The Capital Asset Pricing Model
One common use of the CAPM is as a descriptive tool where the following equation
E(r) = rf + ß [ E(rm) – rf ]
is interpreted as a forecast of expected asset returns.
The coursework project
The purpose of the project is to test validity of the CAPM using monthly close data. The steps in the test are as follows:
1. Determine a candidate for the market portfolio m by picking a stock index of your choice. You can pick an index of your choice. Then choose a minimum of 15 stocks in that market for the purpose of the test. Make sure that your set of stocks doesn’t overlap with those of any other group. Then download the daily historical prices from 1st of Jan. 2007 to 1st of Sep. 2015.
2. For each of the assets making up the index, determine the beta by linear regression.
3. Regress the mean returns of the assets on their respective betas, .
4. If the CAPM in its interpretation above holds, then the equation obtained in step 3 should be the Security Market Line. To evaluate whether this is the case
a. Compare to the average risk-free rate over the period, which is what it should correspond to.
b. Compare to what it should correspond to: , where is the average risk-free rate over the period.
c. Calculate and the t-statistic of the regression to evaluate its statistical significance.
5. Analyse, reflect on, and discuss your results. Critically analyse the theory in light of the results. Formulate your findings.
6. Create relevant charts to illustrate your findings.
Requirements and assessment
? The project should be reported in a written report intended for a professional audience. Your report should contain sections such as
• Abstract – summarising contents and conclusions
• Background/Introduction – with references to relevant sources
• Methodology – describing the methodology used for the project
• Analysis and Findings
• Conclusions and Recommendations
? Calculations and data should be supplied in appendices.
? If it is required you need to prepare a presentation to be presented and discussed in class.
? Submission date will be communicated separately.
Assessed elements of your report:
Marker’s Comments: Mark:
Clarity of explaining the CAPM and its assumptions. References to relevant sources.
(out of 20)
Depth of understanding of the statistical testing procedure in all its aspects. In depth description of the practical procedure and the plan for the work.
(out of 15)
Accurate application of quantitative methods. Accuracy of data interpretation and handling. Accurate statistical interpretation of test results.
(out of 35)
FINDINGS AND CONCLUSIONS
Clear evidence of reflection on findings in light of theory and assumptions; individual judgments supported by sound arguments.
(out of 20)
Effective structure and referencing; observed good writing style and use of language; Effective use of tables, graphs and appendices.
(out of 10 )