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  • Case Study: Calculating CAPM Beta in Excel

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    In this paper, we will look at the capital asset pricing model (CAPM), a simple but widely used factor model in finance. CAPM’s main strength – and its primary weakness – is that it assumes one single source of risk (i.e. market risk) and then buckets everything else as idiosyncratic (i.e. non-systematic). This paper will pave the way to more advanced factor modeling techniques in coming issues. We will begin by discussing the underlying assumptions, define systematic and idiosyncratic risk, and outline their influence on the covariance among assets. Next, using a simple regression model, we will attempt to compute the CAPM sensitivity factor (Beta) for two different tech stocks: Microsoft and IBM. Our coal in applying CAPM to these tech stocks is to compute each asset’s sensitivity (i.e. Beta) to non-diversifiable market risk. To do that, we will use a simple linear regression model, then a normal process to validate the model’s assumptions and ensure its stability over the data sample. for more information, or to download the spreadsheet file(s), http://bitly.com/136RRPj

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    In this paper, we will look at the capital asset pricing model (CAPM), a simple but widely used factor model in finance. CAPM’s main strength – and its primary weakness – is that it assumes one single source of risk (i.e. market risk) and then buckets everything else as idiosyncratic (i.e. non-systematic). This paper will pave the way to more advanced factor modeling techniques in coming issues. We will begin by discussing the underlying assumptions, define systematic and idiosyncratic risk, and outline their influence on the covariance among assets. Next, using a simple regression model, we will attempt to compute the CAPM sensitivity factor (Beta) for two different tech stocks: Microsoft and IBM. Our coal in applying CAPM to these tech stocks is to compute each asset’s sensitivity (i.e. Beta) to non-diversifiable market risk. To do that, we will use a simple linear regression model, then a normal process to validate the model’s assumptions and ensure its stability over the data sample. for more information, or to download the spreadsheet file(s), http://bitly.com/136RRPj

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PDF, TXT or read online from Scribd
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    642 views18 pages

    Case Study: Calculating CAPM Beta in Excel

    Uploaded by

    NumXL Pro
    In this paper, we will look at the capital asset pricing model (CAPM), a simple but widely used factor model in finance. CAPM’s main strength – and its primary weakness – is that it assumes one single source of risk (i.e. market risk) and then buckets everything else as idiosyncratic (i.e. non-systematic). This paper will pave the way to more advanced factor modeling techniques in coming issues. We will begin by discussing the underlying assumptions, define systematic and idiosyncratic risk, and outline their influence on the covariance among assets. Next, using a simple regression model, we will attempt to compute the CAPM sensitivity factor (Beta) for two different tech stocks: Microsoft and IBM. Our coal in applying CAPM to these tech stocks is to compute each asset’s sensitivity (i.e. Beta) to non-diversifiable market risk. To do that, we will use a simple linear regression model, then a normal process to validate the model’s assumptions and ensure its stability over the data sample. for more information, or to download the spreadsheet file(s), http://bitly.com/136RRPj

    Copyright:

    Attribution Non-Commercial (BY-NC)
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    of 18

    Calculating

    CAPM Beta
    Inthispaper,wewilllookatthecapitalassetpricingmodel(CAPM),asimplebutwidelyusedfactor modelinfinance.CAPMsmainstrengthanditsprimaryweaknessisthatitassumesonesingle sourceofrisk(i.e.marketrisk)andthenbucketseverythingelseasidiosyncratic(i.e.nonsystematic). Thispaperwillpavethewaytomoreadvancedfactormodelingtechniquesincomingissues.

    Wewillbeginbydiscussingtheunderlyingassumptions,definesystematicandidiosyncraticrisk,and outlinetheirinfluenceonthecovarianceamongassets.Next,usingasimpleregressionmodel,wewill attempttocomputetheCAPMsensitivityfactor(Beta)fortwodifferenttechstocks:MicrosoftandIBM. OurcoalinapplyingCAPMtothesetechstocksistocomputeeachassetssensitivity(i.e.Beta)tonon diversifiablemarketrisk.Todothat,wewilluseasimplelinearregressionmodel,thenanormalprocess tovalidatethemodelsassumptionsandensureitsstabilityoverthedatasample. Forsampledata,weusedthemonthlyreturnsbetweenJuly2001andMay2013(140observations).For themarketrisk,weselectedmonthlyreturnsoftheRussell3000Index,andforriskfree,weoptedfor the4weektreasurybills(TBILL)returns.

