Homework answers / question archive / Question B - Stock Markets   Introduction   The Capital asset pricing model (CAPM) takes into account the stock's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), often represented by β  in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset

Question B - Stock Markets   Introduction   The Capital asset pricing model (CAPM) takes into account the stock's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), often represented by β  in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset

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Question B - Stock Markets

 

Introduction

 

The Capital asset pricing model (CAPM) takes into account the stock's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), often represented by β

 in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset. CAPM shows that the cost of equity capital is determined only by beta. Despite it was invented in the 1960s, the CAPM still remains popular due to its simplicity and applicability in a variety of situations.It may be a good idea to check out Understanding Beta at  http://www.investopedia.com/video/play/understanding-beta/ .

 

 

The CAPM is a model for pricing an individual security or portfolio. The risk of a portfolio comprises systematic risk, also known as undiversifiable risk, and unsystematic risk which is also known as idiosyncratic risk or diversifiable risk. Systematic risk refers to the risk common to all securities—i.e. market risk. Unsystematic risk is the risk associated with individual assets. Unsystematic risk can be diversified away to smaller levels by including a greater number of assets in the portfolio (specific risks "average out"). The same is not possible for systematic risk within one market. Depending on the market, a portfolio of approximately 20 securities would be sufficiently diversified.

 

The beta from a single factor model in the form

 

ri=αi+βirm+εi

 

 

is a good approximation to the CAPM beta.

 

The basic idea is that stocks tend to move together, driven by the same economic forces (the market). Here, the dependent variable, ri

 are percentage returns for stock i

, and independent variable, rm

 are percentage returns for a broad market index.

 

 

αi

 is the intercept and βi

 is the slope of the linear relationship between the stock returns and the market. εi

 are the residual returns that cannot be explained by the market fluctuation (this is your idiosyncratic or firm-specific fluctuations).

 

 

 

In Lecture 6 (file ASX200.xlsx), you were provided with the prices for 165 stocks as well as the S&P/ASX 200 Index (a benchmark for the Australian stock market) from January 1, 2013 to December 30, 2015.

 

1. Pick any 3 securities (full name, industry and sector information is provided in Stock Information tab in ASX200.xlsx file).

 

2. Convert your chosen security prices and the market index into percentage returns. For each asset/index, percentage returns are defined as price in day (t) – price in day (t-1)price in day (t-1)

   

   . This will define your returns for the three stocks, ri

   

   , and the market return rm

   

   .

 

 

 

 

B1. Perform OLS regression for each stock separately and report regression outputs for the three models from Excel/Matlab including line fit plots and residual plots.

 

 

 

B2. For each stock, discuss the OLS assumptions and violations (if any) based on the results from B1.

 

 

B3. Discuss the estimated betas for your three stocks and their statistical significance. Are these betas in line with your expectations? Provide your reasoning. What does it mean if a stock has a beta equal to 1? What does it mean if a stock has a beta equal to zero?

 

 

 

B4. Discuss the measure of fit (R2

 ) of your regressions in B1. Are these R2

 in line with your expectations? Provide your reasoning. Note that  R2

  gives the fraction of the variance of the dependent variable (the return on a stock/portfolio of stocks) that is explained by movements in the independent variable (the return on the market index).

 

 

 

B5. Construct an equally weighted portfolio consisting of your three chosen stocks (equally weighted portfolio returns are simply the average of individual stock returns in that portfolio, rp=r1+r2+r33

) and find the portfolio beta. Report regression output (including line fit plots and residual plots), assess the OLS assumptions and violations (if any) and discuss the estimated portfolio beta and the measure of fit of your regression. How does the measure of fit for the portfolio compares with the measures of fit for your individual stocks? Comment on portfolio diversification effect using your R2

s.