Capital Asset Pricing Model

Part 3, Sep 2, 2020

So far we know Regression equation as

Rs = a + beta*Rm;

And determined CAPM equation as below :

Rs = Rf + beta * (Rm – Rf)

Where Rs = Return of subject stock

Rf = Risk free rate

Beta = slope of the regression (Stock return and Index return) represents the beta of the stock, and measures the riskiness of the stock.

Rm = Market risk, risk inherent to the entire market that cannot be diversified.

Lets forget CSRP here for a bit. If we do some basic maths and re arrange the CAPM equation:

Rs = Rf + beta * (Rm – Rf)

Rs = Rf*(1-beta) + beta*Rm

Now the difference between a and Rf*(1-beta) is known as Jensen’s alpha, also known as the Jensen's Performance Index, is a measure of the excess returns earned by the stock compared to returns suggested by the CAPM model. It represents by the symbol α. The value of the excess return may be positive, negative, or zero.

1. a > Rf*(1‐beta) .... Stock did better than expected during regression period
2. a = Rf*(1‐beta) .... Stock did as well as expected during regression period
3. a < Rf*(1‐beta) .... Stock did worse than expected during regression period

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