Capm Is a Model

CAPM is a model which enables investors to determine the expected return from a risky security. It observes the relationship between the risk of an asset (Mobil Oil) and its return. The model uses Beta as the main measure of risk. This model works under the following situations: • In a perfectively competitive market where they are many price-takers’ investors, who have a small market share each. • Investors behaviour is myopic • Also investments included in the model are publicly traded financial assets such as bonds and stocks. Investors borrow or lend at a risk free rate. Investors have no transactions cost and do not pay taxes on returns • All investors in the market are rational mean variance optimisers. • Finally, investors have homogenous expectations which imply that they analyse securities in the same way, share the same economic view of the world, therefore they share identical estimates of probability distributions of cash flows.

Beta shows the relationship between the expected return of a stock and the return of the financial market as a whole. In relation to this project, it measures the elasticity of Mobil’s Oil returns in relation to the market index. It is calculated as:

Beta (Mobil) = Covariance (Return of Mobil oil, Return of Market) / Variance (Return of Market).

Using Linear least squares, the estimated beta is the same as that calculated using Regression analysis on Excel. Estimated Beta is 0.714 which implies that the total return of Mobil Oil’s stock is likely to move up and down 71.4% of the time when the market changes. As 0.714 < 1, Mobil Oil’s stock is less volatile than the overall Market Portfolio.

Due to CAPM being a simplified model, Beta has to be tested to see if this Beta value for Mobil Oil (0.714) is accurate. By this, I tested if there is a relationship between Mobil’s Oil Return and the Market. H0: hypothesised slope=0. An alternative hypothesis is that there is a relationship between Mobil