Although the model is widely accepted and practically used as explained above, it is nevertheless far from being perfect as outlined in its record of empirical studies.9 Generally criticized is on the one hand that the underlying assumptions of the model are very theoretical and thus not able to illustrate reality and on the other one that there are problems in implementing well-founded tests of the model relating to the choice of the right market portfolio.10 But, the success of the CAPM will remain as long as there is no other model which offers as “[…] powerful and intuitively pleasing predictions about how to measure risk and the relation between risk and return.”11 The objective of this study is to empirically test the CAPM on the German stock market. Since most of the empirical studies that have been made in the past focus on the U.S. stock market, this paper will try to find out if the results of these U.S. empirical studies can also be shown on the German stock market. Therefore, the goal of this paper is to analyze the relationship between risk and return on the German stock market to find out whether the CAPM holds.
Table of Contents
1 Introduction
1.1 Motivation and Objective
1.2 Course of Exploration
2 The Capital Asset Pricing Model
2.1 The Model
2.2 Criticism and Shortcomings
3 Previous Research
4 Empirical Study
4.1 Data
4.2 Methodology
4.3 Results, Interpretations and Findings
5 Summary and Conclusion
Research Objectives and Topics
The objective of this study is to empirically test the validity of the Capital Asset Pricing Model (CAPM) within the context of the German stock market. By applying time-series and cross-sectional regression analyses, the paper investigates whether the theoretical relationship between systematic risk (beta) and expected asset returns holds true in the German financial environment, comparing these findings with established U.S. empirical evidence.
- Theoretical foundations and assumptions of the CAPM
- Critical analysis of CAPM limitations and empirical challenges
- Methodological implementation of portfolio-based regression tests
- Examination of market efficiency and beta stability on the German stock market
- Evaluation of risk-return relationships across different time periods
Excerpt from the Book
1.1 Motivation and Objective
The capital asset pricing model (CAPM) is one of the most important models in financial economics and has a long history of theoretical and empirical investigations. It was developed by William Sharpe (1964) and John Lintner (1965) and offered first insights in how the risk of an investment affects the expected returns, resulting in a Nobel Prize for Sharpe in 1990. The CAPM states that the risk of an asset is measured by the beta of its cash flows with respect to the return of the market portfolio of all assets in the economy. The fact that is so easy to understand underlines the importance of the model and contributes to its success in today’s business world. Over 40 years after it was developed, the CAPM is still used in many different fields e.g. to evaluate the performance of a managed portfolio or a mutual fund, assess the risk of a cash flow or estimate the cost of capital of a firm. A recent study states that nearly three fourth of U.S. companies almost always use the CAPM when determining their cost of capital. On top of that it is the preferred asset pricing model in finance and investment courses. Furthermore, one can determine the required rate of return of any risky asset when using the CAPM.
Although the model is widely accepted and practically used as explained above, it is nevertheless far from being perfect as outlined in its record of empirical studies. Generally criticized is on the one hand that the underlying assumptions of the model are very theoretical and thus not able to illustrate reality and on the other one that there are problems in implementing well-founded tests of the model relating to the choice of the right market portfolio. But, the success of the CAPM will remain as long as there is no other model which offers as “[…] powerful and intuitively pleasing predictions about how to measure risk and the relation between risk and return.”
Summary of Chapters
1 Introduction: This chapter defines the motivation for testing the CAPM and outlines the structure of the exploration regarding its validity in the German stock market.
2 The Capital Asset Pricing Model: This section details the theoretical framework of the Sharpe-Lintner version of the CAPM, including its underlying assumptions and major criticisms.
3 Previous Research: This chapter provides an overview of the existing literature and empirical debates concerning the performance of the CAPM in international markets.
4 Empirical Study: This chapter presents the data, the methodology of the regression analysis, and the interpretations of the findings derived from the German stock market data.
5 Summary and Conclusion: This final section summarizes the main research results, confirming that the explanatory power of the CAPM for the German market remains questionable.
Keywords
CAPM, Capital Asset Pricing Model, German stock market, Beta, Systematic risk, Empirical study, Time-series regression, Cross-sectional regression, Market portfolio, Financial economics, Investment management, Risk-return relationship, Market efficiency, Portfolio analysis, Asset pricing
Frequently Asked Questions
What is the core focus of this research paper?
The paper focuses on testing the empirical validity of the Capital Asset Pricing Model (CAPM) specifically within the German stock market environment.
What are the primary themes addressed in the study?
The main themes include the theoretical underpinnings of the CAPM, its limitations, the methodology for testing asset pricing models, and the analysis of empirical results concerning risk and return.
What is the specific goal of the research?
The goal is to analyze whether the positive relationship between risk (beta) and return, as predicted by the CAPM, can be confirmed on the German stock market, similar to results observed in U.S. markets.
Which scientific methods are applied?
The study employs a conventional two-step methodology: time-series regressions to estimate beta coefficients and cross-sectional regressions to test the significance of the risk-return relationship.
What does the main part of the paper cover?
The main part covers the selection of data from 213 German companies, the construction of portfolios, the execution of regression models across ten years, and a stationarity check using four distinct sub-periods.
Which keywords best characterize this work?
Key terms include CAPM, German stock market, Beta, Systematic risk, Empirical study, and Portfolio analysis.
How does the author evaluate the stationarity of the results?
The author divides the ten-year testing period into four 30-month sub-periods to see if the empirical relations remain consistent over time or are affected by specific market events like the tech bubble.
What is the final conclusion regarding the CAPM?
The conclusion is that the CAPM's explanatory power on the German stock market is questionable, as empirical results often deviate from the model's predictions, suggesting the model is not a perfect fit for real-world market data.
- Quote paper
- Daniel Loskamp (Author), 2005, Testing the CAPM on the German Stock Market, Munich, GRIN Verlag, https://www.grin.com/document/54593
