Professor Paolo Vitale Capital Markets

Revision Questions and Classwork: The Empirical Analysis of Asset Returns Academic Year 2018-2019

Revision Question 1
Briefly explain which conditions may be tested using time-series and cross-section methods to verify the
validity of the CAPM.

Revision Question 2
Explain how the OLS methodology can be employed to test the validity of the CAPM using time-series
data on the returns of risky assets and the market portfolio.

Revision Question 3
Present the main elements of the test of the validity of the CAPM based on cross-section methods.

Revision Question 4
Present Black’s empirical study on the validity of the CAPM. In particular, illustrate both the method he
used and the results he obtained.

Revision Question 5
Describe betting-against-beta strategies and their relation to Black’s evidence on the validity of the CAPM.

Revision Question 6
Discuss Roll’s critique to the empirical analysis of the CAPM.

Exercise 1
Suppose you estimate the index model on two stocks, L and H, using OLS. Assume you find that the
corresponding intercept and slope coefficients are respectively α L = 0.03, β L = 0.6 and α H = −0.04,
β H = 1.2. Explain how you can exploit these values using a long/short investment strategy. In particular,

a. Find a dollar-neutral and market-neutral portfolio made of the two assets and the risk-free one.
b. Find the expected return on such a portfolio.
c. How does the answer to b. change if to short-sell any of the two risky assets you need to pay fee
corresponding to a lending rate of 2%?

Exercise 2
Asset TradeM possesses expected return equal to 12% and β equal to 1. Asset BitA possesses expected
return equal to 13% and β equal to 1.5. The return on the market portfolio is equal to 11%, while the
risk-free is 5%.

1. According to the CAPM which asset should you purchase?

2. Draw the security market like and indicate where the two assets are placed in the plane you use to
represent the security market like.
Revision Questions and Classwork: The Empirical Analysis of Asset Returns (Part 1) Capital Markets

SOLUTIONS

Exercise 1
You will hold a portfolio which is long in L and short in H to exploit the positive alpha of the former and
the negative one of the latter.

a. Assume that you form portfolio z assigning weights w L and w H to the two risky assets and −w L − w H
to the risk-free one. Notice that in this way this is a zero-dollar portfolio as the sum of the weights is
zero. In addition consider that the beta of the risk-free asset is obviously zero and hence that the beta
for portfolio z is w L β L + w H β H . If you want a market-neutral portfolio you must impose the condition
that w L β L + w H β H = 0, so that w L = − βHL w H . Then, choose w H = − 21 , so that w L = − 1.2 1
β
0.6 × (− 2 ) = 1.
The weight of the risk-free asset is −1 − (− 21 ) = − 21 . In brief, a portfolio z which is dollar-neutral
and market-neutral could be as follows (or any multiple): long $1,000 of asset A and short $500 each
of asset H and the risk-free one.
b. With no frictions
1 1
E[r̃z ] = 1 · E[r̃ L ] − · E[r̃ H ] − · r f ,
2 2
where r f is the risk-free rate. Now,

E[r̃ H ] = r f + α H + β H ( E[r̃m ] − r f ) ,

E[r̃ L ] = r f + α L + β L ( E[r̃m ] − r f ) .

Thus, substituting we find that

   
1 1
E[r̃z ] = 1 · α L − · α H + 1 · β L − · β H ( E[r̃m ] − r f )
2 2
| {z }
βz = 0
 
 1 
= 
1| ·{z
0.03} − · (−0.04) = 0.05 .
2 {z
>0 | }
>0

c. In this case we just need to subtract the lending fee. This is given by the percentage of capital sold
1
short times the lending rate, so that from the previous expected return we need subtracting 2 0.02 =
0.01. The net expected return is hence 4%.

Exercise 2

1. Asset TradeM (BitA) possesses an expected return which is above (below) the equilibrium value
prescribed by the CAPM. In particular, using the index model,

E[r̃ ] − r f = α + β( E[r̃ M ] − r f ) .

we conclude that

αTradeM = (0.12 − 0.05) − 1 · (0.11 − 0.05) = 0.01 ,

αBitA = (0.13 − 0.05) − 1.5 · (0.11 − 0.05) = −0.01 .

2
Revision Questions and Classwork: The Empirical Analysis of Asset Returns (Part 1) Capital Markets

2. Since TradeM’s (BitA’s) alpha is positive this is asset is above (below) the SML, as shown in the Graph.

!
E

αBitA
0.13 TradeM BitA
0.12
αTradeM
0.11

0.05

"
1 1.5 β

Figure 1: The SML for assets TradeM and BitA in Exercise 2.