A Study on Granger Causality in the CAPM

Abstract

At the heart of the Capital Asset Pricing Model (CAPM) lies the concept of systematic risk. The systematic risk of a security is that component of the total risk of the security that is explained by market risk. This is captured through the regression of security returns on market returns. The regression coefficient represents the sensitivity of returns of the security to changes in market returns. Current developments in econometric theory, however, undermine the simplicity of this approach. Firstly, there should be some form of causality from changes in market returns to changes in security returns. In particular, Granger causality from market returns to security returns must hold. Secondly, in order for the regression to be meaningful, the time series should be stationary. In particular, the presence of a unit root would undermine the significance of the regression coefficient, and therefore threaten the entire basis of the CAPM. It is in this context that Granger causality and stationarity should be examined for the security line. This approach may be extended to determining the macroeconomic variables that influence asset returns in general.

Keywords: Capital Asset Pricing Model, systematic risk, market risk, regression, sensitivity, Granger causality, stationarity

JEL Classification: C22, G12