Scribd
Upload
747 views18 pages

Case Study: Calculating CAPM Beta in Excel

In this paper, we will look at the capital asset pricing model (CAPM), a simple but widely used factor model in finance. CAPM’s main strength – and its primary weakness – is that it assumes one single source of risk (i.e. market risk) and then buckets everything else as idiosyncratic (i.e. non-systematic). This paper will pave the way to more advanced factor modeling techniques in coming issues. We will begin by discussing the underlying assumptions, define systematic and idiosyncratic risk, and outline their influence on the covariance among assets. Next, using a simple regression model, we will attempt to compute the CAPM sensitivity factor (Beta) for two different tech stocks: Microsoft and IBM. Our coal in applying CAPM to these tech stocks is to compute each asset’s sensitivity (i.e. Beta) to non-diversifiable market risk. To do that, we will use a simple linear regression model, then a normal process to validate the model’s assumptions and ensure its stability over the data sample. for more information, or to download the spreadsheet file(s), http://bitly.com/136RRPj

Uploaded by

NumXL Pro
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
747 views18 pages

Case Study: Calculating CAPM Beta in Excel

In this paper, we will look at the capital asset pricing model (CAPM), a simple but widely used factor model in finance. CAPM’s main strength – and its primary weakness – is that it assumes one single source of risk (i.e. market risk) and then buckets everything else as idiosyncratic (i.e. non-systematic). This paper will pave the way to more advanced factor modeling techniques in coming issues. We will begin by discussing the underlying assumptions, define systematic and idiosyncratic risk, and outline their influence on the covariance among assets. Next, using a simple regression model, we will attempt to compute the CAPM sensitivity factor (Beta) for two different tech stocks: Microsoft and IBM. Our coal in applying CAPM to these tech stocks is to compute each asset’s sensitivity (i.e. Beta) to non-diversifiable market risk. To do that, we will use a simple linear regression model, then a normal process to validate the model’s assumptions and ensure its stability over the data sample. for more information, or to download the spreadsheet file(s), http://bitly.com/136RRPj

Uploaded by

NumXL Pro
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 18

Calculating

CAPM Beta
Inthispaper,wewilllookatthecapitalassetpricingmodel(CAPM),asimplebutwidelyusedfactor modelinfinance.CAPMsmainstrengthanditsprimaryweaknessisthatitassumesonesingle sourceofrisk(i.e.marketrisk)andthenbucketseverythingelseasidiosyncratic(i.e.nonsystematic). Thispaperwillpavethewaytomoreadvancedfactormodelingtechniquesincomingissues.

Wewillbeginbydiscussingtheunderlyingassumptions,definesystematicandidiosyncraticrisk,and outlinetheirinfluenceonthecovarianceamongassets.Next,usingasimpleregressionmodel,wewill attempttocomputetheCAPMsensitivityfactor(Beta)fortwodifferenttechstocks:MicrosoftandIBM. OurcoalinapplyingCAPMtothesetechstocksistocomputeeachassetssensitivity(i.e.Beta)tonon diversifiablemarketrisk.Todothat,wewilluseasimplelinearregressionmodel,thenanormalprocess tovalidatethemodelsassumptionsandensureitsstabilityoverthedatasample. Forsampledata,weusedthemonthlyreturnsbetweenJuly2001andMay2013(140observations).For themarketrisk,weselectedmonthlyreturnsoftheRussell3000Index,andforriskfree,weoptedfor the4weektreasurybills(TBILL)returns.

Background
Infinance,thecapitalassetpricingmodel(CAPM)isusedtodeterminetheappropriaterequiredrateof returnofanasset(oraportfolio).TheCAPMtakesintoaccounttheassetssensitivitytothenon diversifiablerisk(akasystematicormarketrisk).
T T E[ RiT ] RT f i ( E[ RM ] R f )

E[ RiT ] RT f
T E[ RM ] RT f

Where

E[ RiT ] istheexpectedreturnofanassetIoveraholdingperiodT.
RT f istheriskfreereturnovertheperiodT.

i isthesensitivityoftheassetsexcessreturnovertheexpectedexcessmarketreturn.
T E[RM ] istheexpectedmarketreturnoveraholdingperiodT.
T E[RM ] RT f isthemarketpremium(expectedexcessmarketreturn).

