Abstract

This paper examines the value of the various industries stocks using economic and financial
models. An analysis of a set of financial instruments is conducted, an analysis aimed for the
determination of the price of the financial instruments, and the determination of their true value.
The paper uses time series data on twenty stocks, from the various industries. Annually, empirical
data related to a period from January 3rd, 2000 to January 3rd, 2015 was gathered.
The CAPM model is applied to the gathered data, testing the next hypotheses, implied by the
theoretical model:
(1) There is a linear relationship between excess returns and systematic risk.
(2) Market risk as measured by is the only relevant measure of risk.
(3) Excess returns and market risk are positively related.
The results of the conducted analysis state that

Literature review
The investment decision is based on the analysis of a set of financial instruments, an analysis
through which it is aimed for a proper determination of the price of those financial instruments,
and of course, for a proper determination of their true value. Starting from Markowitzs theory,
William Sharpe (1964) showed that there is a connection between the return of an asset and the
return of a market portfolio, his model, called the Capital Asset Pricing Model, representing a
crucial step in the evaluation of primary financial instruments.
In finance, CAPM is a concept used to establish, at least at a theoretical level, the adequate rate of
return of an asset, if that asset is supposed to be added to a portfolio which has already been welldiversified, given that assets non-diversifiable risk. The formula of CAPM is:
ra = rrf + Ba (rm-rrf)
The concept takes into consideration mainly the assets response to non-diversifiable risk, which
is also known as systematic risk or market risk or beta (), as well as the market expected return
and a risk-free asset expected return.
The CAPM sustains the idea that a portfolios expected return must be equal with the risk-free
rate security plus a premium. If they are not equal, then no investment should be made in that
portfolio. The general aspect behind this model is that investors need to be compensated in from
two different point of views, time value of money and risk. The first one is represented by the
risk-free rate and it is meant to compensate the financer for putting money in an investment for a
specific period of time. The second one, the risk, is supposed to compute how much
compensation an investor should receive for taking on additional risk. This is done by taking the
risk measure, also known as beta, which compares the returns of the asset to the market for a
particular period of time and to the market premium.
The CAPM model was developed independently by William Sharpe (1963, 1964), Jack Treynor
(1961), Jan Mossin (1966) and John Lintner (1965, 1969). It represents the first model that
proves the connection between the return of an asset and the return of a portfolio which was
already diversified via a risk indicator. Out of all the authors that were mentioned above, William
Sharpe was rewarded with a Nobel Prize for his contributions in the domain of economics and
finances, along with Harry Markowitz and Merton Miller.
The CAPM model of William Sharpe (1964) and John Lintner (1965) marks the birth of asset
pricing theory. Half a century later, this model still represent the most used instrument of asset
valuation due to its simplicity and reliability, although many other tools such as Arbitrage Pricing
Theory or Mertons portfolio theory appeared.

What makes CAPM so attractive is its ability to provide powerful and intuitively pleasing
predictions regarding how to measure a risk and the relationship between expected return and
risk. Unfortunately, the empirical record of the model weak enough to invalidate the way it is
used in applications. The CAPMs essence problems may suggest theoretical flaws, as a result of
the numerous simplifying assumptions that stay behind this theoretical concept. But these flaws
can also be the result of the difficulties that occurred when implementing valid tests of the model.
For instance, the CAPM sustains the fact that the risk of a portfolio should be quantified relative
to a comprehensive market portfolio that, in principle, could contain not just traded assets, but
also consumer durables, real estate and human capital
The CAPM is built on a model of portfolio developed by Harry Markowitz (1959). In this model,
an investor is supposed to select a portfolio at time t-1 that produces return at time t. The model
assumes that investors are risk averse and, when deciding between portfolios, they only take into
account the mean and variance of their one-period investment return. Consequently, they select
mean variance-efficient portfolios, meaning that those portfolios must maximize expected
return, given a specific level of variance. Thus, Markowitzs approach is many times called a
mean-variance model.
The portfolio model provides and algebraic condition on asset weights in mean-variance
portfolios. The CAPM transforms this algebraic statement into a verifiable prediction about the
connection between risk and expected return by identifying a portfolio that must be efficient if
the asset prices are to clear the market of all assets.
Sharpe (1964) and Lintner (1965) introduce two essential assumptions to Markowitzs model to
identify a portfolio that must be mean-variance efficient. The first is called complete
agreement: given market clearing asset prices at t-1 to t, investors agree on the joint distribution
of asset returns from t-1 to t. The second assumption is that there is borrowing and lending at a
risk-free rate, which is the same for all investors and does not depend on the amount borrowed or
lent.
Based on the return required by the investors which was previously established by applying the
CAPM model, we can determine if an asset is undervalued, overvalued or correctly valued. For
example, if the estimated return of an asset is lower than the actual return, then that asset is
obviously undervalued and if the return is higher than the actual return, then the asset is clearly
overvalued. The evaluation of an asset can be done by comparing its theoretical price, which is
also supposed to be the correct one, with its market price. If the theoretical price is higher than
the market price, then we can say that the asset is worth less on the market than it should so the
asset is definitely undervalued.
The CAPM model is built on a series of hypothesis, such as:
1. Investors present a behavior such as the one described by Markowitz in his papers, so the
portfolios held by them are efficient or placed on the efficient frontier.

