CAPM: A Covariance Adjustment Approach for Estimating Market Beta
47 Pages Posted: 10 Mar 2016 Last revised: 25 May 2016
Date Written: May 24, 2016
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: Suggested Citation