E[RiT ] RT f isreferredtoastheriskpremium(expectedexcessassetsreturn).Inotherwords,
theassetsriskpremiumequalsthemarketpremiummultipliedbyitsbeta.

CalculatingCAPMBetaTutorial

SpiderFinancialCorp,2013

Theequationabovedescribesasimplelinearregressionmodel(withzerointercept),betweenthe assetsexcessreturnsandtheexcessmarketreturn.
T T RiT RT f i ( RM R f ) i

i ~ i.i.d ~ N (0, 2 )

2 isoftenreferredtoastheidiosyncraticrisk(i.e.riskthatisspecifictotheassetitself,ratherthanthe
overallmarket). Finally,the i istheslope(sensitivity)andcanbeexpressedasfollows:
T Cov ( RiT , RM ) i T Var ( RM )

Furthermore,fortwoassets,thecovariancecanbecomputedusingCAPMasfollows:

Cov ( Ri , R j ) E[ Ri R j ] E[( Ri R f )( R j R f )]

Cov ( Ri , R j ) E[( i ( RM R f ) i )( j ( RM R f ) j )] Cov ( Ri , R j ) E[ i j ( RM R f ) 2 i ( RM R f ) j j ( RM R f ) i i j ] Cov ( Ri , R j ) i j E[( RM R f ) 2 ] i j Var ( RM )

BasedontheCAPM,thevariance(orrisk)ofeachassetconsistsoftwocomponents:systematicand idiosyncraticrisk.
T Var(RiT ) i2 Var(RM ) 2

Why do we care?
BasedontheCAPMtheory,wecancomputenotonlytheexpectedreturns,butalsoconstructa covariancematrixofthedifferentassets.Notethatthevarianceofeachassetconsistsoftwo components.

Case 1: Microsoft
MicrosoftCorporationdevelops,licenses,andsupportssoftwareproductsandservices,aswellas designingandsellinghardwareworldwide.Microsoftisapubliclytradedcompany,listedonNASDAQ withamarketcapitalof290B. LetsplotthemonthlyexcessreturnsofMicrosoftandRussell3000(marketproxy):

CalculatingCAPMBetaTutorial

SpiderFinancialCorp,2013

Next,weplotthescatterplotforthetwodatasetsanddrawalineartrendlinetooutlinethecorrelation betweenthetwo:

UsingthelinearregressionwizardinNumXL,designatethemonthlyexcessreturnsofMicrosoftasthe dependentvariable(Y)andthoseofRussell3000astheindependentvariable(i.e.X).

CalculatingCAPMBetaTutorial

SpiderFinancialCorp,2013

FromtheOptionstabintheregressiondialogbox,settheintercept/constantvaluetozero.

Note:Youmayleavetheintercept/constantfloating(i.e.unset)andtheregressionwillfindit insignificant.Tryit. Whenwearefinished,clickOK.Theregressionwizardwillgenerateseveraloutputtables.

CalculatingCAPMBetaTutorial

SpiderFinancialCorp,2013

Theregressionmodel(i.e.CAPM)isstatisticallysignificant(ANOVAtable)andcapturesabout40%of MSFTmonthlyexcessreturnvariance.TheBeta(i.e.Russell3000coefficient)hasanaveragevalueof 0.98withanerrorof0.10. Thisisgoodsofar,soletsexaminethestandardizedresidualsoftheregression(rightmosttable).The residualsexhibitapositiveskewandfattails,andthusitfailsthenormalitytest. Togetabetterideaabouttheresidualsdistribution,wecreatetheQQplotwithaGaussiantheoretical distribution:

CalculatingCAPMBetaTutorial 5 SpiderFinancialCorp,2013

TheQQPlotshowsasmalldeviationfromnormalityatpositivevalues(i.e.skew)andafatlefttail (negative). BeforewestartusingtheCAPMandourregressionbetatodeterminetheappropriaterequiredreturn ofMicrosoft,weshouldaskourselvesakeyfewquestionsfirst:

Q: Is the regression model stable? Does the Betas value significantly differ throughout the sample data?
A:Toanswerthisquestion,letsdividethesampledataintotwosubsets:dataset1includesall observationspriorto2008(~70observations)anddataset2coversobservationsstartingfromJanuary 2008toMay2013(~70observations). UsingtheRegressionStabilityTestWizardinNumXL,weconductthisimperativetest.Similartowhatwe didwiththeregressionwizard,theRussellsexcessreturnsaretheindependent(X)variable,andthe MSFTreturnsarethedependentvariable(Y).