2. Investors build up their portfolios out of financial assets that are subject to transactions
that take place on secondary market, for example stocks or stocks, so they can borrow and
lend at a risk-free rate.
3. Investors have homogenous expectations, which is why they estimate similar distributions
for the future returns.
4. The time horizon of investments is identical for all investors.
5. Financial instruments are dividable (investors can buy/sell fractions of an asset or of a
portfolio of assets).
6. There are no transaction costs or other taxes/costs that may result from the process of
buying or selling.
7. Inflation rate is considered to be 0 and, in case it is not, it shall be considered as perfectly
anticipated.
8. Capital markets are in equilibrium, the assets being correctly evaluated.
9. There is a perfect competition between investors.
According to the CAPM concept and if the hypotheses presented above are being taken into
consideration, all investors will hold identically efficient portfolios, respectively the market
portfolio or the M portfolio. Obviously, in this case, a question regarding the reason why all
investors shall choose one market portfolio and what particular assets does this portfolio include
is understandable.
The market portfolio will include all the risky assets, as well as the stocks and bonds issued by
corporations at a national and international level and also mortgage titles, real estate, cash, art
objects etc. As a consequence, if the market portfolio includes all the risky assets, than this
portfolio is a completely diversified one from which the specific risk associated to individual
assets is put away.
In general, history acknowledges the development of the CAPM model to the works of Sharpe
(1964), Lintner (1965) and Mossin (1966). But it is Jack L. Treynor who also had a huge
contribution to the development of this concept. His revolutionary papers, Market, Value, Time,
and Risk, Treynor (1961) and Toward a Theory of Market Value of Risky Assets, Treynor
(1962), which were never published in an academic form represent the first steps of his work,
being at the same time some of the most important papers that were not published. It seems that
Treynor work took place before Sharpes, Lintners and Mossins. Anyway, while financial
analysts and economists initially credited Treynor for his development, the CAPM model

developed by him did not go too far in what concerns public reach, which is, apparently, the
reason why Treynor is not thoroughly acknowledged as one of the first contributors of the CAPM
theory.

The CAPM model evidences pro and against

Since the appearance of the model, there have been numerous tests undertaken to test CAPM
models validity, due to its growing popularity. While some of these were favorable for the
model, others have found evidence against him.
Tests that supported the theory
The earliest studies that have found pro arguments for the model were headed by Black, Jensen
and Scholes (1972, pg. 79-124). They used monthly returns and they have combined individual
securities portfolios in order to diversify as much of the risk specific companies and increase
accuracy estimators. The results were pro-CAPM, proving linear relationship between and
profitability indicator and the correlation between a higher/lower risk and a top / bottom return.
Another test that had supported the veracity model, had as promoters: Fama and McBeth (1973),
who also examined and showed positive and linear relationship between expected return and .
They also checked whether the residual variable or variables such factor 2 have influence on
asset portfolio returns, finding as an influential factor only .
Tests partially denied or fought against the CAPM theory
In the early 80s, some studies have suggested that there are deviations from the linear relationship
of the CAPM, because of other variables that may play a role in this. Banz(1981, pg. 3-18)
published an article that highlights the "size effect" (effect of the size of the company concerned),
which is reflected by the ability of the smaller firms shares to provide high returns to large
companies. This paradox was partially confirmed by other subsequent empirical studies, and he
clearly falls against the CAPM model: while the paradox states that in some cases the size
profitability of companies and their securities are in the inverse relationship and that therefore
this variable plays a role in explaining returns, CAPM clearly says that only affects them. Also
Reinganum revealed that firms size is important in this regard.
Keim (1983)finds a securities seasonality profitability, evidenced by a "January effect";
Litzenberger and Ramaswamy (1979,pg. 163-195), find as influential factor dividend earnings;
while Basu (1977, pg. 14-38) states as an important factor the P/E indicator.
In 1992, Fama and French (1992, pg. 427-465) used the same methodology as Fama and McBeth
in 1973, but achieved different conclusions: While the first study confirmed a positive linear
relationship between the and the expected return, the second could not do this.

And their test is criticized in turn: Black and Amihud, Christensen, Mendelson had stated that
available data were not fully relevant and Kothari, Shanken, Sloan says that Fama and Frenchs
obtained conclusions are subjective, depending very much on how they are interpreted in
statistical terms.
The model continued to be the center of debate for over 30 years and is alternatively criticized or
partially validated. Another tests are: Ning and Liu (2004, pg. 154-189) which used data from the
1996-2002 period to test the CAPM in Shanghai Stock Exchange and obtained the lack of a linear
relationship between return and that and non-systematic risk has a significant impact on return.
Cagnetti (2007, pg. 663-682) has tested the Italian capital market using a 10-years time, but he
got only a weak relationship between and profitability and the possibility that other variables to
affect the latter.

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