CAPM econometric formula, implications and imperical evidence
Capital Assed Pricing Model, widely known as CAPM is essentially an equilibrium relationship between expected return and risk of an asset and that is used in the pricing of risky securities. CAPM is the result of William Sharpe (1964) and John Lintner (1965). Sharpe took the Nobel prize in 1990 for the asset pricing theory. CAPM is used for a range of applications and purposes, these include estimating the cost of equity capitals for firms as well as evaluating the performance of managed portfolios. Sharpe and Lintner have made 2 underlying assumptions for developing CAPM;
1. There exists a risk-free asset that investors may borrow or lend any amount of at the same rate.
2. Investors assign the same probability distributions to the end of period values of a given asset.
This implies that investors have homogenous expectations regarding means, variances and covariances.
CAPM has in summary, 2 main implications; there is a centre role for the market portfolio and there is explicit risk-return trade off for individual socks.
1. Centre role for the market portfolio- This basically simplifies the portfolio selection. It also provides a rationale for market indexing investment strategy.
2. Risk-return trade off for individual stocks- This signifies that the model specifies expected returns for use in capital budgeting, valuation, and regulation. Risk premium on an individual security is a function of its systematic risk, measured by the covariance with the market. This entails that we can use the model to evaluate given estimates of expected returns which is relative to risk and we can obtain estimates of expected returns through the estimates of risk. (Statistically speaking, this is more precise as opposed to obtaining direct estimates of expected returns based on averages of past returns).
The econometric formulation for testing CAPM. First of all, the most basic and widely used and known test is the CAPM equation; Eri= rf +bi (ERm
1. There exists a risk-free asset that investors may borrow or lend any amount of at the same rate.
2. Investors assign the same probability distributions to the end of period values of a given asset.
This implies that investors have homogenous expectations regarding means, variances and covariances.
CAPM has in summary, 2 main implications; there is a centre role for the market portfolio and there is explicit risk-return trade off for individual socks.
1. Centre role for the market portfolio- This basically simplifies the portfolio selection. It also provides a rationale for market indexing investment strategy.
2. Risk-return trade off for individual stocks- This signifies that the model specifies expected returns for use in capital budgeting, valuation, and regulation. Risk premium on an individual security is a function of its systematic risk, measured by the covariance with the market. This entails that we can use the model to evaluate given estimates of expected returns which is relative to risk and we can obtain estimates of expected returns through the estimates of risk. (Statistically speaking, this is more precise as opposed to obtaining direct estimates of expected returns based on averages of past returns).
The econometric formulation for testing CAPM. First of all, the most basic and widely used and known test is the CAPM equation; Eri= rf +bi (ERm