Analysis of Capital Asset Pricing Model (CAPM) for US Stocks

Assignment Task

You are provided a dataset called USstocks.csv. This dataset contains monthly stock returns of 982

U.S. Companies listed in the S&P 500 index spanning the time period January, 1980 – December, 2015.

• Variables contained in this dataset are described below:
• permno - Unique number that identifies a company
• year, month - Identifies the time period.
• companyname - Name of the company
• ri - Monthly Stock Returns of the company in % units.
• rm - Monthly Returns of the SP 500 index in % units, a proxy for market return.
• rf - Monthly returns of 3 month U.S. Treasury Bills in % units, a proxy of the riskfree return.

Form 10 portfolios using the method described in Lab 3.

This procedure involves running 5 year rolling regressions to estimate beta and then sorting on these beta values to form portfolio and monthly portfolio returns. Portfolio returns are the arithmetic average of individual stock returns. Start with the years and get portfolio returns for each month in the year 1985. Repeat this procedure to construct portfolio returns for the sample period.

Unlike the dataset used in Lab 3, here you have incomplete data. Every few years, some firms drop out due to delisting and new ones get enlisted. To adjust for this you need to impose an additional condition when forming portfolios - For a firm to be included in a portfolio, it should have atleast 24 months of returns data. This approach is consistent with Black, Jensen and Scholes (1972).

For the 31-year sample of monthly portfolio returns, conduct both the time series regression test and the cross-sectional test, and tabulate your results. Plot and discuss estimated portfolio betas against (annualized) portfolio returns.

Based on your test results, is there enough evidence to reject the CAPM? Explain

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