Study of CAPM on Finnish stock market
Author(s) Tuan Doan
Bachelor’s thesis October 2017 International Business Degree Programme in Business Administration
Description
Author(s) Type of publication Date Doan, Thanh Tuan Bachelor’s thesis October 2017 Number of pages Language of publication: 46 English Permission for web publi- cation: x Title of publication Study of CAPM on Finnish stock market
Degree programme International Business
Supervisor(s) Hundal, Shabnamjit
Assigned by
Description Capital asset pricing model (CAPM) is one of the most important pillars of finance. It has been widely studied and applied for its powerful implication in risk return tradeoff and performance analysis of stocks. The objectives of the study are (a) to do an analysis of Finnish stocks according to CAPM (b) to examine the relationship between return and risk measure derived from the model.
A quantitative approach is chosen in order to answer research questions. Secondary data on stock prices is collected. In total, there are 90 stocks listed on Helsinki stock exchange included in this study. Time horizon of the study is from 2012 to 2016. The method of analysis is called second pass regression which was introduced by Lintner. The first pass regression is time series regression run on each stock to estimates parameters of CAPM. Then, second pass regression is done to examine the causal relationship between risk and return.
The research results indicate that there are more overperforming stocks than underperforming stocks given the level of risk. The degree of deviation from CAPM is moderate. Portfolio including 90 stocks is less volatile than the market index. In addition, market risk increases from 2013 to 2014 and stay stable throughout the period. Both two types of risk are found to affect rate of return positively.
Keywords (subjects)
Capital asset pricing model, asset pricing, risk return trade off, market risk, Jensen alpha.
Miscellanous
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Contents
1 Introduction ...... 3
1.1 Background ...... 3 1.2 Research questions ...... 4 1.3 Structure of thesis ...... 5 2 Theoretical background ...... 5
2.1 Risk and return ...... 5 2.2 Modern portfolio theory ...... 8 2.3 Capital asset pricing model ...... 13 2.4 Previous empirical studies on CAPM ...... 17 3 Methodology ...... 20
3.1 Research approach ...... 20 3.2 Data collection ...... 22 3.3 Data analysis ...... 22 4 Results ...... 25
4.1 Descriptive statistics ...... 25 4.2 Relationship between return and risk measures ...... 32 5 Discussion ...... 34
5.1 Summary of the key findings ...... 35 5.2 Reliability and validity ...... 37 5.3 Limitation and recommendation ...... 38 REFERENCE ...... 40
Appendix ...... 45
Appendix 1 The average percent of each type of risk in total risk of 90 stocks for each period. 45
Appendix 2 Information of 90 stocks chosen ...... 45
Appendix 3 Euribor rate used as proxy for risk free rate in each period ...... 47
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TABLES
Table 1 Probability for each scenario corresponding to certain rate of return ...... 7 Table 2 Descriptive statistics and normality test on return ...... 25 Table 3 Summary statistics of measures of risks for the 5-year period ...... 27 Table 4 Paired samples tests for differences in betas ...... 27 Table 5 Descriptive statistics on Jensen alpha ...... 28 Table 6 Pearson correlation coefficients between return and risk measures using data including outliers ...... 32 Table 7 Regression coefficients and p values from model 2 using data including outliers ...... 32 Table 8 Pearson correlation coefficients between return and risk measures using data with outliers excluded ...... 33 Table 9 Regression coefficients and p values from model 2 using data with outliers excluded ...... 33
FIGURES
Figure 1 Effect of diversification (Lo 2008) ...... 11 Figure 2 The minimum variance frontier of risky assets (Bodie, Kane, Marcus, & 2013, 220)...... 12 Figure 3 The efficient frontier of risky assets with optimal capital allocation line ...... 13 Figure 4 Security Market line ...... 16 Figure 5 Box plots visualizing return distributions in each study period ...... 26 Figure 6 Frequency distributions of Jensen alpha of 90 stocks for each year and total period from 2012-2016 ...... 30
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1 Introduction
1.1 Background
