This is econometrics- using Stata (10)The capital asset pricing model (CAPM) is animportantmodel in the field of finance. It explains variations in the rate of return on a security as a function of...

This is econometrics- using Stata

(10)The capital asset pricing model (CAPM) is animportantmodel 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 themarketportfolio. Generally the rate of return on anyinvestment is measured relative to its opportunity cost, which is the return on a risk free asset. The resulting difference is called therisk premium, since it is the reward or punishment for making a risky investment. The CAPM says that the risk premium on security
jisproportionalto the risk premium on the market portfolio. Thatis:

r_j

-
r_f
=ß_j
(r_m

-
r_f
)

wherer_j
andr_f
are the returns to securityj
and the tisk-free rate, respectively,
r_m
is the return on the market portfolio, andß_j
is thejthsecurity’s“beta” value. A stock’sbeta
is importnant to investors since it reveals the stock’s volatility. Itmeasuresthesensitivityofsecurityj’sreturntovariationinthewholestockmarket.As such, valuesofbetaless than 1 indicatethatthe stock is “defensive” since its variation is less than the market’s. A
betagreater than 1 indicates an “aggressive stock”. Investors usually wantan estimate of a stock’sbetabefore purchasing it. TheCAPMmodel isthe‘economic’modelinthiscase. The“econometricmodel” is obtainsed byincluding an intercept in the model - even though theory says it should bezero) and an errorterm:

r_j

-
r_f
=a_j
+ß_j
(r_m

-
r_f
) +u

(a) Explain why the econometric model above is an example of a simple regression model.

(b) Download and open the data file capm4.dta. This dataset contains data on the monthly returns of sixfirms:

• Disney

• GE

• GM

• IBM

• Mobil-Exxon

• Microsoft

and the rate of retun on the market portfolio (mkt), and the rate of return on hte risk free asset (riskfree).The 132 observations coverJanuary 1998 to December 1998. Estimate the CAPM model for each firm, and comment on their estimatedbetavalues.

(c) Which firm appears mostaggressive?

(d) Which firm appears mostdefensive?

(e) Finance theory says that the intercept parametera_j
should be zero. Does this seem to bethe case given yourestimates?

(f) Forthe Microsoft stock, plot the fitted regression line against thedatapoints

(g) Ifyouwereananalyst, whichstockwouldyousuggest thatinvestorsinvestin?