On a recent Morningstar discussion there was a reference to an interesting
>What's "end-of-month minus 2 days"?
>Yeah, I get it. Minus 2 days ... Right. The CAPM prescription is: [1] where, R If you use end-of-month >I''ll take minus 2 days! Uh ... how 'bout minus 3 days or even ...? You can play yourself with a spreadsheet (comparing your favourite stock with the S&P 500 for Jan, 2000 - Dec,2003)
The green ones are the ones we've considered above: minus 0, 2 and 15 days. >I'll take minus 10, okay? CAPM says my expected GE return is ... uh ...
Anyway, >But what if I don't want to use the S&P 500 as "the Market" or I don't want Jan, 2000 - Dec, 2003 or ... ?
>But what if ... ?
I should point out that, according to CAPM, a bigger
Sometimes beta is calculated using, say, monthly returns, reduced by some risk-free rate (called "excess" returns) ... like short term treasuries.
If the risk-free rate is constant (say 4% month after month), then it has no affect on
beta = COVAR[stock,market] / SD
^{2}[market] = r SD[stock] / SD[market]where r is the correlation between the stock and market returns.
If we subtract a constant risk-free rate from both stock and market returns, none of r, SD[stock] or SD[market] will change.
(See
E[R.
_{m}] - R_{f}The "excess" of the Expected Stock Return (that's E[R] - R) is then determined so that the slope is _{f}beta.
Suppose, too, that this stock is completely uncorrelated to "the Market", so beta = 0.
>Yeah, so?
>Yeah, so?
I suggest that one first look at how closely these stock returns are to the regression line ... and that depends upon some measure of the distance between the points and the regression line. One measure of the error, namely the sum of the squares of the (vertical) distances of the points to the regression line, is:
>So if that Error is small, or zero, then one should have some faith in the >Yet the expected "excess" stock return >So when would you have some faith in the CAPM model?
>So is the market is 3% above Risk-free you'd expect the stock to be 3% above Risk-free, right?
Did I mention that the "excess" we've been talking about has a name? It called:
If the "excess" stock return (or Equity Risk Premium) is, say, 4% (that's above the Risk-free rate) then it's the extra return you'd want because of
the extra risk you take by investing in the stock ... rather in a risk-free asset.
>To compensate for market risk? What's >And the "market" might go up or down depending upon economic factors or some war somewhere or some terrorist activity or ...?
>Assuming your stock is intimately connected to the market.
>Can you ... uh, summarize, like
>R-squared?
>How come that google link has the exact same wording ... about "35% of a fund's movements"?
>And should I swallow it?
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