The relation between risk and return have always been one of the most enthusiastically discussed in the financial economics because of its great impact on many related areas. For example, one of the primary jobs of a corporate financial officer is to make decision whether the company should invest in new projects which could be new machinery, new plant, a new product research and development proje ts…et . Because these expenditures and investments often require a large amount of money, it is important for managers to carefully evaluate them. The whole planning process of doing this is called capital budgeting. Given the fact that any investments can essentially be reduced to a sequence of cash flows, one standard approach to capital budgeting is by calculating the net present value (NPV) of the project (Andrew Lo, 2008). NPV is simply the difference between present value of cash inflows and cash outflows. Then, managers have to make decision on allocation of budget among projects with positive net present value while taking into account company’s strategy. By doing this, managers increase the value of the company according to the value additivity principle. NPV calculation consists of two essential components: future cashflows and discount rate. The fact that investment’s cashflow is generated in the future makes the problem more complicated because there is always a certain degree of uncertainty in them. Hence, the core issue of NPV method is finding the appropriate discount rate to adjust for the riskiness of projects. The academic name for this discount rate is cost of capital. Cost of capital can be viewed as the opportunity cost of investing in the project because investors expected to earn at least the same rate of return for funding the projects as for investing on company’s stock under the assumption that the investment on the project has the same riskiness as the company’s overall business. The company cost of capital is quantitatively estimated as the weighted-average cost of capital, which is the average rate of return demanded by investors in the company’s debt and equity. Rate of return of debt is simply the interest on the debt which is known in many cases. The puzzle is figuring out the cost of 4 equity to which expected rate of return to investors in the company’s common stock is used as proxy. (Brealey, Myers, and Allen 2011, 241).
It is common knowledge that rate of return is determined by the level of risk. Then, the questions should be asked are: what specifically risk means? , how many types of risk are there? , Does all of them affect rate of return , and how exactly does risk determine return? . One of most widely studied model answering these questions is capital asset pricing model. According to the model, there are two types of risk: systematic risk and unsystematic risk. But investors are only rewarded for systematic risk because unsystematic risk can be eliminated by diversification. Systematic risk is referred to as beta. It is the type of risk that is common to the entire economic system. It is also called by economists as business cycle risk. It measures the sensitivity of a stock to general market movement. Ever since being introduced by Treynor, William Sharpe, and John Lintner, CAPM has been widely applied and studied because of its simplicity and usefulness. Most of these studies are conducted using US stock market data. Therefore, the authors believe it is worthwhile to do a thesis about CAPM on Finnish Stock market.
1.2 Research questions
The main purpose of this thesis is to examine the Finnish stock market under the scope of CAPM. The time frame of study is from 2012 to 2016. Data sample includes 90 stocks listed on Helsinki stock exchange.
1. Is there a change in systematic risk on year to year basis in Finnish stocks? 2. To what extend Finnish stocks overperform or underperform on annual basis?
A metric derived from CAPM called Jensen alpha would be used to answer this question.
3. What is the relationship between risk and return?
This question will be examined both theoretically and empirically with Finnish stock data. Uncovering the structure of risk return relationship would be greatly beneficial for financial officials and investors. 5
1.3 Structure of thesis
The remainder of this thesis consists of 4 main parts. The first part is literature review in which the key concepts concerning the research would be explained in detail. This part also presents the empirical research of previous studies on the topic. Next, methodology part will discuss the research approach and data analysis method. After that, quantitative results and findings would be presented in result part. In the last part discussion , the author will summarize the result. Also included in this part is a presentation of the implication, limitations, validity of the findings and suggestion for further researches.
2 Theoretical background
2.1 Risk and return
RATE OF RETURN
One of the ultimate purposes of every investor is to make profit. Profit in investment world is called return. Rate of return is a key measure of an investment’s performance. Thus, it is important to determine the definition of return and how it is quantitatively measured.
The general quantified measurement of return is holding period return (HPR). HPR is basically the sum of dividend paid and the difference between price at the beginning and price at the end of holding period divided by the price paid to buy security: