Question

Please use data in sheet beta_portfolios for this question. The data description is included in the Excel file which you should read carefully.

The Capital Asset Pricing Model (CAPM) predicts that differences in the exposure to market returns should explain all cross-sectional expected return differences between different assets. In this question, you will evaluate CAPM using annual data on portfolios sorted by CAPM beta from 1964 to 2019.

a)Compute the average return, volatility, average beta, and Sharpe ratio for each portfolio.
b) As a mean-variance investor who needs to pick one of the five beta-sorted portfolios, which portfolio would you choose?
c) Show graphically that CAPM does not hold. To do this, plot the security market line (SML) – predicted by the data on the market return and the riskless rate –along with the average returns and average betas of portfolios.
d) What does the relation between the expected portfolio returns and betas imply for mispricing under the assumption that the CAPM is the right model? Which portfolios are overpriced, and which portfolios are underpriced?

Answer 1

To evaluate CAPM using annual data on portfolios sorted by CAPM beta, compute the average return, volatility, average beta, and Sharpe ratio for each portfolio.

Step-by-step explanation:

In order to evaluate CAPM using annual data on portfolios sorted by CAPM beta, you will need to compute the average return, volatility, average beta, and Sharpe ratio for each portfolio. This will allow you to assess the performance and risk-adjusted returns of each portfolio.

As a mean-variance investor, you would choose the portfolio that offers the highest Sharpe ratio. The Sharpe ratio measures the excess return per unit of risk, so a higher Sharpe ratio indicates a better risk-adjusted return.

To show that CAPM does not hold, you can plot the security market line (SML) along with the average returns and average betas of the portfolios. If the average returns and average betas do not align with the SML, it suggests that the expected return and beta relationship predicted by CAPM is not accurate.

In terms of mispricing under the assumption that CAPM is the right model, portfolios that have higher expected returns than predicted by their betas would be considered underpriced, while portfolios with lower expected returns than predicted by their betas would be considered overpriced.