1- Perform the first-pass regressions and tabulate the summary statistics.

The table should include

the Alpha (coefficient and t-statistic/p-value), Beta (coefficient and t-statistic/p-value) and R-
square for each stock.

Parameter A B C D E F G H I
Average Return 5.18% 4.19% 2.75% 6.15% 8.05% 9.90% 11.32% 13.11% 22.83%
Alpha 0.09 -0.01 -0.01 -0.05 0.01 -0.05 0.06 -0.02 0.06
Alpha T Test 0.73 -0.04 -0.06 -0.41 0.05 -0.45 0.33 -0.27 0.64
Alpha P Value 48.45% 96.99% 95.71% 68.77% 95.83% 65.90% 75.13% 79.62% 53.85%
Beta -0.47 0.59 0.42 1.38 0.90 1.78 0.66 1.91 2.08
Beta T test -0.81 0.78 0.78 2.42 1.42 3.83 0.78 4.51 4.81
Beta P value 43.44% 45.32% 45.58% 3.58% 18.57% 0.33% 45.29% 0.11% 0.07%
R2 6.22% 5.74% 5.68% 37.02% 16.80% 59.45% 5.75% 67.06% 69.80%
All Alpha P-values are insignificant and only 4 stocks (D, F, H and I) have significant Beta values.

2- Specify the hypotheses for a test of the second-pass regression for the SML. That is, state what
are the null hypothesis for intercept and slope if the CAPM is correct.
 Null Hypothesis for Intercept: Alpha/intercept equal to zero
 Null Hypothesis for slope: Risk premium %/slope equal to ‘average Market index=8.12%’

3- Perform the second-pass SML regression by regressing the average excess return of each
Portfolio on its beta and report the regression output.

Regression Statistics
Multiple R 0.707440357
R Square 50.05%
Adjusted R Square 0.429110695
Standard Error 0.046234328
Observations 9

ANOVA
df SS MS F Significance F
Regression 1 0.01499156 0.01499156 7.013224515 0.033025512
Residual 7 0.014963292 0.002137613
Total 8 0.029954852

Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept 0.039229987 0.025417292 1.543436958 16.66% -0.020872357 0.099332331 -0.020872357 0.099332331
Risk Premium in % 5.21% 0.019655756 2.64824933 3.30% 0.005574865 0.098531819 0.005574865 0.098531819

4- Summarize your test results and compare them to the results reported in the text. That is, are
the null hypotheses accepted or rejected and how do these finding compare to earlier tests by
Linter, Black Jensen and Scholes, and Fama and McBeth. To do so, first comment on just the
magnitude of the coefficient to its hypothesized value. Then, discuss statistical significance for
each null. You may have to calculate addition t-tests than are on the regression output.
 Coefficients T Stat P-value Results
Don’t have enough evidence to
Intercept = Gemma-not 0.039229987 1.543436958 16.66% Reject Null Hypothesis = Fail to
reject Null Hypothesis
Gemma One= Risk Premium 5.21% 2.64824933 3.30% Reject Null Hypothesis

 Ideally intercept should be equal to zero and since this value is not equal to zero then has it raised
question about validity of CAPM theory, but we also must look its statistical significance. As per
P-value and T-test, this value is not statistically significant. Hence, we don’t have enough evidence
to reject null hypothesis (that intercept is zero) which is a Pass for CAPM.
 Ideally risk premium should be equal to Average risk premium (8.12%) and since this value is not
equal to 8.12% then it raises question about validity of CAPM theory. Also, by looking at the
statistical data, this value is significant thence we can reject null hypothesis which is a fail for
CAPM.

Above results shows that CAPM is rejected and it corresponds more to Linder theory. But Linter theory
doesn’t consider the fact that Beta estimation is done through stock returns which are highly volatile in
each year. For example. Average volatility of each stoke in 12 years is shown as reference and it very high.
Therefore, considering only Excess return of each individual stock is not a good strategy to empirically test
CAPM.

Market Index A B C D E F G H I
Average Return 8.12% 5.18% 4.19% 2.75% 6.15% 8.05% 9.90% 11.32% 13.11% 22.83%
STD 20.74% 39.12% 51.39% 36.27% 47.01% 45.60% 47.79% 57.37% 48.40% 51.69%

Beta Vs. Average Excess Returns

25.00%

20.00%

y = 0.0521x + 0.0392
15.00% R² = 0.5005
H
G
10.00% F
E
D
A 5.00%
B
C

0.00%
-1.00 -0.50 0.00 0.50 1.00 1.50 2.00 2.50
 5- Group the nine stocks into three portfolios, maximizing the dispersion of the betas of the three
resultant portfolios. Repeat the tests above and explain any changes in the results. Note, you
should have fewer observations for the second pass this time.