    Background
    Infinance,thecapitalassetpricingmodel(CAPM)isusedtodeterminetheappropriaterequiredrateof returnofanasset(oraportfolio).TheCAPMtakesintoaccounttheassetssensitivitytothenon diversifiablerisk(akasystematicormarketrisk).
    T T E[ RiT ] RT f i ( E[ RM ] R f )

    E[ RiT ] RT f
    T E[ RM ] RT f

    Where

    E[ RiT ] istheexpectedreturnofanassetIoveraholdingperiodT.
    RT f istheriskfreereturnovertheperiodT.

    i isthesensitivityoftheassetsexcessreturnovertheexpectedexcessmarketreturn.
    T E[RM ] istheexpectedmarketreturnoveraholdingperiodT.
    T E[RM ] RT f isthemarketpremium(expectedexcessmarketreturn).

    E[RiT ] RT f isreferredtoastheriskpremium(expectedexcessassetsreturn).Inotherwords,
    theassetsriskpremiumequalsthemarketpremiummultipliedbyitsbeta.

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    Theequationabovedescribesasimplelinearregressionmodel(withzerointercept),betweenthe assetsexcessreturnsandtheexcessmarketreturn.
    T T RiT RT f i ( RM R f ) i

    i ~ i.i.d ~ N (0, 2 )

    2 isoftenreferredtoastheidiosyncraticrisk(i.e.riskthatisspecifictotheassetitself,ratherthanthe
    overallmarket). Finally,the i istheslope(sensitivity)andcanbeexpressedasfollows:
    T Cov ( RiT , RM ) i T Var ( RM )

    Furthermore,fortwoassets,thecovariancecanbecomputedusingCAPMasfollows:

    Cov ( Ri , R j ) E[ Ri R j ] E[( Ri R f )( R j R f )]

    Cov ( Ri , R j ) E[( i ( RM R f ) i )( j ( RM R f ) j )] Cov ( Ri , R j ) E[ i j ( RM R f ) 2 i ( RM R f ) j j ( RM R f ) i i j ] Cov ( Ri , R j ) i j E[( RM R f ) 2 ] i j Var ( RM )

    BasedontheCAPM,thevariance(orrisk)ofeachassetconsistsoftwocomponents:systematicand idiosyncraticrisk.
    T Var(RiT ) i2 Var(RM ) 2

    Why do we care?
    BasedontheCAPMtheory,wecancomputenotonlytheexpectedreturns,butalsoconstructa covariancematrixofthedifferentassets.Notethatthevarianceofeachassetconsistsoftwo components.

    Case 1: Microsoft
    MicrosoftCorporationdevelops,licenses,andsupportssoftwareproductsandservices,aswellas designingandsellinghardwareworldwide.Microsoftisapubliclytradedcompany,listedonNASDAQ withamarketcapitalof290B. LetsplotthemonthlyexcessreturnsofMicrosoftandRussell3000(marketproxy):

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    Next,weplotthescatterplotforthetwodatasetsanddrawalineartrendlinetooutlinethecorrelation betweenthetwo:

    UsingthelinearregressionwizardinNumXL,designatethemonthlyexcessreturnsofMicrosoftasthe dependentvariable(Y)andthoseofRussell3000astheindependentvariable(i.e.X).

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    FromtheOptionstabintheregressiondialogbox,settheintercept/constantvaluetozero.

    Note:Youmayleavetheintercept/constantfloating(i.e.unset)andtheregressionwillfindit insignificant.Tryit. Whenwearefinished,clickOK.Theregressionwizardwillgenerateseveraloutputtables.

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    Theregressionmodel(i.e.CAPM)isstatisticallysignificant(ANOVAtable)andcapturesabout40%of MSFTmonthlyexcessreturnvariance.TheBeta(i.e.Russell3000coefficient)hasanaveragevalueof 0.98withanerrorof0.10. Thisisgoodsofar,soletsexaminethestandardizedresidualsoftheregression(rightmosttable).The residualsexhibitapositiveskewandfattails,andthusitfailsthenormalitytest. Togetabetterideaabouttheresidualsdistribution,wecreatetheQQplotwithaGaussiantheoretical distribution:

