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MSc Banking & Finance

MSc in Banking and Finance, Module 10, Research Exercises

Sample Solution for Assignment 3: CAPM: Theory and Evidence

Part b: Reproducing Statistical Results

Lecturer: Fabio Sigrist

Literature reference: Fama, E. F., French, K. R. (2004). The Capital Asset Pricing Model: Theory and
Evidence. Journal of Economic Perspectives. 18 (3), p. 25–46.


𝑆𝑆𝑅𝑅𝐷𝐷𝐷𝐷𝐷𝐷 = = 0.0070
𝑆𝑆𝑅𝑅𝑆𝑆𝑆𝑆500 = = 0.0044
𝑆𝑆𝑅𝑅𝑀𝑀𝑀𝑀𝑀𝑀 = = 0.0123
The (daily) Sharpe ratio is highest for the broad US stock market index and lowest for the Magellan


There exists a very strong positive linear relationship between the excess return on the
S&P500 and the Magellan Fund. (So far, that’s good news for the CAPM and for a simple
linear regression analysis.)

b) You should get the following two tables.

i. The excess return of the S&P500 „explains“ about 95% of the variance of Magellan‘s ex-
cess return. So almost all of the variation in the fund‘s return are explained by the model.

ii. If the S&P500 increases (decreases) by 1 percent, the Magellan Fund increases (de-
creases) by an estimated average of 1.07 percent. The coefficient is highly significant
(different from 0), as the p-value shows (Sig.=0.000).

iii. Since the degrees of freedom are very big (T − 2 = 2519 − 2), the test statistic is approxi-
mately normally distributed (t-distributed with 2517 df).
𝛽𝛽̂1 − 𝛽𝛽𝐻𝐻𝐻𝐻 1.070 − 1
𝑧𝑧 = = = 14
𝑠𝑠𝛽𝛽�1 0.005
The critical value is much lower (𝑧𝑧0.05 = 1.96), therefore we can clearly reject the null hy-
pothesis. The slope is significantly different to 1. (Remark: It is questionable if the devia-
tion from 1 is economically significant! With big sample sizes, we can often find statistical
significance but we always have to ask ourself if the significance is of any economic im-

iv. Jensen’s alpha is slightly negative but not significantly different from 0. Hence, there is no
evidence that the Magellan Fund earned a risk adjusted excess return over the S&P500.
(And there is also no evidence that the Fund did significantly worse than the benchmark.)


The beta of the fund is very similar to the one we got with the S&P500 as a proxy for the market port-
folio. Jensen’s alpha is much smaller, though, and (just) significantly different (two-sided) from 0 at
the 2% level (and significantly smaller to 0 (one-sided) at the 1% level).
0.014 252
The annualized alpha is about 252 ⋅ (−0.014%) ≐ −3.53% (exactly: �1 − � − 1= −3.47%).


• Estimated cost of equity capital:

𝑅𝑅�𝐸𝐸,𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 = 1% + 0.554 ⋅ 8.3% = 5.6%
𝑅𝑅�𝐸𝐸,𝐽𝐽𝐽𝐽𝐽𝐽 = 1% + 1.623 ⋅ 8.3% = 14.5%

The equity cost of capital is much bigger for the (risky) high beta stock, i.e. JP Morgen
Chase, leading to a higher WACC. High beta firms have to discount cash flows at a higher

1% + 1.623 ⋅ (8.3% ± 1.96 ⋅ 2.4%) = (6.8%, 22.1%)

b) The confidence interval is huge. Considering the range of possible levels of the equity cost of
capital (with 95% certainty), most projects can be accepted or rejected.
In the words of Fama and French (p. 44, footnote 7): “The two standard error range thus runs
from [6.8%] percent to [22.1%] percent, which is sufficient to make most projects appear either
profitable or unprofitable. This problem is, however, hardly special to the CAPM.”


Only one stock has a significant alpha on the 5% level (stock 19, which is McDonald’s).

b) Yes. We can expect 5% of the alphas to be significant purely by chance on the chosen level of
significance. 5% of 30 stocks is 1.5 stock. So far, this is completely in line with the CAPM predic-


The scatter plot reveals that there is a slightly negative relationship between alphas and betas, con-
firming the quote above from Fama and French. The negative relationship is very weak, though, as
the scatter around the regression line shows. „To improve the precision of estimated betas, research-
ers such as Blume (1970), Friend and Blume (1970) and Black, Jensen and Scholes (1972) work with
portfolios, rather than individual securities.” (Fama and French, p. 31) We are going to follow that
route of research strategy below…


