Market Returns and Risk by gtw75969

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									7c5f7cd0-61fa-49bc-bf49-3351e34b9f5d.xls                                                                                   Model
  Ch 03 Tool Kit                                                                                           1/28/2001

      Chapter 3. Tool Kit for Risk and Return: Portfolio Theory and Asset Pricing Models


  PROBABILITY DISTRIBUTIONS

  The probability distribution is a listing of all possible outcomes and the corresponding probability.


      Probability of
       Occurrence                              Rate of Return Distribution
                                  E                 F                G                  H
           0.10                  10%               6%               14%                4%
           0.20                  10%               8%               12%                6%
           0.40                  10%              10%               10%                8%
           0.20                  10%              12%               8%                 15%
           0.10                  10%              14%               6%                 22%
           1.00




  EXPECTED RATE OF RETURN AND STANDARD DEVIATION

  The expected rate of return is the rate of return that is expected to be realized from an investment. It is
  determined as the weighted average of the probability distribution of returns.

  To calculate the standard deviation, there are a few steps. First find the differences of all the possible returns
  from the expected return. Second, square that difference. Third, multiply the squared number by the
  probability of its occurrence. Fourth, find the sum of all the weighted squares. And lastly, take the square
  root of that number.

  Calculation of expected return and standard deviation for E
                             Expected rate of return for E               Standard deviation for E
      Probability of                                         Deviation from    Squared
       Occurrence          Rate of Return        Product         k hat         deviation      Sq Dev * Prob.

          10%                    10%               1.00%              0%              0.00%               0.00%
          20%                    10%               2.00%              0%              0.00%               0.00%
          40%                    10%               4.00%              0%              0.00%               0.00%
          20%                    10%               2.00%              0%              0.00%               0.00%
          10%                    10%               1.00%              0%              0.00%               0.00%
          100%                                                                           Sum:             0.00%
                             Expected                                            Std. Dev. =
                          Rate of Return,                                        Square root of
                          k hat =                   10%                          sum =                    0.00%

  If the probabilities are fairly simple, then a short-cut method is to use the excel functions for AVERAGE and
                                                                                  ay       "weigh
  STDEVP, but to "trick" them by entering arguments more than once, in a way that "weights" them like
                                                                                                     ten probability.
  the probabilities. For example, for stock E we would enter 6% once, since it has only a one innten probability
                                                                lity.
  We would enter 8% twice, since it has a two in ten probability. We would enter 10% 4 times, since it has
  a four in ten probability. We can do the same thing with the standard deviation function. Note that we use
  STDEVP and not STDEV, since we are measuring the standard deviation for the entire population and not
  for a sample. We call this the "indirect" method.

  Indirect method                    k hat =        10%                                       s=          0.00%


  Calculation of expected return and standard deviation for F

Michael C. Ehrhardt                                            Page 1                                                   4/19/2011
7c5f7cd0-61fa-49bc-bf49-3351e34b9f5d.xls                                                                          Model
                           Expected rate of return for F                 Standard deviation for F
      Probability of                                        Deviation from     Squared
       Occurrence         Rate of Return      Product           k hat          deviation      Sq Dev * Prob.

          10%                   6%             0.60%             -4%             0.16%           0.02%
          20%                   8%             1.60%             -2%             0.04%           0.01%
          40%                  10%             4.00%             0%              0.00%           0.00%
          20%                  12%             2.40%             2%              0.04%           0.01%
          10%                  14%             1.40%             4%              0.16%           0.02%
          100%                                                                      Sum:         0.05%
                           Expected                                         Std. Dev. =
                        Rate of Return,                                     Square root of
                        k hat =                 10%                         sum =                2.19%
  Indirect method                 k hat =       10%                                     s=           2.19%


  Calculation of expected return and standard deviation for G
                            Expected rate of return for G                Standard deviation for G
      Probability of                                         Deviation from     Squared
       Occurrence          Rate of Return       Product          k hat         deviation      Sq Dev * Prob.

          10%                  14%             1.40%             4%              0.16%           0.02%
          20%                  12%             2.40%             2%              0.04%           0.01%
          40%                  10%             4.00%             0%              0.00%           0.00%
          20%                   8%             1.60%             -2%             0.04%           0.01%
          10%                   6%             0.60%             -4%             0.16%           0.02%
          100%                                                                      Sum:         0.05%
                           Expected                                         Std. Dev. =
                        Rate of Return,                                     Square root of
                        k hat =                 10%                         sum =                2.19%
  Indirect method                 k hat =      10.00%                                   s=       2.19%


  Calculation of expected return and standard deviation for H
                            Expected rate of return for H                Standard deviation for H
      Probability of                                         Deviation from     Squared
       Occurrence          Rate of Return       Product          k hat         deviation      Sq Dev * Prob.