IntheOptionstab,settheintercept/constanttozero.

CalculatingCAPMBetaTutorial

SpiderFinancialCorp,2013

Now,ClickOK.TheWizardgeneratesthestatisticalstabilitytestoutputtable.

TheBetavalueisstablethroughoutoursampledataset(2001to2013).Letscomputeandplotthe betavaluethroughoutthedataset.Theshadedareaisour95%confidenceinterval.

Q: Are the regressions standardized residuals serially (aka auto) correlated?


A:Thewhitenoisetestanswersthisspecificquestion,andisavailableintheNumXLstatisticalteststab.

CalculatingCAPMBetaTutorial

SpiderFinancialCorp,2013

IntheOptionstab,setthemaximumlagorderto12(1year).ClickOK.

Theresidualstimeseriesexhibitsnosignificantserialcorrelation. Sofar,wefoundthefollowing: ThemonthlyreturnsofMicrosoftstockhaveanaveragesensitivityof0.98withtheoverall market. Theresidual(akaidiosyncratic)risk(i.e. )isaround5.54%.

Q: Do we have observation(s) that significantly affect the regression more than others (i.e. Influential data)?

CalculatingCAPMBetaTutorial

SpiderFinancialCorp,2013

Toanswerthequestionabove,wecomputetheCooksdistanceforeachobservationinthesample 4 data.Furthermore,weusetheheuristicthresholdof toidentifythoseinfluentialpoints.Nisthe N numberofnonmissingvaluesinthedataset.

Tohandleinfluentialandatapoint,wedecidedtoremoveitbysettingtheMSFTreturnsto#N/A,thus removingtheobservationfromanyanalysis.Weremoveoneobservation(theonewiththehighest Cooksdistance)atatime,thenrecalculatetheCooksdistancefortheremainingdatapointsusingthe reduceddataset.Notethatthethresholdslightlyincreasesaswedropobservations.Wecontinuewith theprocessuntilnoapparentinfluentialdataisinsight.

CalculatingCAPMBetaTutorial

SpiderFinancialCorp,2013

4 Notethatthe thresholdisaheuristic,soweaccepteddatapointswhoseCooksdistanceisslightly N higherthanthethreshold.Recalculatingtheregression(SHIFT+F9),weobservethenewBetavalue (1.21)andregressionerror(5.07%).

PlottingtheCAPMBetavaluethroughoutthesampledata,weobservethattheBetaslightlychanges overtimeandistrendinglowerovertime.OnemayconcludethatMSFTssensitivitytomarketriskis goingdown,duetoitsmarketcaporthenatureofinvestmentthatthecompanyitselfisundertaking.

CalculatingCAPMBetaTutorial

10

SpiderFinancialCorp,2013

Case 2: IBM
InternationalBusinessMachines(IBM)Corporationprovidesinformationtechnology(IT)productsand servicesworldwide.Thecompanyoperatesinfivesegments:GlobalTechnologyServices,Global BusinessServices,Software,SystemsandTechnology,andGlobalFinancing.IBMispubliclytraded,listed onNYSEwithamarketcapof233B. LetsplottheIBMmonthlyexcessreturnsalongwiththeRussell3000(marketproxy)excessreturns.

Next,weplotthescatterplotforthetwodatasetsanddrawalineartrendlinetooutlinethecorrelation betweenthetwo.

CalculatingCAPMBetaTutorial

11

SpiderFinancialCorp,2013

Thetwoseriesdemonstrateastrongcorrelationbetweenthem.Again,usingtheRegressionWizard, designateIBMexcessreturnsasthedependentvariableandtheRussell3000astheindependent, settingtheintercept/constanttozero.

TheoutputtablesshowsimilarresultstowhatwesawwiththeMicrosoftcase.Letsexaminethe residualsdistributioncloserusingtheQQPlot.

CalculatingCAPMBetaTutorial

12

SpiderFinancialCorp,2013

TheQQplotexhibitspositiveskew,withaheavyfattailontheleft(negative)side. BeforewestartusingtheCAPMandourregressionbetatodeterminetheappropriaterequiredreturn ofMicrosoft,weoughttoaskourselvesakeyfewquestions:

Q: Is the regression model stable? Does the Betas value significantly differ throughout the sample data?
Again,welldividethedatasetinto2separatesubsets:dataset1includesallobservationspriorto 2008,anddataset2includesallobservationsstartingfromJanuary2008todate.UsingtheNumXL regressionstabilitytest,wespecifytheindependent(X)anddependentvariable(Y)valuesforeachdata set,settheintercepttozero,andclickOK.

