You are on page 1of 3

Econ 457-01: Fall 2008

The econometric specification of CAPM model is the following:

This type of model can be estimated with ordinary least squares regression. We assume that the expected value of the error is zero and that it is uncorrelated with the independent variable. We also took expected values of each side of this model:

which looks like the CAPM. But the asset pricing model that we developed imposes the following constraint on expected returns:

The security's expected excess return is linear in the security's beta. The beta represents the risk of security i in the market portfolio -- or the contribution of security i to the variance of the market portfolio. The beta risk is the only type of risk that is rewarded or priced in equilibrium. What makes the CAPM different from the statistical model is that the CAPM imposes the constraint that the intercept or alpha is zero. 1. Time Series Tests of the CAPM 1) Testing method and hypothesis One test of the CAPM is to test whether the alpha of any security or portfolio is statistically different from zero and beta is stable over the time. The null hypothesis is (the CAPM holds) is that the intercept is equal to zero. Under the alternative hypothesis, the intercept or alpha is not equal to zero. The standard test is a t-test on the intercept of the regression. If the intercept is more than 2 standard errors from zero (or having a t-statistic greater than 2), then there is evidence against the null hypothesis (the CAPM).

2) Data to be used:

Tested assets: One stock (IBM) and one portfolio(Dow index) (test them separately) Market portfolio: S&P 500 index Frequency of the data: monthly Risk free return rate: 4-week Treasury bill rate, and before 2001 July, use 3month Treasury bill rate. (Ideally we should use 4-week rate all the time because our test is based on monthly data, however, 4-week Treasury bill rate is only available after 2001 July. So before that, use a proxy, 3-month rate) Time period: January 1965 to January 2005. Divide the whole period into several sub-periods, which last 5 years each. Test the model in each 5-year sub-period, i.e. Jan.1965- Jan.1970, Jan.1970- Jan.1975, and so on.