Consider the regression equation: r_i − r_f = g₀ + g₁b₁ + g₂s²(e_i) + e_it Where: R_i − r_f = the average difference between the monthly return on stock i and the monthly risk-free rate B_i = the beta of stock i S²(e_i) = a measure of the nonsystematic variance of the stock i If you estimated this regression equation and the CAPM was valid, you would expect the estimated coefficient, g₀, has to be A) 0. B) 1. C) equal to the risk-free rate of return. D) equal to the average difference between the monthly return on the market portfolio and the monthly risk-free rate. E) None of the options are correct.

Question

Quizplus · Accepted Answer

CThe CAPM (Capital Asset Pricing Model) posits that the expected excess return on a stock (the difference between the stock's return and the risk-free rate) is proportional to the expected excess return on the market portfolio, scaled by the stock's beta. The intercept term (g₀ in the given equation) in a regression equation testing the CAPM should theoretically be zero if the model holds perfectly because it represents the expected return on an asset with a beta of zero, which would be the risk-free rate, indicating no excess return over the risk-free rate. However, in empirical tests, if the CAPM perfectly explains stock returns, the intercept could also be interpreted as capturing any consistent deviation from the model, which could align with the risk-free rate if all other model assumptions hold and there are no arbitrage opportunities. This nuanced interpretation acknowledges potential empirical deviations from the theoretical model.

Consider the Regression Equation: Ri − Rf = G0

Consider the Regression Equation: R_i − R_f = G₀