Online]
Available at:
https://www.minneapolisfed.org/~/media/files/mea/contest/2010papers/gupta.pdf?la=en
[Accessed 4 April 2019].

Ludbrook, J., 2010. Linear regression analysis for comparing two measurers or methods of
measurement: but which regression?. Clinical and Experimental Pharmacology and
Physiology,, 37(7), pp. 692-699.

Mukaka, M., 2012. A guide to appropriate use of correlation coefficient in medical research.
Malawi Medical Journal, 24(3), pp. 69-71.