EMPIRICAL TESTS OF THE CAPM

THE MODELS

Standard CAPM:
Zero Beta (Two Factor):

THE CRITICS

These models are formulated in terms of expectations (ex-ante expectations):

The

relevant Beta is the future Beta. The return on the market and the return of the minimum variance zero Beta portfolio are expected future returns.

Large-scale systematic data on expectations do not exist Ex-post tests

THE DEFENSE
The expectations are on average correct, thus over long periods of time, actual events can be taken as proxies of expectations. Security returns are linearly related to the return on a market portfolio (the market): model:

THE DEFENSE

THE DEFENSE

Testing a model of this form with ex-post data seems appropriate, however there are three assumptions behind this model:
The

market model holds in every period. The CAPM model holds in every period. The Beta is stable over time.

A SIMPLE TEST OF THE CAPM

Is higher return associated with higher Beta? Sharpe and Cooper (1972):
Using

60 months of previous data to measure Beta. Once a year (1931-1967) all stocks were divided into deciles based on Beta equally weighted portfolio. A strategy consisted of holding the stocks of a particular decile over the entire period. The stocks in each decile change every year. Table 15.1 shows what would have happened, on average, if an investor had followed the strategy from 1931 to 1967.

A SIMPLE TEST OF THE CAPM

The rank correlation coefficient between strategy and return is over 0.93, which is statistically significant at the 0.01 level

A SIMPLE TEST OF THE CAPM

A SIMPLE TEST OF THE CAPM

SOME EARLY EMPIRICAL TESTS

Lintner and reproduced in Douglas (1968) First-pass regression the use of time series to estimate Beta

Second-pass regression crosssectional regression

SOME EARLY EMPIRICAL TESTS

SOME PROBLEMS IN METHODOLOGY

Miller and Scholes (1972): Possible biases due to misspecification of the basic estimation equations. Returns should follow simple form CAPM:

SOME PROBLEMS IN METHODOLOGY

Rf is not constant and it is correlated with RMt regression Beta will be a biased estimate of the true Beta. Rf and RMt are negatively correlated, so in the second pass regression:

Intercept

(a1) is upward biased. Slope (a2) is downward biased.

Nonlinearity does not cause any bias.

SOME PROBLEMS IN METHODOLOGY

Heteroscedasticity:
The

variance of the error is larger for higher values of the independent variable than it is for smaller values. Higher Beta stocks have a higher variance of return, unexplained by the market (nonmarket) risk, than lower Beta stocks.

Heteroscedasticity biased the results in other directions.

SOME PROBLEMS IN METHODOLOGY

Possible errors in the definition of the variables

Estimate

of the true Beta is subjected to sampling

error:

a2 is only 64% of its true value. a1 is upward biased commensurately. Residual variance acts as a proxy variable for the true, but unobserved, Beta statistically related to return.

Return

distributions appear to be positively skewed statistical association between residual risk and return.

TESTS OF BLACK, JENSEN, AND SCHOLES

TESTS OF BLACK, JENSEN, AND SCHOLES

To alleviate the problem is to run the time series regression on portfolios. Use 5 years of monthly data to estimate Betas. Rank stocks into deciles based on Beta in the previous time period (from highest to lowest) each decile is the portfolio in the next (sixth) year.

TESTS OF BLACK, JENSEN, AND SCHOLES

Roll the data every 5 years to form the next year portfolio the return for each decile is computed for 35 years. This was done until deciles and the return for each decile was computed for 35 years. Regress each of the 10 portfolios against the market and an intercept.

TESTS OF BLACK, JENSEN, AND SCHOLES

TESTS OF BLACK, JENSEN, AND SCHOLES

TESTS OF BLACK, JENSEN, AND SCHOLES

TESTS OF BLACK, JENSEN, AND SCHOLES

Second-pass regressions

TESTS OF BLACK, JENSEN, AND SCHOLES