Capital Asset Pricing Model: Empirical Study on Dow Jones Industrial Securities

In making an investment in an instrument, investors need to know how much risk they are taking. They have to assess whether the instrument is properly priced, or whether they are getting sufficient returns for the chance they are taking. The CAPM can be defined as ‘a mathematical model that seeks to explain the relationship between risk and return in a rational equilibrium market’ and ‘ an economic model for valuing stocks, securities, derivatives and/or assets by relating risk and expected return’. For this study, CAPM is tested using a basket of 20 randomly selected stocks from the Dow Jones Industrial index, a U.S. stock market index consisting of 30 large, industrial companies. The coverage period is from January 1997 to December 2006, which is prior to the credit crisis that engulfed the financial world back in 2007, to enable us to take a much deeper look at the CAPM. Inclusion of the post-crisis data could distort the resulting models, consequently leading to a biased evaluation of the model. The chosen proxy for the risk-free rate was the monthly rate of the 3-month Treasury Bill issued by the Treasury Department of the U.S. This would indeed be the most appropriate proxy for a risk-free rate as the U.S. is the leading economy of the world and most, if not all, of the debt instruments issued by its government are considered ‘risk-free’.