Question

  CAPM potpourri

• Can you re- define the CAPM mode as:

E(Ri) – Rf = [E(Rm) - Rf]

a. Yes or not? Why?

• Studies have found that Beta is not the only factor that matters for determining the expected return on a stock

a. Mention 3 other factors that impact the expected return of the stock and how they could affect  

     it. Explain thoroughly

• Why Beta was declared “dead” after the market crash of 1987?  

a. Explain what was the reasoning for this statement?

Answer 1

No the formula is represented as follows

E(Ri) = Rf + (E(Rm) - Rf)ßi

The beta factor is for the risk premium which is missing in the given equation.

3 other factors that impact expected return other than beta

1. The price earnings multiple. In general higher the pe , lower should be the stock price based on the relative share price model.

2. Thematic influences - at times some themes are over priced during their bubbles. Eg. Real estate bubble..or the dot com bubble.

3. Premium stocks - certain stocks have a premium and pride attached to them, and even when they make losses , there will be buyers, eg. Some Italian car manufacturers

Beta is dead

Reason 1 - they posited thatht the relationship between average return and beta is weak over the period from 1941 to 1990 and virtually nonexistent from 1963 to 1990. S

Reason 2 - that the average return on a security is negatively related to both the firm’s price-earnings (P/E) ratio and the fi rm’s market-to-book (M/B) ratio.

If these two were confirmed, this would impact the capm results, since according to capm only the performance of the company should impact the expected return, and not market factors.