Modern Portfolio Theory: Foundations, Analysis, and New Developments, + Website

Chapter 14

Empirical Tests of the CAPM

The capital asset pricing model (CAPM) states that the expected return from a risky asset is positively and linearly related to its beta. Although many extended models of the CAPM, described in chapter 12, support a linear relationship between the expected return and beta, other models, including the multiperiod asset pricing model to be described in Chapters 15 and 16, suggest that systematic risks other than beta are needed to explain the expected return. That is, other models suggest that beta is not the sole source of systematic risk. Moreover, the expected return may be associated with the standard deviation or with some firm characteristics such as firm size and financial ratios. These alternative risk measures create the need to test how well the CAPM fits empirical data. There are two approaches to testing the validity of asset pricing models: time-series tests and cross-sectional regression tests.

14.1 Time-Series Tests of the CAPM

Black, Jensen, and Scholes (1972) first introduced time-series tests to examine restrictions on the intercept term of market model regressions. They considered the following regression model for asset i:

14.1

Equation (14.1) is identical to regression equation (8.5). If the CAPM is valid, the intercept term should be zero for all assets. That is, the CAPM implies that the intercept estimate, , should not ...