Reference no: EM13558580

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Some experts deny beta is an efficient form of measuring risk, but are those doubts valid? The capital asset pricing model has long been relied on by professionals in order to find the required return using the coefficient beta, but some are now shying away from this technique claiming beta is an inaccurate measure of risk. The purpose of this paper will be to test through regression if the coefficient beta has correlation with returns. Return information will be collected on 70 different stocks and the S&P 500 in order to run a regression and show if there is correlation.

INTRODUCTION

The CAPM model was first published by William Sharpe in 1964 and later extended by Treynor (1965), Lintner (1965), and Mossin (1966). The model is used to determine a proper rate of return of an asset, or more specifically a stock. Three things the capital asset pricing model takes into consideration are the expected return for the market, expected return of the risk free asset, and the coefficient beta, which represents the asset's sensitivity to non-diversifiable risk. This model uses the formula: Ke = Rf + (Rm - Rf) βe; which demonstrates that the firms cost of equity (Ke) is a linear function of its risk correlated with the market. The variable Rf represents the risk-free rate, while (Rm - Rf) is the market risk premium. βe signifies beta, which is defined as the market risk. CAPM makes three critical assumptions in order to simplify the measure. The first assumption is that there are no transactions costs or taxes. The second notion is that all investors have the exact same intentions with their investments. The last assumption is that all investors have the same opinions on things such as return and risk. The CAPM also divides a portfolio's risk into two separate categories, systematic and unsystematic risk. Unsystematic risk can be defined as risk that is not correlated with the market, and therefore can be diversified away. Systematic risk is correlated with the market and is measured by beta.