Capital Asset Pricing Model (CAPM)

A Case from Chinas Stock Market

CAPM: A great innovation in the field of finance
invented by William Sharpe (1963 1964)
and John Lintner (1965 1969)
Objectives:

1.The expression and meaning of the CAPM

2.The methodology used to test the CAPM

1. The Expression and Implication of the CAPM
The CAPM quantifies tradeoff between risk and
expected return and yields the following
expression:

E(R
i
) = R
f
+ [E(R
m
) R
f
]|
I



( )
2
) (
/ , cov
Rm m i i
R R o | =
1.The Expression and Implication of CAPM
The essence of CAPM is that the expected
return on any asset is a positive linear
function of its beta and that beta is the only
measure of risk needed to explain the
cross-section of expected returns.
The spirit of CAPM is . No , no CAPM.
| |
2. Methodology: Fama-MacBeth Approach
The basic idea of the approach is the use of a time
series (first pass) regression to estimate betas and
the use of a crosssectional (second pass)
regression to test the hypothesis derived from the
CAPM.

2. Methodology: Fama-MacBeth Approach
Step 1 (First-Pass Regression):
For each of the N securities included in the sample, we
first run the following regression over time to estimate
beta:


Step 2 (Second-Pass Regression)
We run the following cross-section regression over the
sample period over the N securities:



(1)
i mt i i it
R R q | o + + =
(2)
3
2
2 1 0 it ei t i t i t t it
S R q | | + + + + =
2. Methodology: Fama-MacBeth Approach
1). should not be significantly different from
zero, or residual risk does not affect return.
2). should not be significantly different from
zero, or the expected return on any asset is a
positive linear function of its beta.
3). must be more than zero: there is a positive
price of risk in the capital markets, namely, a
positive relationship exists between systematic
risk and expected return.


3

2

1