          10%                   4%             0.40%             -6%             0.36%           0.04%
          20%                   6%             1.20%             -4%             0.16%           0.03%
          40%                   8%             3.20%             -2%             0.04%           0.02%
          20%                  15%             3.00%             5%              0.25%           0.05%
          10%                  22%             2.20%             12%             1.44%           0.14%
          100%                                                                      Sum:         0.28%
                           Expected                                         Std. Dev. =
                        Rate of Return,                                     Square root of
                        k hat =                10.00%                       sum =                5.27%
  Indirect method                 k hat =      10.00%                                   s=       5.27%




Michael C. Ehrhardt                                        Page 2                                              4/19/2011
7c5f7cd0-61fa-49bc-bf49-3351e34b9f5d.xls                                                                               Model
  COVARIANCE

  The covariance is a measure that combines the variance of a stock's return with the tendency of those returns
  to move up or down at the same time another stock moves up or down.

  To calculate the covariance, there are a few steps. First find the differences of all the possible returns from
  the expected return; do this for both stocks. Second, multiply the differences of both stocks. Third, multiply
  the previous product by the probability of its occurrence. Fourth, find the some of all the weighted products.
  The result is the covariance.

  Calculation of covariance between F and G

      Probability of       Deviation of F     Deviation of G     Product of       Product *
       Occurrence           from k hat         from k hat        deviations         Prob.

          10%                   -4%                4%             -0.1600%          -0.02%
          20%                   -2%                2%             -0.0400%          -0.01%
          40%                    0%                0%              0.0000%          0.00%
          20%                    2%                -2%            -0.0400%          -0.01%
          10%                    4%                -4%            -0.1600%          -0.02%
          100%
                                                               Covariance =
                                                               sum =                   -0.048%

  Calculation of covariance between F and H

      Probability of       Deviation of F     Deviation of H     Product of       Product *
       Occurrence           from k hat         from k hat        deviations         Prob.

          10%                   -4%               -6%             0.2400%           0.02%
          20%                   -2%               -4%             0.0800%           0.02%
          40%                    0%               -2%             0.0000%           0.00%
          20%                    2%                5%             0.1000%           0.02%
          10%                    4%               12%             0.4800%           0.05%
          100%
                                                               Covariance =
                                                               sum =                    0.108%

  Calculation of covariance between F and E

      Probability of       Deviation of F     Deviation of E     Product of       Product *
       Occurrence           from k hat         from k hat        deviations         Prob.

          10%                   -4%                0%             0.0000%           0.00%
          20%                   -2%                0%             0.0000%           0.00%
          40%                    0%                0%             0.0000%           0.00%
          20%                    2%                0%             0.0000%           0.00%
          10%                    4%                0%             0.0000%           0.00%
          100%
                                                               Covariance =
                                                               sum =                    0.000%




Michael C. Ehrhardt                                            Page 3                                               4/19/2011
7c5f7cd0-61fa-49bc-bf49-3351e34b9f5d.xls                                                                                 Model

  CORRELATION COEFFICIENT
  Like covariance, the correlation coefficient also measures the tendency of two stocks to move together, but it is
  standardized and it is always in the range of -1 to +1. The correlation coefficient is equal to the covariance
  divided by the product of the standard deviations.

  Calculation of the correlation between F and G

                     rFG = Covariance FG              ÷               SigmaF * SigmaG
                        =           -0.048%           ÷                  2.19%           2.19%
                         =          -0.048%           ÷                 0.048%
                     rFG =               -1.0

  Calculation of the correlation between F and H

                     rFH = Covariance FH              ÷               SigmaF * SigmaH
                        =            0.108%           ÷                  2.19%           5.27%
                         =           0.108%           ÷                 0.116%
                     rFH =             0.935


  PORTFOLIO RISK AND RETURN: THE TWO-ASSET CASE

  Suppose there are two assets, A and B. X is the percent of the portfolio invested in asset A.
  Since the total percents invested in the asset must add up to 1, (1-X) is the percent of the
  portfolio invested in asset B.

  The expected return on the portfolio is the weighted average of the expected returns on
  asset A and asset B.



