Date of Completion

Spring 5-8-2011

Thesis Advisor(s)

Po-Hsuan Hsu

Disciplines

Finance and Financial Management

Abstract

The purpose of this work is to empirically assess the validity of the Capital Asset Pricing Model (CAPM) in terms of how can it model an equity’s return. The goal of this work is not to challenge the theory behind CAPM, nor compare it to alternatives, but simply to test whether or not it is applicable in the real world. This is an exploratory research study: rather than testing a specific hypothesis, my goal is to let the data speak for itself.

The main difficulty with assessing CAPM is that there is no consensus on how much data we ought to use when calculating an equity’s Beta. Overall, there are two divergent schools of thought:

  1. The more data you use, the more accurate your approximation. (Rule of Large Numbers)
  2. Companies have major shifts and trends; using too much old information will dilute the newer, more pertinent data.

Rather than taking a stance one way or another, I test the strength of both arguments. I use many different strategies for calculating the Beta of ten different individual equities and a single portfolio with 10% allocated in each. More importantly, I apply CAPM in a retroactive fashion to past data—if you had used CAPM to anticipate the return of an equity, how correct would you have been over the last five, ten, twenty, or even forty years?