The file contains monthly returns for two portfolios: L and W . It also contains the excess return return on a proxy for the market portfolio (rM ? rf ), and a proxy for the riskfree rate (rf ). In this part, we test the CAPM using two simple portfolio strategies based on past returns. The two portfolios are the following:
1. L is a portfolio comprised of past losers. Every year in June (starting in 1963). I rank all stocks based on their past five year return. I put the 20% worst performers during the past five years into an equal weight portfolio, and compute the return every month from July to the next June.
2. W is a portfolio comprised of past winners. Every year in June (starting in 1963). I rank all stocks based on their past five year return. I put the 20% best performers during the past five years into an equal weight portfolio, and compute the return every month from July to the next June.
1. Compute and report the sample mean (arithmetic average), standard deviation, and Sharpe ratio of L, W, and the proxy for market portfolio. Evaluate the validity of the CAPM using the Sharpe ratios. What do the Sharpe ratios tell you? Why are they important? Can you reject they hypothesis that the CAPM is correct?
2. Estimate and plot the security market line (SML) using the sample mean of rM ? rf and rf .
3. Estimate the following regression:
rW ?rf =?W +?W(rM ?rf)+?W
(a) What is the dependent variable and the independent variable in the regression? (b) Report the estimates and p-values from the regression in a table.
(c) Can you reject the hypothesis that the CAPM is correct? Explain.
4. Estimate the following regression:
rL ?rf =?L +?L(rM ?rf)+?L
(a) Report the estimates and p-value from the regression in a table (feel free to report
any other regression results you think are relevant).
(b) Can you reject the hypothesis that the CAPM is correct? Explain.
5. Is one portfolio riskier than the other or they do they have very similar risk? Explain.
6. Your boss is considering investing in W (he believes you should only invest in companies with a record of good performance). In addition, your boss is a visual person and will not look at tables or regression results. Using a graphical approach convince your boss why he should invest in L instead of W .
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