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CAPM two-pass test fro individual firms What do we need? 1. Intercept to be... 2. Slope...

CAPM two-pass test fro individual firms

What do we need?

1. Intercept to be...

2. Slope to be...

3. R-square to be...

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Answer #1

Two pass technique: –First pass: time series estimation where security (or portfolio) returns were regressed against a market index, m: Ri,t -r f = αi + βi (Rm,t -r f) + εi,t (CAPM)
–Second pass: cross-sectional estimation where the estimated CAPM-beta from the first pass is related to average return: Ri = γ(1-βi) + λβ i + ζi,t (SML for security i) (γ equals rf in the CAPM and E[R0m] in the Black CAPM. While λis the expected market return.
•Main problem: Measurement error in βi. Solution: Measure β’sbased on the notion that portfolio βp estimates will be less affected by measurement error than individual βi estimates due to aggregation.

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