 When we made portfolios by combining different stocks. Stocks were combined based on the
Beta’s. Lower Beta stocks were stacked in one portfolio while higher Beta stock were assembled
in another portfolio. When results were plotted and performed regression analysis, then results
were quite opposite to what we found in previous questions. We gave equal weightage to every
stock in portfolio.
 Here, results were amazing that not only R2 improved near to 100% but also slope coefficient
(6.47%) were closer to the ‘average market index (8.12%)’. Significance of slope coefficient
increased substantially as compared to previous results. While intercept coefficient is still
insignificant as P-value is 13.79% vs. confidence level of 5%
 This result shows that CAPM actually holds, it’s just that linter performed a bad test to empirically
test CAPM.

Portfolio Name B J S
Weights 33.33% 33.33% 33.33% 33.33% 33.33% 33.33% 33.33% 33.33% 33.33%
Stock Name A C B G E D F H I
Beta -0.47 0.42 0.59 0.66 0.90 1.38 1.78 1.91 2.08
Average return 5.18% 2.75% 4.19% 11.32% 8.05% 6.15% 9.90% 13.11% 22.83%

Equally weighted Portfolio " Beta's Vs. Excess Returns)

Portfolio Name B J S
Portfolio Beta 0.18 0.98 1.92
Portfolio Return 4.04% 8.51% 15.28%
Portfolio STD 19.30% 29.47% 43.96%

Regression Statistics
Multiple R 0.997468126
R Square 99.49%
Adjusted R Square 0.989885324
Standard Error 0.005692868
Observations 3

ANOVA
df SS MS F Significance F
Regression 1 0.006375853 0.006375853 196.7324863 0.045311439
Residual 1 3.24087E-05 3.24087E-05
Total 2 0.006408262

Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept 2.62% 0.005770625 4.545229223 13.79% -0.047093932 0.099551562 -0.047093932 0.099551562
Portfolio Beta 6.47% 0.004612582 14.02613583 4.53% 0.00608829 0.123305103 0.00608829 0.123305103
 Equally weighted Portfolio " Beta's Vs. Excess Returns)
18.00%
16.00% y = 0.0647x + 0.0262 S
14.00% R² = 0.9949
Equally weighted average

12.00%
Excess Return

10.00%
8.00% J

6.00%
4.00% B
2.00%
0.00%
-0.50 0.00 0.50 1.00 1.50 2.00 2.50
Equally weighted average Beta

6- Explain Roll’s critique as it applies to the tests performed in Problems 3 to 7?

Since there must be a COMPLETELY diversified portfolio - against which we can measure covariance of
any individual stock – is important condition in CAPM. As per Roll’s, no such portfolio exits in real world,
therefore testing CAPM is not a good idea as you are only testing it against your supposed Proxy, not
against IDEAL FULLY Diversified Portfolio.

7- Plot the capital market line (CML), the nine stocks, and the three portfolios on a graph of average
returns versus standard deviation. Compare the mean-variance efficiency of the three portfolios
and the market index. Does the comparison support the CAPM?

We summarized the Expect return and Volatility of the market, 3 portfolios from Question 5 and nine
stocks given in the case and plotted on a graph:

Capital assets/stocks below the CML are less mean-variance efficient than the ideal market index. Under
CAPM, the market index is the most mean-variance efficient portfolio and all other portfolios or bonds
or individual stocks should be below the CML. However, in our graph we had “stock I” above the CML,
which indicates that this comparison did not support CAPM theory.

Parameters Individual Stock Portfolios

Market
A B C D E F G H I P1 P2 P3
Average Return 5% 4% 3% 6% 8% 10% 11% 13% 23% 4% 9% 15% 8.12%
STD 39% 51% 36% 47% 46% 48% 57% 48% 52% 19% 29% 44% 20.74%
However, if we back-trace Q5 graph made with portfolio’s, then we will get to know that back-traced line
will cut Vertical axis about at 3%. Therefore, we are assuming 3% Risk free rate and given another graph
below. Another way to find our Risk free rate is by using solver by shorting some stock and find out
appropriate risk free value like we did in case 2.

Average Return vs. Volatility

25%

20%
Average Return

y = 0.2469x + 0.03
15% R² = 1P3
H
G
10% F
Market P2 E
D
5% A
P1 B
C

0%
0% 10% 20% 30% 40% 50% 60% 70%

Volatility (%)
Individual Stock Portfolios Market Linear (Market)