Question

Exercise 1 Consider the following APT-style model: where rA and rM are excess returns on, respectively, an asset A and a market index and π is the inflation rate. You have observed a sample of 88 data points and estimated the ß vector by OLS, resulting in: 0.4, βι 1.5 and β2-0.8, with standard errors, respectively, 0.6, 0.2 and 0.5. You want to compare this model with the standard CAPM model (with intercept) Based on the information you have now., decide which of the two models is the best description of the data

Answer 1

CPAM model is the best description of the data. Because the Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk and expected return for assets, particularly stocks. CAPM is widely used throughout finance for pricing risky securities and generating expected returns for assets given the risk of those assets and cost of capital.

The beta of a potential investment is a measure of how much risk the investment will add to a portfolio that looks like the market. If a stock is riskier than the market, it will have a beta greater than 1. If a stock has a beta of less than one, the formula assumes it will reduce the risk of a portfolio.