                 ^           ^                  ^
                k p = X k A + (1 - X ) k B



  The standard deviation of the portfolio, sp, is not a weighted average. It is:




               sp = X2 s 2 + (1 - X) 2 sB + 2X(1 - X) rAB s A sB
                         A
                                        2




  ATTAINABLE PORTFOLIOS: THE TWO ASSET-CASE

                                 Asset A            Asset B
  Expected return, k hat          5%                  8%
  Standard deviation, s           4%                 10%


  Using the equations above, we can find the expected return and standard deviation of a
  portfolio with different percents invested in each asset.




Michael C. Ehrhardt                                            Page 4                                                 4/19/2011
7c5f7cd0-61fa-49bc-bf49-3351e34b9f5d.xls                                                               Model
  Correlation =                            1
                                               Proportion of
      Proportion of                             Portfolio in
  Portfolio in Security A                       Security A
       (Value of X)                            (Value of 1-X)        kp                sp
                                    1.00                  0.00            5.00%              4.0%
                                    0.90                  0.10            5.30%              4.6%
                                    0.80                  0.20            5.60%              5.2%
                                    0.70                  0.30            5.90%              5.8%
                                    0.60                  0.40            6.20%              6.4%
                                    0.50                  0.50            6.50%              7.0%
                                    0.40                  0.60            6.80%              7.6%
                                    0.30                  0.70            7.10%              8.2%
                                    0.20                  0.80            7.40%              8.8%
                                    0.10                  0.90            7.70%              9.4%
                                    0.00                  1.00            8.00%             10.0%


                                                 rAB = +1: Attainable Set of Risk/Return
                                                              Combinations
                  10%
                  Expected return




                         5%




                         0%
                                      0%              5%       10%           15%
                                                        Risk, sp


  Correlation =                            0


                                               Proportion of
      Proportion of                             Portfolio in
  Portfolio in Security A                       Security A
       (Value of X)                            (Value of 1-X)        kp                sp
                                    1.00                  0.00            5.00%              4.0%
                                    0.90                  0.10            5.30%              3.7%
                                    0.80                  0.20            5.60%              3.8%
                                    0.70                  0.30            5.90%              4.1%
                                    0.60                  0.40            6.20%              4.7%
                                    0.50                  0.50            6.50%              5.4%
                                    0.40                  0.60            6.80%              6.2%
                                    0.30                  0.70            7.10%              7.1%
                                    0.20                  0.80            7.40%              8.0%
                                    0.10                  0.90            7.70%              9.0%
                                    0.00                  1.00            8.00%             10.0%




Michael C. Ehrhardt                                                               Page 5            4/19/2011
7c5f7cd0-61fa-49bc-bf49-3351e34b9f5d.xls                                                                          Model


                                               rAB = 0: Attainable Set of Risk/Return
                                                            Combinations
                                              10%




                            Expected return    5%




                                               0%
                                                    0%        5%           10%          15%
                                                                    Risk, sp


  Correlation =                                -1


                                                   Proportion of
      Proportion of                                 Portfolio in
  Portfolio in Security A                           Security A
       (Value of X)                                (Value of 1-X)              kp                 sp
                             1.00                             0.00                  5.00%               4.0%
                             0.90                             0.10                  5.30%               2.6%
                             0.80                             0.20                  5.60%               1.2%
                             0.70                             0.30                  5.90%               0.2%
                             0.60                             0.40                  6.20%               1.6%
                             0.50                             0.50                  6.50%               3.0%
                             0.40                             0.60                  6.80%               4.4%
                             0.30                             0.70                  7.10%               5.8%
                             0.20                             0.80                  7.40%               7.2%
                             0.10                             0.90                  7.70%               8.6%
                             0.00                             1.00                  8.00%              10.0%


                                                     rAB = -1: Attainable Set of Risk/Return
                                                                  Combinations
                                         10%
                   Expected return




                                              5%




                                              0%
                                                    0%        5%           10%              15%
                                                                    Risk, sp




                                                         Expected
                                                         Portfolio                    Efficient Set
Michael C. Ehrhardt                                                                      Page 6                4/19/2011
                                                         Return, kp
7c5f7cd0-61fa-49bc-bf49-3351e34b9f5d.xls                                                Model
  ATTAINABLE AND EFFICIENT PORTFOLIOS: MANY ASSETS



                                Expected
                                Portfolio    Efficient Set
                                Return, kp



                                                                 Feasible Set




                                                                     Risk, sp
                          Feasible and Efficient Portfolios
                            .



