Computer Exercises (Please print your R seript and submit it along with this problem set.) 3. The capital asset pricing model (CAPM) is an important model in the field of finance. It explains variations in the rate of return on a security as a function of the rate of return on a portfolio consisting of all publicly traded stocks, which is called the market portfolio. Generally, the rate of return on any investment is measured relative to its opportunity cost, which is the return on a risk free asset. The resulting difference is called the risk premium, since it is the reward or punishment for making a risky investment. The CAPM says that the risk premium on security j is proportional to the risk premium on the market portfolio. That is, where r and r are the returns to security j and the risk-free rate, respectively. 7mis the return on the market portfolio, and Bi is the security j's "beta" value. A stock's beta is important to investors since it reveals the stock's volatility. It measures the sensitivity of security j's return to variation in the whole stock market. As such, values of beta less than 1 indicate that the stock is "defensive" since its variation is less than the market's. A beta greater than 1 indicates an "aggressive stock". Investors usually want an estimate of a stock's beta before purchasing it. The CAPM model shown above is the "economic model" in this case. The econometric model" is obtained by including an intercept in the model (even though theory says it should be zero) and an error term, (a) Explain why the econometric model above is a simple regression model like those discussed in this chapter. (b)In the data file capm5 are data on the monthly returns of six firms (Microsoft, GE, GM, IBM Disney, and Mobil-Exxon), the rate of return on the market portfolio (MKT), and the rate of return on the risk free asset (RISKFREE). The 180 observations cover January 1998 to December Computer Exercises (Please print your R seript and submit it along with this problem set.) 3. The capital asset pricing model (CAPM) is an important model in the field of finance. It explains variations in the rate of return on a security as a function of the rate of return on a portfolio consisting of all publicly traded stocks, which is called the market portfolio. Generally, the rate of return on any investment is measured relative to its opportunity cost, which is the return on a risk free asset. The resulting difference is called the risk premium, since it is the reward or punishment for making a risky investment. The CAPM says that the risk premium on security j is proportional to the risk premium on the market portfolio. That is, where r and r are the returns to security j and the risk-free rate, respectively. 7mis the return on the market portfolio, and Bi is the security j's "beta" value. A stock's beta is important to investors since it reveals the stock's volatility. It measures the sensitivity of security j's return to variation in the whole stock market. As such, values of beta less than 1 indicate that the stock is "defensive" since its variation is less than the market's. A beta greater than 1 indicates an "aggressive stock". Investors usually want an estimate of a stock's beta before purchasing it. The CAPM model shown above is the "economic model" in this case. The econometric model" is obtained by including an intercept in the model (even though theory says it should be zero) and an error term, (a) Explain why the econometric model above is a simple regression model like those discussed in this chapter. (b)In the data file capm5 are data on the monthly returns of six firms (Microsoft, GE, GM, IBM Disney, and Mobil-Exxon), the rate of return on the market portfolio (MKT), and the rate of return on the risk free asset (RISKFREE). The 180 observations cover January 1998 to December
