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# week5 - incorrect ●(2 Difficult to judge whether CAPM is...

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Week 5 Asset pricing models (2)

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Testing CAPM CAPM relates expected returns to betas, i.e. It is a theory about what determines returns on average CAPM says: Linear relationship between average returns and beta Relationship has intercept = r f and slope = equity risk premium No other variable beside beta affects average returns
Evidence on CAPM Testing the CAPM Measure each stock's historical beta over some time period t Measure stock return over next period t+1 Relate return to historical beta R it+1 – r ft+1 = intercept + slope x β it + residual it+1 Repeat – get track record of measured relationship between return and β Find average intercept, average slope

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Evidence on CAPM Results Measured relationship between average return and beta is weak Measured relationship (measured Security Market Line) has intercept above theoretical intercept; slope below theoretical slope Other variables (e.g., size, book-to-market) have stronger relationship with average return
Interpreting the evidence (1) CAPM theory is correct, evidence

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Unformatted text preview: incorrect ● (2) Difficult to judge whether CAPM is correct or incorrect ● (3) CAPM theory is incorrect, need an improved theory Multifactor CAPM ● Intuition for simple CAPM: – Return has systematic and unsystematic components ● R i – r f = α i + (r m – r f ) β i + residual i ● = α i + F 1 β i + residual i – Expected return depends only on sensitivity to source of systematic return F 1 (Security Market Line) ● E(r i ) = r f + ( E(r m ) – r f ) β i = λ + λ 1 β i Multifactor CAPM ● More generally – Return has systematic and unsystematic components ● R i – r f = α i + F 1 β 1i + F 2 β 2i + F 3 β 3i + residual i – Expected return depends only on sensitivity to sources of systematic return F1, F2, F3, etc. (Security Market Plane) ● E(r i ) = λ + λ 1 β 1i + λ 2 β 2i + λ 3 β 3i What are the factors F? ● Macroeconomic factors ● Statistical factors ● Fundamental factors ● Examples...
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week5 - incorrect ●(2 Difficult to judge whether CAPM is...

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