The alpha of the low beta portfolio ( 𝛽𝛽̂𝑙𝑙𝑙𝑙𝑙𝑙 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 = 0.656) is highest ( 𝛼𝛼�𝑙𝑙𝑙𝑙𝑙𝑙 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 = 0.012, annualized 3.1%),
lower for the mid beta portfolio (𝛽𝛽̂𝑚𝑚𝑚𝑚𝑚𝑚 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 = 0.934, 𝛼𝛼�𝑚𝑚𝑚𝑚𝑚𝑚 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 = 0.009, annualized 2.3%), and lowest for the
high beta portfolio (𝛽𝛽̂ℎ𝑖𝑖𝑖𝑖ℎ 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 = 1.330, 𝛼𝛼�ℎ𝑖𝑖𝑖𝑖ℎ 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 = 0.004, annualized 1.0%). This is in line with much re-
search. But note that the 95% confidence intervals for the alphas overlap each other. Using just Dow
Jones Industrial Average stocks (and the chosen sample period), there is no sound evidence against the
CAPM yet.

i) The relationship between beta and excess daily return positive and linear, as the CAPM pre-
ii) The return of a zero beta portfolio should equal the risk free rate according to the Sharpe-
Lintner CAPM. Hence the excess return of zero beta portfolios should be zero. The figure
shows that the intercept is not equal to zero but to 0.02%, which corresponds to an annual-
ized rate of 5.2% (instead of 0%).
iii) The excess return per unit of beta should be the “market” excess return.
Sample 2003-2011:

The slope should be 0.0287, which is quite higher than 0.0166. But then again: The standard
error is very large and, hence, the 95% confidence interval for the mean overlaps the value of
0.0166 by big margins.


The mean excess return is much higher for the equally weighted portfolio of Dow stocks com-
pared to the Dow Jones Industrial Average. The annualized excess mean return of the equally
weighted index equals 7.1%, whereas the annualized mean return for the DJIA equals “only”
2.3%. The volatility is just marginally bigger for the former.


The higher return of the equally weighted portfolio is only to a small degree due to the (margin-
ally) higher beta. Confirming our earlier conjecture, the risk adjusted return is bigger for the
equally weighted Dow. Whereas the equally weighted index has a positive alpha (which is signifi-
cantly different from 0 at the 5.5% level), the DJIA has a small (but not significant) negative alpha.

i) The equally weighted portfolio is constructed with (implicit) daily rebalancing. Therefore,
stocks that do well in a day are partially sold and stocks that do badly in a day are subject to
additional investment. With momentum/rending in stock returns, this would lead to a under-
performance of the portfolio versus the price-weighted index.



There is a highly significant negative first order autocorrelation in the time series of daily returns of
the DJIA (mean reversion). This is quite surprising. Usually, it is found that time series of daily
(short run) stock returns are characterized by positive (first order) autocorrelation. Over the longer
run (3 to 5 years), (a slight degree of) mean reversion is quite common. The negative autocorrela-
tion helps to explain, why the (daily) equally weighted portfolio performed better than the bench-

As an aside:
The result could have been influenced by a couple of outliers. Therefore, I also carried out a non-
parametric test for autocorrelation; the so called “runs test”.

The runs test can be found in SPSS under

Menu -> Analyze -> Nonparametric Tests -> Legacy Dialogs -> Runs…


A positive z statistic is indicative of too many “runs” (changes from returns above and below the
cutoff value, here the mean) and is evidence for negative autocorrelation. The z statistic is very sig-
nificant (p-value=0.001).


a) No, the variable HML (High minus Low) is highly significant (at the 1% level) and the variable
SMB (Small minus Big) is weakly significant (at the 10% level).

b) Since the coefficient on the variable SMB is negative, the fund seems to be more of a large cap
fund. If small caps outperform large caps by 1 percent, the estimated return of the Magellan fund
decreases by 0.02 percent, everything else equal. Since the coefficient on the variable HML
(High minus Low) is significantly negative, the fund seems to invest predominantly in low book-to-
market stocks.


a) No, for both stocks. The variable SMB and HML are highly significant in both cases.


𝐸𝐸(𝑅𝑅𝐸𝐸 ) = 𝑅𝑅𝑓𝑓 + 𝛽𝛽(𝐸𝐸(𝑅𝑅𝑚𝑚 ) − 𝑅𝑅𝑓𝑓 ) + 𝛽𝛽𝑆𝑆 𝑆𝑆𝑆𝑆𝑆𝑆 + 𝛽𝛽ℎ 𝐻𝐻𝐻𝐻𝐻𝐻

As before we use 8.3 percent as an estimate for the excess return of the market portfolio and 1
percent as the risk free rate.
SMB and HML can be estimated from the historical data (or use long run averages from other

0.014811 252
Annualized risk premium SMB: �1 + � − 1 = 3.80%
0.011596 252
Annualized risk premium HML: �1 + � − 1 = 2.97%

Cost of equity capital for Coke, three-factor model:

1% + 0.593 ⋅ 8.3% − 0.205 ⋅ 3.80% − 0.260 ⋅ 2.97%% = 4.37%
The corresponding value from the CAPM was 5.6%.

Cost of equity capital for JPM, three-factor model:

1% + 1.442 ⋅ 8.3% − 0.223 ⋅ 3.80% + 1.606 ⋅ 2.97% = 16.89%
The corresponding value from the CAPM was 14.5%.

The estimates from the three-factor model are quite similar to the ones from the CAPM for our
examples. (Especially if you consider the huge standard errors and, therefore, confidence inter-