Portfolio Construction and Capm Testing
Introduction
The Capital Asset Pricing Model (CAPM) has been one of the most widely used techniques in the global investing community for calculating the required return of a risky asset. This project aims to test whether CAPM is a valid model for predicting the price/return of some selected companies listed on the S&P 500 Index. Also we investigate, whether there appear to be some deviations from the model and look for plausible reasons to explain these. For the purpose of the project, actual monthly returns of sample companies listed on NYSE for the period July 2008 to June 2013 are compared with the CAPM based (predicted) returns for the corresponding time period. The benchmark for the risk free rate Rf is taken as USA 5 year Treasury Bill Return corresponding to the relevant monthly time periods. For estimating market return R , changes in the S&P 500 index for each relevant time period is used. Stability tests are also conducted to assess the consistency of results over the entire range of data.
The conclusions arrived at through data analysis might lead to useful recommendations about how and to what extent CAPM can be used as tool for predicting stock returns and facilitating investment decisions.
Theoretical Background & Literature Review
CAPM developed by Sharpe (1964), Lintner (1965) and Mossini (1965) builds upon the “Portfolio Theory” introduced by Harry Markowitz (1959). CAPM presents the basis for determining the required rate of return on all risky assets. CAPM theory is built upon the assumptions of the Portfolio Theory plus some additional ones. The major factor that allowed Portfolio Theory to develop into CAPM Theory is the concept of the risk free asset. The inclusion of the risk free asset resulted in the derivation of a Capital Market Line (CML) which was referred to as the new efficient frontier. Assumptions of the CAPM model are:
1) Investors evaluate portfolios taking into account the expected rate of return and standard deviation
The Capital Asset Pricing Model (CAPM) has been one of the most widely used techniques in the global investing community for calculating the required return of a risky asset. This project aims to test whether CAPM is a valid model for predicting the price/return of some selected companies listed on the S&P 500 Index. Also we investigate, whether there appear to be some deviations from the model and look for plausible reasons to explain these. For the purpose of the project, actual monthly returns of sample companies listed on NYSE for the period July 2008 to June 2013 are compared with the CAPM based (predicted) returns for the corresponding time period. The benchmark for the risk free rate Rf is taken as USA 5 year Treasury Bill Return corresponding to the relevant monthly time periods. For estimating market return R , changes in the S&P 500 index for each relevant time period is used. Stability tests are also conducted to assess the consistency of results over the entire range of data.
The conclusions arrived at through data analysis might lead to useful recommendations about how and to what extent CAPM can be used as tool for predicting stock returns and facilitating investment decisions.
Theoretical Background & Literature Review
CAPM developed by Sharpe (1964), Lintner (1965) and Mossini (1965) builds upon the “Portfolio Theory” introduced by Harry Markowitz (1959). CAPM presents the basis for determining the required rate of return on all risky assets. CAPM theory is built upon the assumptions of the Portfolio Theory plus some additional ones. The major factor that allowed Portfolio Theory to develop into CAPM Theory is the concept of the risk free asset. The inclusion of the risk free asset resulted in the derivation of a Capital Market Line (CML) which was referred to as the new efficient frontier. Assumptions of the CAPM model are:
1) Investors evaluate portfolios taking into account the expected rate of return and standard deviation