Capital Asset Pricing Model Revisited: Empirical Studies on Beta Risks and Return

The Capital Asset Pricing Model (CAPM) has been the dominating capital market equilibrium model since its inception and continues to be widely used in practical portfolio management and in academic research. Its central implication is that the contribution of an asset to the variance of the market is the correct measure of the asset’s risk and the only systematic determinant of the asset’s return. However, studies showed that firm size appeared to be a significant determinant of stock returns that there is no cross-sectional relationship between beta risk and return once firm size and book-tomarket ratios are included as explanatory variables. In this study, we revisited the CAPM with empirical data from large firms. We gathered stock information for more than 288 publicly traded companies with market cap larger than 500 million dollars, price-earning-ratio less than ten, and a greater than zero profitability for over a one year period. We also categorize risk factors of the stocks into three categories: low (beta around point five), market (beta about one), and high (beta about two). Covariance and correlation relations between the stocks as well as their risk factors were used to create optimal portfolios in hindsight. The goal is to test the hypothesis that the systematic risk of a portfolio as measured by its market model beta is indeed a relevant measure of risk, and we would like to examine if beta is reliably related to the return of the portfolio conditional on the sign of the market risk premium, so we can justify the use of market model betas estimated from historical price.