Beta Method CAPM Model

Question: Describe about the Beta Method for CAPM Model? Answer: Beta Method Various portfolios have been formed as instructed with low beta, medium beta and high beta. These portfolios have been reflected in the attached excel. The requisite returns for the desired period is shown below. The above returns are not in line with the CAPM model and hence raise questions about its overall effectiveness. This is primarily because as per CAPM, the required return on a given stock is directly proportional to the underlying beta that captures the underlying risk of the individual stock. Required return = Risk Free Rate + Beta*Market Risk Premium Hence, for the model to be effective, for all the given mentioned periods the highest return should have been observed for the high beta stocks while lowest should have been observed for the low beta stocks which are comparatively less risky since they are less volatile. Additionally, even though for short periods there may be a deviation but in the long term, the returns should be directly proportional to the underlying beta. However, the returns are not in line with the CAPM model since there is a high degree of variation in the returns derived and no consistent pattern can be obtained. Standard Deviation Method Various portfolios have been formed based on standard deviation approach. Low standard deviation has been taken as deviation of returns lesser than 6% pa Medium standard deviation has been taken as deviation of returns in the range of 6%-10% pa High standard deviation has been taken as deviation of returns in excess of 10% pa The returns of various portfolios formed on the basis of standard deviation approach are summarised in the table below. It is evident from the above that the returns of portfolio comprising of stocks with high standard deviation constantly outperform both those with low standard deviation and medium standard deviation. Further, portfolio of stocks with medium standard deviation tends to outperform the portfolio of stocks with low standard deviation on a sustained basis. Hence, it can be concluded that the returns on the portfolio is directly proportional to the underlying standard deviation of the constituent stocks. Also, it can be concluded that underlying risk seems to be more adequately captured by standard deviation rather than the beta of the stock.