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CAPM (Capital Asset Pricing Model) is a model that describes the relationship between risk and expected return and that is used in the pricing of risky securities. The model tries to theoretically determine how well the asset reacts to the changes in the market pricing. Based on the results from the CAPM, an investor can decide upon whether to invest in a particular portfolio or not. CAPM takes two things into consideration time value of money and risk. The formula for CAPM is given by,
Rs Rf= (Rm Rf), Where, Rs - Return on the stock/asset Rm - Market Return Rate Rf - Risk free rate - Volatility or Sensitivity of the stock with respect to the market fluctuations
Note: 1. Generally, a positive value of Beta indicates that the market and the portfolio movements are positively correlated and vice versa. ||<=1, then the volatility is lesser than the market and vice versa. 2. The risk free rate is usually taken as the yield rate of the treasury bonds issued by the sovereign. 3. The stock market index or the industry index in which the company is present is usually taken for calculating the market return rate.
The Model The capital asset pricing model provides a formula that calculates the expected return on a security based on its level of risk. The formula for the capital asset pricing model is the risk free rate plus beta times the difference of the return on the market and the risk free rate.
Procedure : Weekly returns were taken for 25 stocks and S&P BSE 500 for the last 1 year from BSE website. Beta calculated for data rows using the returns on equity and market for 1-98 data rows. This was done using SLOPE function in excel. 10 yeary T-bil rates were used as the risk free rate. Rf was obtained by dividing this rate by 365. Ri-Rf was calculated for the 51-100 data rows. Regression analysis was done using Y values as Ri- Rf and X values as the Beta Following regression was used: Ri-Rf =i + i (Rm-Rf) + ei
Hypothesis Testing
If CAPM holds in general, correlation of equity return with the market return (i) alone could provide sucient explanation to the risk premium, such that i should be zero. For this reason, a hypothesis testing is performed with null hypothesis =0 at 5% significance level. H0: = 0 H1: 0