Thetestfailed!Wehaveastructuralbreakinthedataset.ThiscanbeinterpretedastheBetavalue changedsignificantly.

CalculatingCAPMBetaTutorial

13

SpiderFinancialCorp,2013

Whatcanwedonow?LetsfirstplottheBetavalueovertimeinanattempttoidentifythepoint(s) wherestructuralchangecommenced.

TheIBMstockhasundergoneaBetastartingin2008.Thiscanbeduetointernalcompanypolicy change:typeofinvestment,particularmarketexposure,etc.Theimportantfacthereisthattheidentity oftheIBMstockmorphed(withrespecttoCAPM). Insum,weneedtotossawaytheobservationspriorto2008andusethelaterobservations(i.e.2008to May2013)toestimatetheCAPMBeta.

Examiningtheregressionoutputs(usingpost2008observations),theBetahasameanvalueof0.66. Furthermore,theresidualdiagnosistestsallpassed.Additionally,thenonsystematicrisk(i.e.regression standarderror)isaround4%. Inshort,theIBMstockmorphedfrombeingahighbetavalueabove1toavaluelowerthanone.

CalculatingCAPMBetaTutorial

14

SpiderFinancialCorp,2013

Q: Are the regressions standardized residuals serially (aka auto) correlated?


A:Thewhitenoisetestanswersthisspecificquestion,andisavailableinNumXLsstatisticalteststab.

Theresidualstimeseriesexhibitsnosignificantserialcorrelation.

Q: Do we have observation(s) that significantly affect the regression more than others (i.e. influential data)?
Toanswerthequestionabove,wecomputetheCooksdistanceforeachobservationinthesampledata post2008.

SimilartowhatwedidintheMicrosoftcase,weremovedinfluentialdatabysettingtheMSFTreturnsto #N/A,thusremovingtheobservationfromanyanalysis.Weremoveoneobservation(onewiththe highestcooksdistance)atatime,thenrecalculatetheCooksdistancefortheremainingdatapoints CalculatingCAPMBetaTutorial 15 SpiderFinancialCorp,2013

usingthereduceddataset.Notethatthresholdslightlyincreasesaswedropobservations.Wecontinue withtheprocess,untilnoapparentinfluentialdataisinsight.

Recalculatingtheregressionmodel:

Thenonsystematicerrordroppedto3.42%(from4.27%earlier),andalltheresidualsdiagnosistestsare passed.

CalculatingCAPMBetaTutorial

16

SpiderFinancialCorp,2013

PlottingtheCAPMbetavaluethroughoutthesampledata,weobservethattheBetaslightlychanges overtimeandistrendingupwardovertime.OnemayconcludethatMSFTssensitivitytomarketriskis goingup,duetothenatureofnewinvestmentthatthecompanyisundertaking.

CalculatingCAPMBetaTutorial

17

SpiderFinancialCorp,2013

Conclusion
Inthispaper,wedemonstratedtheprocessforcomputingtheCAPMBetafortwotechstock:IBMand MSFT. Inbothcases,weproposedasimplelinearregressionmodelforthestocksmonthlyexcessreturns versusthemonthlyexcessreturnsoftheRussell3000Index(marketproxy).Theregressionslopeisthe empiricalCAPMBetaandtheregressionstandarderrorisviewedasthestocksnonsystematic (idiosyncratic)error. Afterward,wecarriedonaplainregressionanalysisprocess:ANOVA,coefficientsvaluetest,residuals diagnosis,regressionstabilitytest,andinfluentialdataanalysis. ThecomputedCAPMBetasignificantlyimprovedaswecarriedourthoroughanalysistotheregression results. AlltoolsyouneedtocarryonthisexercisearepartofNumXL1.60Pro. TheCAPMisarelativelysimpleonefactormodel.Inlaterissues,welltacklemultifactors(e.g.Fama Frenchthree(3)factormodel(FFM),etc.),whichmayaddsomenumericalcomplexitywhilethebasic stepsandintuitionremainthesame.

CalculatingCAPMBetaTutorial

18

SpiderFinancialCorp,2013

You might also like