  OPTIMAL PORTFOLIOS




                          Expected
                                                  IB2 I
                          Return, kp                   B1




                                                                 Optimal Portfolio
                                 IA2                                Investor B
                                  IA1

                                                                 Optimal Portfolio
                                                                    Investor A


                                                                   Risk sp
                                    Optimal Portfolios
                            .




                                  Efficient Set with a Risk-Free Asset
Michael C. Ehrhardt                            Page 7                                4/19/2011
                                Expected                     Z
                                Return, kp
                                                                  .B
7c5f7cd0-61fa-49bc-bf49-3351e34b9f5d.xls                                                                  Model
  EFFICIENT SET WITH A RISK-FREE ASSET




                                      Efficient Set with a Risk-Free Asset

                                 Expected                                    Z
                                 Return, kp
                                                                                      .B
                                     ^
                                     kM                    .
                                                           M

                                                                             The Capital Market

                                 kRF
                                              A   .                             Line (CML):
                                                                              New Efficient Set


                                                           sM                               Risk, sp
                             .



  OPTIMAL PORTFOLIO WITH A RISK-FREE ASSET



                            Expected
                            Return, kp
                                                                                      CML
                                                      I2
                                                               I1



                                              . .
                                  ^                        M
                                  kM
                                  ^               R
                                  k   R

                                                                        R = Optimal
                                 kRF                                     Portfolio




                                              sR           sM                           Risk, sp
                                 .




Michael C. Ehrhardt                                            Page 8                                  4/19/2011
7c5f7cd0-61fa-49bc-bf49-3351e34b9f5d.xls                                                                               Model

  CALCULATING BETAS



  We downloaded stock prices and dividends from http://finance.yahoo.com for Wal-Mart,
  using its ticker symbol, WMT. We also downloaded data for the Wilshire 5000 Index
  (^WIL5), which contains most actively traded stocks, and the Fidelity Magellan mutual
  fund (FMAGX). We computed returns, as shown in Chapter 2. We also obtained the
  monthly rates on Treasury bills from the Federal Reserve, http://www.federalreserv.gov/.

