The Importance and Significance of the Capital Asset Pricing Model - Coursework Example

FINANCIAL MODELING Name of Professor The Name of the School The Date TABLE OF CONTENTS TABLE OF CONTENTS 2 SECTION A 3 A1: Assumptions and implication of CAPM 3 A2: Validity of the assumptions 4 A3: Empirical test of the CAPM 5 A5: Empirical test of the Fama French three factor model 8 Section B: Wage determination 10 B1: Descriptive analysis 10 B2: First Model 10 B3: Adding experience to the model 11 B4: Adding Gender 12 B5 Correlation analysis 13 B6: Other factors 14 Reference 17 SECTION A A1: Assumptions and implication of CAPM The capital asset pricing model by Sharpe (1964) and Lintner (1995) has a few suspicions and suggestion. In the first place, the CAPM model has accepted that there is complete understanding between investors in the business sector and obtaining and loaning is occurring between them (Bollerslev, Engle & Wooldridge 2008). As indicated by CAPM this doesn't rely on upon the sum acquired or loaned. Besides, the CAPM model accept that base change wilderness follows a blends of expected return and hazard for the arrangement of the advantages which are unsafe that minimizes return on difference at various levels of expected return. Bollerslev, Engle & Wooldridge 2008). expresses that with complete understanding about dispersions of profits, all financial specialists see the same open door set and they help in consolidating the comparable danger intersection portfolios T with the danger free loaning or the borrowings. It is known as the worth weight market hazardous juncture arrangement of dangerous asset. It expect that every benefit's weight must be the aggregate business sector estimation of every exceptional unit of advantages separated by the aggregate markets estimation of every dangerous asset. In conclusion, the model accept that affectability of the advantage return variety is measured utilizing the beta (Jacoby, Fowler & Gottesman 2000). Breeden & Litzenberger (2008) expresses that these suspicions has suggestions like unhindered free obtaining and loaning is something which is unlikely. Dark model of CAPM for example built up a model without danger free getting or loaning. He could demonstrate that the business sector portfolio mean fluctuation proficient can conceivable be acquired by permitting unhindered short offers of the hazardous assets. In any case, the presumptions of short offering is unhindered is likewise farfetched as free obtaining. Another ramifications is that the CAPM demonstrate commonly decides foreseen that benefits would be used as a part of the capital arranging evaluation and bearing which is unrealistic in all actuality. A2: Validity of the assumptions CAPM has introduced by William Sharpe (1964 and Litner (1965) describes that in the situation of equilibrium, asset return is the sum of the risk free rate plus the beta times the excess return. The model is punctuated with several assumptions which to some extend are unrealistic with few exceptions (Jagannathan & McGrattan 2005). The validity of the model from the past study includes As one of the risk measures, beta appears to be related to the past returns due to close relationship between a total and systematic risk. However, it is not easy to distinguish the effect of the two empirically. One of the assumptions is the costless of the transactions so theories are esteemed to all fall on the capital business area line. This is not factual and a couple endeavors would glide underneath or increasingly the line - with trade costs discouraging clear swaps. Jagannathan & McGrattan (2005) states that be it may, we understand that various endeavors for example, securing a little business is incorporate huge trade costs. Possibly the capital business division line is really a band whose width reflects exchanging costs. Furthermore, investors hold very much diversified portfolio and this is done to ensure that the financial analyst has shed out some risk arising from the firm. In this manner, we can infer that those given portfolio are having high probabilities of relating with the CAPM model (Ross 2007). Lastly, it should be noted that empirical SML appears less steeply sloped than the normal theoretical SML with low beta securities earning on return to some extend higher than the ones predicted by CAPM (Ross 2007). An assortment of insufficiencies in CAPM and/or in the factual techniques utilized have been progressed to clarify this wonder. A3: Empirical test of the CAPM In doing the empirical test of CAPM model using the data from Fama French’ on Moodle, downloaded from Ken French’s website. The model specification is as follows; :  Test:  First we run a model for 30 years to test the CAPM and the null hypothesis. From the result in appendix 1 table 1 and 2, R-square are 0.576419 and 0.603952 respectively indicating that the model is fit. For the significance level and beta coefficient the results are shown in the tables below Table 1: Technology portfolio   Coefficients Standard Error t Stat P-value Intercept 0.148372 0.306539 0.484022 0.628666 Mkt-RF 1.464847 0.066367 22.07204 9.23E-69 Table 2: Shop portfolio   Coefficients Standard Error t Stat P-value Intercept 0.08297 0.206011 0.402748 0.687374 Mkt-RF 1.042133 0.044602 23.36518 5.37E-74 From table 1 in technology p-value is 9.23E-69 < 0.05 and for shop p-value is 5.37E-74< 0.05. Therefore, null hypothesis is rejected and alternative hypothesis is accepted since they are statistically significance at significance level of 95%. On the market volatility and risk of the market portfolio, technology industry market portfolio beta is 1.464847 while that for shop is 1.042133 where both are greater than 1 and not zero an indication of high risk level (Ross 2007). Secondly to empirically test the CAPM model we divided the same data into three parts of 10 years each and carried out regression analysis to test whether the CAPM theory stands. For the year 1980 to 1989, both technology and shop portfolio have R-square square of 0.709073 and 0.730631 indicating that the model is fit. The results are shown in appendix Q3 appendix 2 in excel file. On the significance level and beta coefficient are shown below Table 3: Technology portfolio   Coefficients Standard Error t Stat P-value Intercept -0.57413 0.370171 -1.551 0.12358 Mkt-RF 1.278496 0.075389 16.95877 2E-33 Table 4: Shop portfolio   Coefficients Standard Error t Stat P-value Intercept -0.07943 0.271174 -0.29291 0.770107 Mkt-RF 0.988024 0.055227 17.89026 2.1E-35 The detailed output result are in appendix 2 in excel. For the result both are statistically significance with p-value of 2E-33 and 2.1E-35 < 0.05 hence rejecting null hypothesis. The beta value of technology for the first ten years is very risky giving beta of 1.278496 >1 and shop giving beta of 0.988024 Read More