Econometric Analysis of Capm

Eugene Fama, Heteroscedasticity, Efficient-market hypothesis

Prepared by:

Lok Kin Gary Ng,
contact email:

May, 2009

School of Economic

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)

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...
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