                                                                               kRF, Risk-free
                              kM, Market                         kp, Fidelity  rate (Monthly                  Excess stock
                            Return (Wilshire   kS, Wal-Mart     Magellan Fund return on T-     Excess market     return
           Date               5000 Index)          Return          Return           bill)     return (kM-kRF)   (ks-kRF)
                  Apr-00              -5.3%             -2.0%            -4.3%          0.47%           -5.7%        -2.5%
                  Mar-00               7.5%             16.2%             9.1%          0.47%            7.1%        15.7%
                  Feb-00               0.5%            -11.0%             1.0%          0.46%            0.0%       -11.4%
                  Jan-00              -4.2%            -20.8%            -4.8%          0.44%           -4.7%       -21.2%
                  Dec-99               5.6%             20.1%             6.9%          0.43%            5.2%        19.7%
                  Nov-99               5.0%              2.3%             2.0%          0.42%            4.6%         1.9%
                  Oct-99               6.3%             18.4%             6.0%          0.41%            5.9%        18.0%
                  Sep-99              -2.7%              7.6%            -1.5%          0.39%           -3.1%         7.2%
                  Aug-99              -3.4%              4.9%            -1.2%          0.39%           -3.8%         4.5%
                   Jul-99             -0.9%            -12.4%            -3.4%          0.38%           -1.3%       -12.8%
                  Jun-99               5.1%             13.4%             6.5%          0.38%            4.7%        13.1%
                  May-99              -3.1%             -7.3%            -3.0%          0.38%           -3.5%        -7.7%
                  Apr-99               5.6%             -0.2%             2.4%          0.36%            5.2%        -0.6%
                  Mar-99               3.7%              7.3%             5.4%          0.37%            3.4%         6.9%
                  Feb-99              -2.9%              0.1%            -3.2%          0.37%           -3.3%        -0.2%
                  Jan-99               2.7%              5.6%             5.6%          0.36%            2.3%         5.2%
                  Dec-98               6.3%              8.4%             6.4%          0.37%            5.9%         8.0%
                  Nov-98               5.7%              9.0%             7.8%          0.37%            5.4%         8.7%
                  Oct-98               7.8%             26.4%             7.7%          0.33%            7.4%        26.1%
                  Sep-98               6.4%             -7.2%             6.0%          0.38%            6.0%        -7.5%
                  Aug-98             -15.7%             -6.5%           -15.5%          0.41%          -16.1%        -6.9%
                   Jul-98             -2.3%              3.9%            -0.7%          0.41%           -2.7%         3.5%
                  Jun-98               3.4%             10.5%             4.3%          0.42%            3.0%        10.1%
                  May-98              -2.8%              9.0%            -2.1%          0.42%           -3.2%         8.6%
                  Apr-98               1.1%             -0.5%             1.2%          0.41%            0.7%        -0.9%
                  Mar-98               4.9%             10.1%             5.0%          0.42%            4.5%         9.6%
                  Feb-98               7.1%             16.3%             7.6%          0.42%            6.7%        15.9%
                  Jan-98               0.5%              1.0%             1.1%          0.42%            0.0%         0.5%
                  Dec-97               2.1%             -1.2%             1.2%          0.43%            1.7%        -1.6%
                  Nov-97               2.7%             14.5%             1.9%          0.43%            2.3%        14.0%
                  Oct-97              -3.4%             -4.4%            -3.4%          0.41%           -3.8%        -4.9%
                  Sep-97               5.8%              3.6%             5.9%          0.41%            5.4%         3.1%
                  Aug-97              -3.9%             -5.3%            -4.4%          0.43%           -4.3%        -5.8%
                   Jul-97              7.6%             10.9%             8.4%          0.42%            7.1%        10.5%
                  Jun-97               4.5%             13.6%             4.1%          0.41%            4.0%        13.2%
                  May-97               6.9%              6.2%             7.2%          0.42%            6.5%         5.8%
                  Apr-97               4.2%              0.9%             4.5%          0.43%            3.8%         0.5%
                  Mar-97              -4.5%              6.2%            -3.4%          0.43%           -5.0%         5.8%
                  Feb-97              -0.3%             11.1%            -1.3%          0.42%           -0.7%        10.6%
                  Jan-97               5.2%              4.4%             4.4%          0.42%            4.8%         4.0%
                  Dec-96              -1.3%            -10.4%            -2.0%          0.41%           -1.7%       -10.8%
                  Nov-96               6.4%             -3.8%             6.5%          0.42%            6.0%        -4.2%
                  Oct-96               1.3%              0.5%             2.4%          0.42%            0.9%         0.1%
                  Sep-96               5.2%              0.0%             4.0%          0.42%            4.7%        -0.4%
                  Aug-96               3.0%             10.3%             2.5%          0.42%            2.6%         9.9%
                   Jul-96             -5.5%             -5.4%            -4.7%          0.43%           -6.0%        -5.8%

Michael C. Ehrhardt                                             Page 9                                             4/19/2011
7c5f7cd0-61fa-49bc-bf49-3351e34b9f5d.xls                                                                                                 Model
                 Jun-96                -1.0%                -1.5%                    -0.1%           0.42%              -1.4%         -2.0%
                 May-96                 2.5%                 8.4%                     0.4%           0.42%               2.1%          8.0%

  Average (Annual)                     19.8%                45.3%                21.5%                 4.9%            14.9%          40.3%
  Standard deviation
  (Annual)                             16.6%                32.3%                16.8%                 0.1%            16.7%          32.3%
  Correlation with market.                                    0.54                 0.97                -0.15             1.00           0.54
  Slope                                                       1.05                 0.98                 0.00             1.00           1.05
  R-square                                                    0.29                 0.94                 0.02             1.00           0.29


  Using the AVERAGE function and the STDEV function, we found the average historical
  returns and standard deviations. (We converted these from monthly figures to annual
  figures. Notice that you must multiply the monthly standard deviation by the square root
  of 12, and not 12, to convert it to an annual basis.) These are shown in the rows above.
  We also use the CORREL function to find the correlation of the market with the other assets

  Using the function Wizard for SLOPE, we found the slope of the regression line, which is
  the beta coefficient. We also use the function Wizard and the RSQ function to find the
  R-Squared of the regression.



  Using the Chart Wizard, we plotted the Wal-Mart returns on the y-axis and the market
  returns on the x-axis. We also used the menu Chart > Options to add a trend line, and to
  display the regression equation and R2 on the chart. The chart is shown below. We also
  used the regression feature to get more detailed data. These results are also shown below.




