Econometric Analysis of Capm
Prepared by:
Lok Kin Gary Ng, contact email: gary_ng_@hotmail.com
May, 2009
School of Economic
Introduction
The analysis of this paper will derive the validity of the Fama and French (FF) model and the efficiency of the Capital Asset Pricing Model (CAPM). The comparison of the Fama and French Model and CAPM (Sharpe, 1964 & Lintner, 1965) uses real time data of stock market to practise its efficacy. The implication of the function in realistic conditions would justify the utility of the CAPM theory. The theory suggests that the expected return demanded by investors on a risky asset depends on the risk-free rate of interest, the expected return on the market portfolio, the variance of the return on the market portfolio, and the covariance of the return on the risky asset with the return on the market portfolio. (Peirson et al, 2007)
CAPM can be express as a function; rprf = ∫(rmrf)
There is an anticipate relationship between the expected return and risk for the portfolio; a risk factor, observed based on finance and economic theory (Peirson et al, 2007). This relationship can explain the demand on investing in the financial market; under the economic principle of profit maximization; if the return on investment is greater then interest rate, then people would favor investment (Peirson et al, 2007).
Under the CAPM theory, the expected return on investment can be express as;
E(Rp) = Rf + (E(Rm) –Rf) Cov(Rp,Rm) ((m)2
The CAPM risk factor can be estimated with this empirical equation. The risk associate with the CAPM can be divided into two categories; company specific factors (unsystematic risk) and market-wide factors (systematic risk). In order to minimise the risk and fluctuation effect on market, a portfolio of five stocks are choose to stabilise the flux effect and eliminate the unsystematic risk (Peirson et al, 2007).
In 1996, Fama and French (1996) suggested an alternative asset pricing model (AAPM) that extended the
Lok Kin Gary Ng, contact email: gary_ng_@hotmail.com
May, 2009
School of Economic
Introduction
The analysis of this paper will derive the validity of the Fama and French (FF) model and the efficiency of the Capital Asset Pricing Model (CAPM). The comparison of the Fama and French Model and CAPM (Sharpe, 1964 & Lintner, 1965) uses real time data of stock market to practise its efficacy. The implication of the function in realistic conditions would justify the utility of the CAPM theory. The theory suggests that the expected return demanded by investors on a risky asset depends on the risk-free rate of interest, the expected return on the market portfolio, the variance of the return on the market portfolio, and the covariance of the return on the risky asset with the return on the market portfolio. (Peirson et al, 2007)
CAPM can be express as a function; rprf = ∫(rmrf)
There is an anticipate relationship between the expected return and risk for the portfolio; a risk factor, observed based on finance and economic theory (Peirson et al, 2007). This relationship can explain the demand on investing in the financial market; under the economic principle of profit maximization; if the return on investment is greater then interest rate, then people would favor investment (Peirson et al, 2007).
Under the CAPM theory, the expected return on investment can be express as;
E(Rp) = Rf + (E(Rm) –Rf) Cov(Rp,Rm) ((m)2
The CAPM risk factor can be estimated with this empirical equation. The risk associate with the CAPM can be divided into two categories; company specific factors (unsystematic risk) and market-wide factors (systematic risk). In order to minimise the risk and fluctuation effect on market, a portfolio of five stocks are choose to stabilise the flux effect and eliminate the unsystematic risk (Peirson et al, 2007).
In 1996, Fama and French (1996) suggested an alternative asset pricing model (AAPM) that extended the
References: Ball, R, (1978). ‘Anomalies in Relationships Between Securities ' Yields and Yield-Surrogates.’ Journal of Financial Economics, Vol. 6, No. 2, p103-26, viewed 16th April, 2009, Basu, S, (1977) Fama, EF, and. French, KR, (1996), ‘Multifactor Explanations of Asset Pricing Anomalies’, Journal of Finance, Vol. 51, No. 1, March, p55-84. Viewed 25th of March, 2009, Fama, EF, and HKSAR, (1999), ‘HKSAR – The Key Issues 1998/99’, viewed 5th May, 2009, Lintner, J Markowitz, H. (1959). ‘Portfolio Selection: Efficient Diversification of Investment’. Cowles Foundation Monograph No. 16. New York: John Wiley & Sons, Inc. Peirson, G, et al (2007), ‘Chapter 7 Portfolio Theory and Asset Pricing’, Business Finance, 9th ed., McGraw-Hill, Australia, p186-219 Sharpe, WF Verbeek, M., (2008), A Guide to Modern Econometrics, 3rd ed., Chichester UK and New York, Wiley. Data Sources French, KR, (2009) ‘Country Portfolios formed on B/M, E/P, CE/P, and D/P [ex RBA, (2009) ‘Cash Rate - Overnight - Interbank - Securities and Interbank Overnight Cash Rate’ viewed 14th of April, 2009, Yahoo7, (2009a) ‘^ALFI: Historical Prices for S&P/ ASX 50 – Yahoo!7 Finance’, viewed 14th of April, 2009, Yahoo7, (2009b) ‘^AORD: Historical Prices for ALL ORDINARIES – Yahoo!7 Finance’, viewed 14th of April, 2009, Yahoo7, (2009c) ‘^AXSO: Historical Prices for S&P/ ASX SMALL ORDINARIES – Yahoo!7 Finance’, viewed 14th of April, 2009, Yahoo7, (2009d) ‘MEO.AX: Historical Prices for MEO AUST FPO – Yahoo!7 Finance’, viewed 14th of April, 2009, Yahoo7, (2009e) ‘NXS.AX: Historical Prices for NEXUS FPO – Yahoo!7 Finance’, viewed 14th of April, 2009, Yahoo7, (2009f) ‘PRT.AX: Historical Prices for PRIME TV FPO – Yahoo!7 Finance’, viewed 14th of April, 2009, Yahoo7, (2009g) ‘SGM.AX: Historical Prices for SIM METAL FPO – Yahoo!7 Finance’, viewed 14th of April, 2009, Yahoo7, (2009h) ‘UGL.AX: Historical Prices for UNITED GRP FPO – Yahoo!7 Finance’, viewed 14th of April, 2009, Appendices |rmrf |1.554 |(0.3738)* | |constant |0.0176 |(0.0098) | |rmrf |1.6402 |(0.3843)* | |smb |0.6994 |(0.4070) | |hml |0.2195 |(0.3115) | |constant |0.0154 |(0.0098) |