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CAPM and the cross-section of stock returns

Stig Vinther Møller

Quantitative Financial Economics

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The Capital Asset Pricing Model (CAPM)

CAPM:
E [Ri] = Rf + i(E [RM ] Rf ); (1)
which says that for any asset i there is a linear relation between the
expected return, E [Ri], and the asset’s -value, i. Subscript M denotes
the market portfolio and Rf is the riskfree rate.

Beta:
Cov (Ri; RM )
i = 2
(2)
M
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We estimate beta from time series regressions:

Rit Rf t = i + i (RM t Rf t) + "it; t = 1; :::; T (3)

As proxy for the market portfolio, we can use a broad market index such
as the S&P500 index.

As proxy for the risk-free rate, we can use the yield on US Treasury secu-
rities.

CAPM implies:

i = 0 8i (4)
which can be tested with a t-test for one asset at time or joint tests of
1 = 2 = ::: = N = 0:
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CAPM implies that high expected returns are matched by high i:

Cross-sectional regression:
h i
ET Ri Rf = c + i + vi ; i = 1; :::; N (5)
h i
where ET Ri Rf is the time-series average excess return on asset i
h i
calculated over the sample length of T observations: ET Ri Rf =
1 PT R Rf t :
T t=1 it

CAPM implies:

– c = 0:
h i
– = ET RM Rf :

– Cross-sectional R2 = 1.
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The cross section of expected returns

In the following, we study the cross section of expected returns by examining
portfolios formed by:

Industry.

Size (market capitalization).

Book-to-market equity ratio (B=M ).

Momentum.

The data are obtained from Kenneth French’s data library.

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Industry portfolios, 1963M7-2018M12

0.8

0.75

0.7
Hlth
NoDur
0.65 Shops
Mean excess return (%)

HiTec
0.6
Enrgy Manuf
0.55 Other

0.5

Telcm
0.45 Utils
Durbl

0.4

0.35

0.3
0.4 0.5 0.6 0.7 0.8 0.9 1 1.1 1.2 1.3
CAPM beta
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Value-weighted monthly excess returns on ten industry-sorted portfolios on the

US stock market, July 1963 to December 2018. Returns are in excess of a
1-month t-bill rate.

Rit Rf t = i + i RM t Rf t + "it

NoDur Durbl Manuf Enrgy HiTec Telcm Shops Hlth Utils Other
0.25 -0.16 0.04 0.16 -0.02 0.06 0.13 0.25 0.18 -0.03
t 2.5 -1.1 0.6 1.0 -0.2 0.5 1.2 2.1 1.3 -0.3
R2 0.68 0.65 0.88 0.43 0.74 0.55 0.74 0.59 0.33 0.86
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Size portfolios, 1963M7-2018M12

0.8

s3
0.75
s1 s5
s4
0.7 s2
s7
Mean excess return (%)

s6

0.65 s8

0.6
s9

0.55

0.5

s10
0.45

0.4
0.8 0.85 0.9 0.95 1 1.05 1.1 1.15 1.2 1.25 1.3
CAPM beta
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Value-weighted monthly excess returns on ten size-sorted portfolios on the US

stock market, July 1963 to December 2018. Returns are in excess of a 1-month
t-bill rate.

Rit Rf t = i + i RM t Rf t + "it

s1 s2 s3 s4 s5 s6 s7 s8 s9 s10
0.15 0.07 0.15 0.11 0.14 0.10 0.11 0.10 0.06 -0.02
t 1.0 0.6 1.4 1.1 1.7 1.4 1.7 1.8 1.4 -0.5
R2 0.60 0.71 0.78 0.80 0.84 0.87 0.91 0.93 0.95 0.95
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Value portfolios, 1963M7-2018M12

0.9

0.85 v10

v9
0.8

0.75
Mean excess return (%)

0.7 v8

0.65 v6

0.6
v7 v3

0.55 v2
v5
v4

0.5

0.45 v1

0.4
0.8 0.85 0.9 0.95 1 1.05 1.1 1.15 1.2
CAPM beta
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Value-weighted monthly excess returns on ten value-sorted portfolios on the

US stock market, July 1963 to December 2018. Returns are in excess of a
1-month t-bill rate.

Rit Rf t = i + i RM t Rf t + "it

v1 v2 v3 v4 v5 v6 v7 v8 v9 v10
-0.10 0.03 0.08 0.03 0.07 0.19 0.11 0.22 0.31 0.27
t -1.2 0.6 1.5 0.4 0.9 2.5 1.2 2.3 3.3 1.8
R2 0.86 0.91 0.91 0.87 0.83 0.80 0.78 0.76 0.77 0.68
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Momentum portfolios, 1963M7-2018M12

1.2
m10

0.8
Mean excess return (%)

m9
m8
0.6
m7 m6 m4
m5 m3
0.4
m2

0.2

-0.2 m1

0.8 0.9 1 1.1 1.2 1.3 1.4 1.5

CAPM beta
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Value-weighted monthly excess returns on ten momentum-sorted portfolios on

the US stock market, July 1963 to December 2018. Returns are in excess of a
1-month t-bill rate.

Rit Rf t = i + i RM t Rf t + "it

m1 m2 m3 m4 m5 m6 m7 m8 m9 m10
-0.93 -0.32 -0.06 0.01 -0.03 0.04 0.05 0.20 0.23 0.49
t -5.0 -2.4 -0.5 0.1 -0.4 0.6 0.8 3.0 2.9 3.8
R2 0.62 0.72 0.73 0.80 0.84 0.86 0.85 0.85 0.82 0.72
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Cross-sectional patterns in stock returns:

Size e¤ect: small stocks tend to earn higher returns than large stocks.

Value e¤ect: stocks with high book-to-market ratios tend to earn higher
returns than low book-to-market stocks.

Momentum e¤ect: stocks that have high returns in the recent past (short-
term winners) continue to perform well.
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Reversal e¤ect: stocks with low long-term past returns tend to have higher
returns going forward.

Pro…tability e¤ect: stocks with higher pro…ts tend to have higher returns.

Investment e¤ect: stocks with high investments tend to have low returns.

Idiosyncratic risk e¤ect: stocks with higher idiosyncratic risk tend to have
lower returns.

etc.

etc.
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Concluding remarks

Bottom line: although there is a strong market component across portfo-

lios, one risk factor is probably not enough to fully explain the cross section
of expected returns.

Some cross-sectional patterns in stock returns re‡ect systematic risk, while

others are unexplaind by the CAPM.

Response to CAPM anomalies: many new risk factors and explanations of

why expected returns vary across assets.