    CalculatingCAPMBetaTutorial 5 SpiderFinancialCorp,2013

    TheQQPlotshowsasmalldeviationfromnormalityatpositivevalues(i.e.skew)andafatlefttail (negative). BeforewestartusingtheCAPMandourregressionbetatodeterminetheappropriaterequiredreturn ofMicrosoft,weshouldaskourselvesakeyfewquestionsfirst:

    Q: Is the regression model stable? Does the Betas value significantly differ throughout the sample data?
    A:Toanswerthisquestion,letsdividethesampledataintotwosubsets:dataset1includesall observationspriorto2008(~70observations)anddataset2coversobservationsstartingfromJanuary 2008toMay2013(~70observations). UsingtheRegressionStabilityTestWizardinNumXL,weconductthisimperativetest.Similartowhatwe didwiththeregressionwizard,theRussellsexcessreturnsaretheindependent(X)variable,andthe MSFTreturnsarethedependentvariable(Y).

    IntheOptionstab,settheintercept/constanttozero.

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    Now,ClickOK.TheWizardgeneratesthestatisticalstabilitytestoutputtable.

    TheBetavalueisstablethroughoutoursampledataset(2001to2013).Letscomputeandplotthe betavaluethroughoutthedataset.Theshadedareaisour95%confidenceinterval.

    Q: Are the regressions standardized residuals serially (aka auto) correlated?


    A:Thewhitenoisetestanswersthisspecificquestion,andisavailableintheNumXLstatisticalteststab.

    CalculatingCAPMBetaTutorial

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    IntheOptionstab,setthemaximumlagorderto12(1year).ClickOK.

    Theresidualstimeseriesexhibitsnosignificantserialcorrelation. Sofar,wefoundthefollowing: ThemonthlyreturnsofMicrosoftstockhaveanaveragesensitivityof0.98withtheoverall market. Theresidual(akaidiosyncratic)risk(i.e. )isaround5.54%.

    Q: Do we have observation(s) that significantly affect the regression more than others (i.e. Influential data)?

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    Toanswerthequestionabove,wecomputetheCooksdistanceforeachobservationinthesample 4 data.Furthermore,weusetheheuristicthresholdof toidentifythoseinfluentialpoints.Nisthe N numberofnonmissingvaluesinthedataset.

    Tohandleinfluentialandatapoint,wedecidedtoremoveitbysettingtheMSFTreturnsto#N/A,thus removingtheobservationfromanyanalysis.Weremoveoneobservation(theonewiththehighest Cooksdistance)atatime,thenrecalculatetheCooksdistancefortheremainingdatapointsusingthe reduceddataset.Notethatthethresholdslightlyincreasesaswedropobservations.Wecontinuewith theprocessuntilnoapparentinfluentialdataisinsight.

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    4 Notethatthe thresholdisaheuristic,soweaccepteddatapointswhoseCooksdistanceisslightly N higherthanthethreshold.Recalculatingtheregression(SHIFT+F9),weobservethenewBetavalue (1.21)andregressionerror(5.07%).

    PlottingtheCAPMBetavaluethroughoutthesampledata,weobservethattheBetaslightlychanges overtimeandistrendinglowerovertime.OnemayconcludethatMSFTssensitivitytomarketriskis goingdown,duetoitsmarketcaporthenatureofinvestmentthatthecompanyitselfisundertaking.

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    Case 2: IBM
    InternationalBusinessMachines(IBM)Corporationprovidesinformationtechnology(IT)productsand servicesworldwide.Thecompanyoperatesinfivesegments:GlobalTechnologyServices,Global BusinessServices,Software,SystemsandTechnology,andGlobalFinancing.IBMispubliclytraded,listed onNYSEwithamarketcapof233B. LetsplottheIBMmonthlyexcessreturnsalongwiththeRussell3000(marketproxy)excessreturns.

    Next,weplotthescatterplotforthetwodatasetsanddrawalineartrendlinetooutlinethecorrelation betweenthetwo.

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    Thetwoseriesdemonstrateastrongcorrelationbetweenthem.Again,usingtheRegressionWizard, designateIBMexcessreturnsasthedependentvariableandtheRussell3000astheindependent, settingtheintercept/constanttozero.

    TheoutputtablesshowsimilarresultstowhatwesawwiththeMicrosoftcase.Letsexaminethe residualsdistributioncloserusingtheQQPlot.

