OPERATIONALIZING CAPM

MODEL
Assignment No.1
Calculation of Beta
MARKS = 3
DUE ON:

Will be announced in class.

Note: The following assignment must be done in group of 2.

A.
Try to submit the assignment on due date otherwise 0.5
mark will be deducted per day.
B.
You are advised to comprehend each step thoroughly so that
you answer any question at the time of submission. Those who
fail to answer the questions will face penalty of 2 marks.
C.
Assignments similar in contents, format, and explanation,
will not get any mark.
You are required to calculate beta for any security with two years monthly data.
Then use CAPM model to calculate required of return on the security, compare that
return with actual return of the security and decide whether the security should be
purchased, sold or held. You can follow the following steps for doing this
assignment:
1.

Select any one security and collect any 2 years monthly data from
www.brecorder.com between July 2005 till October 2008.
2.
Obtain KSE 100 points data for the corresponding months (will be
provided to you)
3.
Obtain risk free rates on T-bills for corresponding period (will be
provided to you).
4.
Calculate monthly return from the security prices (Ri) using formula
Ri= ( Price Current Price previous) / Price previous
5.
Deduct the monthly risk free rate from Ri = (Ri-Rf)
6.
Calculate monthly market returns (Rm) from the index points (will be
provided to you) using formula
Ri= (Index Current Index previous) / Index previous
7.
Deduct the monthly risk free rate from Rm = (Rm-Rf)
8.
Ri-Rf is your dependent variable and Rm-Rf is your
independent variable
9.
Use regression technique to find the coefficient of Ri-Rf, this
coefficient is your beta
10. After finding beta, use the CAPM equation to find out the required rate of
return on your stock

11. Compare this required rate of return with actual rate of return of the
stock to find out whether the stock is overvalued, undervalued
or fairly valued.

How to use regression in Excel

1.
Go to Tools >> Data Analysis>>Regression>>Input Y range>>
Select your (Ri-Rf) Column>>come back to regression window and
select X range>>select your (Rm-Rf) range
2.
If you CANNOT SEE the Data Analysis in tools, then perhaps it
is not installed yet, for installation, go to Tools menu>>Add
ins>>select Data Analysis Toolpack>> the installation will ask for
Office CD, so insert Office CD in CD rom.

Explanation of Expected return with CAPM

We use the following equation for calculation of beta under CAPM:
(Ri-Rf) = + (Rm-Rf)
(Ri-Rf) is the actual risk premium on a given stock while B(Rm-Rf) is the expected
risk premium as suggested by CAPM. If CAPM correctly predicts the risk premium on
a given security, the expected risk premium and actual risk premium will be the
same. If so, the value of intercept will be zero. For example, if actual risk premium
is 15% and expected risk premium is also 15%, then replacing these values in the
above equation, shall get the following result:
(Ri-Rf) = + (Rm-Rf)
15% = + 15%
15% - 15% =
= 0 i.e. intercept = 0
In any other case where expected risk premium and actual risk premium differ, the
value of intercept will be either positive or negative. In such cases, CAPM will not be
truly predicting the risk premium on the stock. Consider another example where
actual risk premium is 15% and expected risk premium is 20%, the value of
intercept will be:
15% = + 20%

15% - 20% =
-5% = i.e intercept = -5%
The above example suggests when CAPM gives expected risk premium above the
actual risk premium, the value of intercept will be negative, and vice versa. In both
cases where the value of intercept is either positive or negative, CAPM fails to
correctly predict the risk premium. In nutshell, we can judge the validity of CAPM by
looking at the value of intercept. If the value of intercept is different from zero and
is statistically significant, CAPM fails to predict the true risk premium.