ASSIGNMENT 1

MAKING THIS ASSIGNMENT IS MORE THAN SIMPLY ANSWERING

THE QUESTIONS. YOU HAVE TO WRITE A SHORT PAPER, WITH A
CLEAR INTRODUCTION, WITH A CLEAR AIM. MAKE ALSO
DIFFERENT SECTIONS AND WRITE AN OVERALL CONCLUSION.
INCLUDE A LIST OF REFERENCES AND JEL CODES. WE REFER TO
NESTOR UNDER ASSIGNMENTS, WHERE WE INDICATE HOW THE
ESSAY WILL BE EVALUATED

In this assignment you apply the ordinary least squares (OLS) model,
and some simple econometrics, in order to test the relevance of the
CAPM model. The assignment uses a strongly simplified version of the
methodology of testing CAPM as has been applied by Eugene Fama
and James MacBeth, The Journal of Political Economy, 81, 3, 1973, pp.
607-636 (can be downloaded through the Library).

In order to do this assignment, you need to switch between Excel and

Eviews. Excel enables you to structure your data so that you can use it
in Eviews more easily. For this assignment you need to use dataset 1,
which contains monthly stock market returns of a set of listed UK
companies, for the period 1986:01 to 2005:12.

The CAPM model can be specified as:

E(Ri) Rf i. (E(Rm) -Rf)

(1)

where E(Ri) is the expected return on security i, E(Rm) is the expected

return on the
market portfolio, Rf is the risk-free rate and iis a measure of risk for
security i.

The CAPM has three testable implications:

 The relationship between the expected return on a security and
its risk is linear.
 I is a complete measure of the risk of security i. No other
measure of risk of i appears in (1).
 In a market of risk-averse investors, higher risk should be
associated with higher expected return.
The aim of this assignment is to empirically test these outcomes.

First we know that can be estimated from the covariance of the

returns of security i with the returns on the market portfolio (Cov (R i,
Rm)), which is then normalized by dividing by the variance of the
market portfolio (Var(Rm) =Cov(Rm, Rm)). So, first calculate the two
components of beta and beta itself for each security by using monthly
data over the period 1986:01 to 1995:12. For Rm we use the monthly
return of the “market” (the UK Market Index). Please also calculate the
standard deviation of individual stocks for that period for later use. Tip:
use EXCEL to calculate the relevant variables. Take care that the
standard deviation and variance in Excel may be calculated for
samples and that it is therefore wise to use the covariance formula for
calculating the variance of the market portfolio.

Then calculate the average return of each stock for the period 1996:01
to 2005:12 (Rai) also through EXCEL). Take care of the different period
used here: you want to know if past betas i, t-1) are informative of
future average returns!1

Furthermore, estimate the following cross-sectional regression by using

OLS in EVIEWS:

Rait = α0 + α1 . i, t-1 + ε i,t

(2)

where α0is a constant, α1 is a coefficient and ε i,tis an error term, Rit is

the average return
of each stock calculated for the later subperiod i,t-1 the calculated for
the original period.

Present the estimation results in a table; include relevant test statistics

such as the t-values, the coefficient of determination R-square, and the
adjusted R-square. Provide also information on the distribution of the
error terms in a footnote, like statistics on skewness, kurtosis and
Jarque Bera (Bera-Jarque). Also explain the economic meaning of α1.

Use the Ramsey reset test in order to test linearity in relationship

between return and beta. Give and interpret the results.

Also estimate cross-sectional equation 2 with an additional quadratic

beta term.

Rait = α0 + α1 . i, t-1 + α2 . i, t-1 + ε i,t

(3)

1
In fact we would like to know expected returns, but these are quite difficult to
obtain, so we substitute average returns for expected returns.
What does this say in relation with the previous Ramsey reset test and
what happens if you apply the Ramsey reset test again to equation 3?
Again present the estimation results in a table; include relevant test
statistics, such as the t-values, the R2, adjusted R2, and the
significance of the Ramsey reset test. Do also provide information on
the distribution of the error terms in a footnote.

We may also test here if the standard deviation and/or the variance of
the individual stocks explain future expected returns. Therefore, please
show the results of the inclusion of these two variables separately and
collectively with the original betas in equation 2. What can you
conclude on the relevance of these variables. Can you conclude that no
other variables are relevant in explaining expected returns? (See also
Fama and French, 1993).

Some economists suggest that testing the relevance of the CAPM can
better be done by using portfolios, in stead of individual stocks. Give
some possible advantages/ disadvantages of testing CAPM by testing
the CAPM based on portfolios rather than by basing yourself on
individual securities.

You now rank the i ’s in 35 portfolios of each 8 securities (don’t include

the UK Market Index) on the basis of the ranked values of the .
Compute betas for the first period for the 35 portfolios (so-called
portfolio betas: p’s) These betas are calculated as simple averages of
individual security betas in the portfolio and the portfolio returns are
measured by equally weighting the returns of individual securities in
each portfolio p in period t. Present the portfolio betas and average
returns in a table in the appendix.

Then replicate the steps that you used to prove the linearity or its
absence as well as the Ramsey reset test and the quadratic impact of
portfolio beta’s and evaluate these results. Explain in a footnote that
you don’t test on the impact of the portfolio standard deviation.

Please now give an overall conclusion or conclusions based on your

research results.