Bankruptcy Case

Computing Class 2: Empirically Testing the Capital Asset Pricing Model

However, empirical literature has found that the CAPM fails to explain some outperforming stocks in the market. Therefore, it is important to know why CAPM fails and analyze how the CAPM should be used. This report will help to explain why and how the CAPM fails. It will do so by empirically testing realized risk premium of a stock or portfolio relative to the market index.

This empirical test will start with section 2. In this section the computations are given of both the excess log return on the market and the excess log return of each individual stock. This is followed by a regression analysis in section 3. The beta and the average excess market return are calculated in sections 4 and 5 respectively. In the following section, the average excess stock returns will be provided. Furthermore, in section 7 the SML will be replicated. Additionally, an F-test on the regression will be performed to check whether the regression coefficients are in line with the CAPM. Finally, a conclusion will be drawn on whether the CAPM is supported by our empirical results.

2. Excess log return

The first step taken in the analysis was to load the data file into MatLab.

MatLab Figure 1: Load Data Set

For the analysis of the CAPM, a dataset was used containing monthly stock prices of 14 firms in the market of which the first seven were chosen for this research. Furthermore, both the risk free rate of the market and the return on the market were provided in the data set.

The next step in the analysis was to generate both the excess log return of the market and of seven chosen stocks in the market. In order to do this, the risk free rate was transformed from an annual risk free rate to a monthly risk free rate. The excess log return on the market was generated by extracting the monthly risk free rate from the return on the market (see MatLab figure 2). The excess return on each individual chosen...