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    TheQQplotexhibitspositiveskew,withaheavyfattailontheleft(negative)side. BeforewestartusingtheCAPMandourregressionbetatodeterminetheappropriaterequiredreturn ofMicrosoft,weoughttoaskourselvesakeyfewquestions:

    Q: Is the regression model stable? Does the Betas value significantly differ throughout the sample data?
    Again,welldividethedatasetinto2separatesubsets:dataset1includesallobservationspriorto 2008,anddataset2includesallobservationsstartingfromJanuary2008todate.UsingtheNumXL regressionstabilitytest,wespecifytheindependent(X)anddependentvariable(Y)valuesforeachdata set,settheintercepttozero,andclickOK.

    Thetestfailed!Wehaveastructuralbreakinthedataset.ThiscanbeinterpretedastheBetavalue changedsignificantly.

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    Whatcanwedonow?LetsfirstplottheBetavalueovertimeinanattempttoidentifythepoint(s) wherestructuralchangecommenced.

    TheIBMstockhasundergoneaBetastartingin2008.Thiscanbeduetointernalcompanypolicy change:typeofinvestment,particularmarketexposure,etc.Theimportantfacthereisthattheidentity oftheIBMstockmorphed(withrespecttoCAPM). Insum,weneedtotossawaytheobservationspriorto2008andusethelaterobservations(i.e.2008to May2013)toestimatetheCAPMBeta.

    Examiningtheregressionoutputs(usingpost2008observations),theBetahasameanvalueof0.66. Furthermore,theresidualdiagnosistestsallpassed.Additionally,thenonsystematicrisk(i.e.regression standarderror)isaround4%. Inshort,theIBMstockmorphedfrombeingahighbetavalueabove1toavaluelowerthanone.

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    Q: Are the regressions standardized residuals serially (aka auto) correlated?


    A:Thewhitenoisetestanswersthisspecificquestion,andisavailableinNumXLsstatisticalteststab.

    Theresidualstimeseriesexhibitsnosignificantserialcorrelation.

    Q: Do we have observation(s) that significantly affect the regression more than others (i.e. influential data)?
    Toanswerthequestionabove,wecomputetheCooksdistanceforeachobservationinthesampledata post2008.

    SimilartowhatwedidintheMicrosoftcase,weremovedinfluentialdatabysettingtheMSFTreturnsto #N/A,thusremovingtheobservationfromanyanalysis.Weremoveoneobservation(onewiththe highestcooksdistance)atatime,thenrecalculatetheCooksdistancefortheremainingdatapoints CalculatingCAPMBetaTutorial 15 SpiderFinancialCorp,2013

    usingthereduceddataset.Notethatthresholdslightlyincreasesaswedropobservations.Wecontinue withtheprocess,untilnoapparentinfluentialdataisinsight.

    Recalculatingtheregressionmodel:

    Thenonsystematicerrordroppedto3.42%(from4.27%earlier),andalltheresidualsdiagnosistestsare passed.

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    PlottingtheCAPMbetavaluethroughoutthesampledata,weobservethattheBetaslightlychanges overtimeandistrendingupwardovertime.OnemayconcludethatMSFTssensitivitytomarketriskis goingup,duetothenatureofnewinvestmentthatthecompanyisundertaking.

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    Conclusion
    Inthispaper,wedemonstratedtheprocessforcomputingtheCAPMBetafortwotechstock:IBMand MSFT. Inbothcases,weproposedasimplelinearregressionmodelforthestocksmonthlyexcessreturns versusthemonthlyexcessreturnsoftheRussell3000Index(marketproxy).Theregressionslopeisthe empiricalCAPMBetaandtheregressionstandarderrorisviewedasthestocksnonsystematic (idiosyncratic)error. Afterward,wecarriedonaplainregressionanalysisprocess:ANOVA,coefficientsvaluetest,residuals diagnosis,regressionstabilitytest,andinfluentialdataanalysis. ThecomputedCAPMBetasignificantlyimprovedaswecarriedourthoroughanalysistotheregression results. AlltoolsyouneedtocarryonthisexercisearepartofNumXL1.60Pro. TheCAPMisarelativelysimpleonefactormodel.Inlaterissues,welltacklemultifactors(e.g.Fama Frenchthree(3)factormodel(FFM),etc.),whichmayaddsomenumericalcomplexitywhilethebasic stepsandintuitionremainthesame.

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