Reading Assignment #4 – Article “The Capital Asset Pricing Model vs. The Three Factor Model”

August 30, 2017

Question

Read the introduction (pages 1 to 5) of the Article “The Capital Asset Pricing Model vs. The Three Factor Model” which is provided on Aula Virtual under the link CAPM_RA, and do the following:

1) Provide a short summary of the reading in which you answer the following questions: What are the main assumptions and predictions of the CAPM.IN YOUR OWN WORDS, provide brief explanation of the CAPM. What is the main criticism of the Three Factor Model (TFM) by Fama and French (1993, 1996) against the CAPM? (20 points)

Then, use the stockdata excel file (here you will be working with the variables MKT-ex-Ret, Stock 3 and Stock 4) and do the following:

2) Generate a scatterplot of (Stock(i) – Rf) against (Mkt – Rf). Does there appear to be a linear relation between S(i) and Mkt return?(8 points)

3) Draw the distribution of both stocks’ return and the market return as well. What kind of distribution do they appear to follow?(8 points)

4) Calculate the ?i for both stocks. Provide a Table with the value of ?, E(R), and SD of the two stocks, and comment on the relation between the three values. Do they follow the predictions of the CAPM? Explain(8 points)

5) The results from the CAPM imply that the real return from a given stock (Stock(i) – Rf) are directly proportional to the real return from the market portfolio (Mkt – Rf). The Risk coefficient ? measures the strength of the relation between the two returns. Now, in order to test the validity of the CAPM you will compare the expected return of each stock E(Ri) with the returns of the market portfolio E(Rm) multiplied by its respective coefficient. That is you will test whether (Stock(i) – Rf) = ?i(Mkt – Rf). First, formulate the appropriate null/alternative hypothesis in this case. Then, at a 5% confidence level, test whether you reject your null hypothesis or not for both stocks. In the end, do your results support the implications of the CAPM? Explain(8 points)

Notes:

– .investopedia.com/terms/c/capm.asp”>http://www.investopedia.com/terms/c/capm.asp

– See the link above for a simpler explanation of the CAPM.

– This Assignment is due Thursday, December 10th

– You will provide a two page, side by side, double spaced writing report in which you answer all of the questions above. You will provide a two page, side by side, appendix with all the relevant graphs and tables.

– Any form of cheating will result in aZERO for the assignment.

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