Estimating the CAPM

In this recipe, we learn how to estimate the famous Capital Asset Pricing Model (CAPM) and obtain the beta coefficient. This model represents the relationship between the expected return on a risky asset and the market risk (also known as systematic or undiversifiable risk). CAPM can be considered a one-factor model, on top of which more complex factor models were built.

CAPM is represented by the following equation:

Here, E(r_i) denotes the expected return on asset i, r_f is the risk-free rate (such as a government bond), E(r_m) is the expected return on the market, and is the beta coefficient.

Beta can be interpreted as the level of the asset return’s sensitivity, as compared to the market in general. Below we mention the possible interpretations of the coefficient:

• <= -1: The asset moves in the opposite direction to the benchmark and in a greater amount than the negative of the benchmark.
• -1 < < 0: The asset...