  Wal-Mart Analysis

  The beta coefficient is about 1.05, as shown by the slope coefficient in the regression
  equation on the chart. The beta coefficient has a t statistic of 4.39, and there is virtually a
  zero chance of getting this if the true beta coefficient is equal to zero. Therefore, this is a
  statistically significant coefficient. However, the confidence interval ranges from 0.57 to
  1.54, which is very wide. The R2 of about .29 indicates that 29% of the variance of the stock
  return can be explained by the market. The rest of the stock's variance is due to factors
  other than the market. This is consistent with the wide scatter of points in the graph.

                                          Historic                                           Wal-Mart Regression Results       (See columns J-N)
                                          Realized                                                    Beta
      y = 1.054x + 0.0203                  Returns
                                                                                                                 Coefficient             1.05
          R² = 0.2948                  on Wal-Mart, kS
                                                                                                                   t statistic           4.39
                                    30%
                                                                                                        Probability of t stat.          0.0%
                                                                                              Lower 95% confidence interval              0.57
                                    20%                                                       Upper 95% confidence interval              1.54

                                                                                                   Intercept
                                    10%
                                                                                                                 Coefficient            0.02
                                                                                                                   t statistic          1.68
                                     0%                                                                 Probability of t stat.        10.0%
        -30%      -20%       -10%          0%      10%         20%          30%                Lower 95% confidence interval            0.00
                                                         Historic Realized Returns             Upper 95% confidence interval            0.04
                                    -10%                         on the Market, kM


                                    -20%


                                    -30%



Michael C. Ehrhardt                                                 Page 10                                                          4/19/2011
7c5f7cd0-61fa-49bc-bf49-3351e34b9f5d.xls                                                                                      Model




  Magellan Analysis


  The beta coefficient is about 0.98, as shown by the slope coefficient in the regression
  equation on the chart. The beta coefficient has a t statistic of 25.67, and there is virtually a
  zero chance of getting this if the true beta coefficient is equal to zero. Therefore, this is a
  statistically significant coefficient. The confidence interval ranges from 0.90 to 1.05, which
  is very small compared to the confidence interval for a single stock. The R2 of about 0.98
  indicates that 98% of the variance of the portfolio return can be explained by the market.
  This is consistent with the very narrow scatter of points in the graph. The estimate of the
  intercept is equal to 0.00, and has a t statistic with a probability of 34.3%. Since this is
  greater than 5%, we would say that the coefficient is not statistically significant-- in other
  words, the true intercept might well be equal to zero.




                                                                                  Wal-Mart Regression Results       (See columns J-N)
                                         Historic
                                         Realized                                          Beta
     y = 0.9757x + 0.0018                Returns                                                      Coefficient             0.98
          R² = 0.9347                  on Magellan,                                                     t statistic          25.67
                                           kP
                                20%                                                          Probability of t stat.          0.0%
                                                                                   Lower 95% confidence interval              0.90
                                                                                   Upper 95% confidence interval              1.05


                                10%
                                                                                         Intercept
                                                                                                       Coefficient           0.00
                                                                                                         t statistic         0.96
                                                                                              Probability of t stat.       34.3%
                                                                                     Lower 95% confidence interval           0.00
                                0%
                                                                                     Upper 95% confidence interval           0.01
        -30%     -20%    -10%         0%     10%       20%       30%
                                              Historic Realized Returns
                                                      on the Market, kM

                             -10%




                             -20%




Michael C. Ehrhardt                                                  Page 11                                              4/19/2011
7c5f7cd0-61fa-49bc-bf49-3351e34b9f5d.xls                                                           Model

  The Market Model vs. CAPM

  We have been regressing the stock (or portfolio) returns against the market returns.
  However, CAPM actually states that we should regress the excess stock returns (the stock
  return minus the short-term risk free rate) against the excess market returns (the market
  return minus the short-term risk free rate). We show the graph for such a regression
  below. Notice that it is virtually identical to the market model regression we used earlier
  for Wal-Mart. Since it usually doesn't change the results whether we use the market model
  to estimate beta instead of the CAPM model, we usually use the market model.




                                Excess Returns
   y = 1.0549x + 0.0205          on Wal-Mart,
        R² = 0.2956                 kS-kRF
                                 30%



                                 20%



                                 10%



                                  0%
      -30%     -20%      -10%           0%       10%    20%         30%
                                                              Excess Returns
                                 -10%                  on the Market, kM-kRF



                                 -20%



                                 -30%




Michael C. Ehrhardt                                            Page 12                          4/19/2011

								
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