Question

The CAPM is used to price the risk (estimate the expected return) for any asset. Our examples have focused on stocks, but we could also use CAPM to estimate the expected rate of return for bonds. Explain why.

Answer 1

CAPM relies on estimates of beta

Global Corporate Bond Index and Barclay?s Capital U.S. Long Index Corporate Bond van be used instead of S&P 500 to calculate Market return.

Beta can be calculated by Regressing bond returns to index return.

Intercept = Individual Bond Returns

Beta = sensitivity of bond returns to market return

After obtaining beta for individual bonds grouping can be done based on beta ranking (low to high), rating and industry to create portfolio of bonds

The beta ranked portfolios are regressed against the index which was used to calculate the respective beta values.

The result may violate assumptions of homoscedasticity and no-autocorrelation. Advance econometrics models like Generalized least squares can be used to minimize the problem.

The problem using CAPM to calculate bond returns is inability of data.