CAPM: A Covariance Adjustment Approach for Estimating Market Beta

47 Pages Posted: 10 Mar 2016 Last revised: 25 May 2016

See all articles by James W. Kolari

James W. Kolari

Texas A&M University - Department of Finance

Wei Liu

Texas A&M University - Department of Finance

Seppo Pynnonen

University of Vaasa, Department of Mathematics and Statistics

Date Written: May 24, 2016

Abstract

Due to a lack of supporting evidence, market beta in the widely-acclaimed Capital Asset Pricing Model (CAPM) is considered dead nowadays. In this paper we propose a novel approach for estimating market beta using the traditional market model. Upon deriving a covariance adjustment term, we specify a so-called observed market beta for each asset. We show that observed market beta can be approximated from information contained in the market model, including the estimated market beta, variance of market index returns, and residual error variance. Based on historical U.S. stock returns, different test assets, and standard cross-sectional tests, we find that observed market beta is significantly priced in the cross section of average stock returns with no pricing error. Similar to the findings of other researchers, evidence does not support the traditional market beta. We conclude that observed market beta provides renewed empirical support for CAPM theory.

Keywords: asset pricing, CAPM, cross-sectional tests, market beta

JEL Classification: G12

Suggested Citation

Kolari, James W. and Liu, Wei and Pynnonen, Seppo, CAPM: A Covariance Adjustment Approach for Estimating Market Beta (May 24, 2016). Available at SSRN: https://ssrn.com/abstract=2746180 or http://dx.doi.org/10.2139/ssrn.2746180

James W. Kolari (Contact Author)

Texas A&M University - Department of Finance ( email )

MS-4218
Department of Finance
College Station, TX TX 77843-4218
United States
979-845-4803 (Phone)
979-845-3884 (Fax)

Wei Liu

Texas A&M University - Department of Finance ( email )

430 Wehner
College Station, TX 77843-4218
United States

Seppo Pynnonen

University of Vaasa, Department of Mathematics and Statistics ( email )

Wolffintie 34
65200 Vaasa
Finland
+358-21-449 8311 (Phone)

HOME PAGE: http://www.uva.fi/~sjp/

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