CAPM
Question Two
In this question, with the data provided we estimate each portfolio’s security characteristic line (SCL) and obtain an estimate of its true beta coefficient; then we use the findings to estimate and plot the Security Market Line (SML). In doing so, we have two purpose to fulfill. First, demonstrating the fact that the total variance of a portfolio approaches the systematic variance as diversification increases, which means diversifying across industries offer benefit over diversifying within a given industry. Second, using the figures estimated to testify that the CAPM works in practice.
The capital asset pricing model (CAPM) provides us with an insight into the relationship between the risk of an asset and its expected return. This relationship serves two significant functions. First, it provides a benchmark rate of return for evaluating possible investments. Second, the model helps us to make an educated guess as to the expected return on asset that have not yet been traded in the marketplace. Although the CAPM is widely used because of the insight it offers, it does not fully withstand empirical tests. CAPM is a one-period model that treats a security’s beta as a constant, but beta can be changed in respond to firms investment in new industry, change in capital structure and so on. If betas change over time, simple historical estimates of beta are not likely to be accurate. Mismeasuring of betas will not reflect stocks’ systematic risk, so in this case the CAPM does not compute the risk premium correctly. Furthermore, the systematic risk, the source of risk premiums, cannot be confined to a single factor. While the CAPM derived from a single-index market cannot provide any insight on this.
The data we used provides us with 5-year period (60 observations) monthly returns for 48 industry portfolios, the excess return on a broad market index and the one-month (risk-free) Treasury bill rates. In order to better illustrate the methodological
In this question, with the data provided we estimate each portfolio’s security characteristic line (SCL) and obtain an estimate of its true beta coefficient; then we use the findings to estimate and plot the Security Market Line (SML). In doing so, we have two purpose to fulfill. First, demonstrating the fact that the total variance of a portfolio approaches the systematic variance as diversification increases, which means diversifying across industries offer benefit over diversifying within a given industry. Second, using the figures estimated to testify that the CAPM works in practice.
The capital asset pricing model (CAPM) provides us with an insight into the relationship between the risk of an asset and its expected return. This relationship serves two significant functions. First, it provides a benchmark rate of return for evaluating possible investments. Second, the model helps us to make an educated guess as to the expected return on asset that have not yet been traded in the marketplace. Although the CAPM is widely used because of the insight it offers, it does not fully withstand empirical tests. CAPM is a one-period model that treats a security’s beta as a constant, but beta can be changed in respond to firms investment in new industry, change in capital structure and so on. If betas change over time, simple historical estimates of beta are not likely to be accurate. Mismeasuring of betas will not reflect stocks’ systematic risk, so in this case the CAPM does not compute the risk premium correctly. Furthermore, the systematic risk, the source of risk premiums, cannot be confined to a single factor. While the CAPM derived from a single-index market cannot provide any insight on this.
The data we used provides us with 5-year period (60 observations) monthly returns for 48 industry portfolios, the excess return on a broad market index and the one-month (risk-free) Treasury bill rates. In order to better illustrate the methodological