CAPM Analysis: Calculating stock Beta as a Regression with Python

Capital Asset Pricing Model (CAPM) is an extension of the Markowitz’s Modern Portfolio Theory. This model was developed by the independent works of William Sharpe, Jack Treynor, Jan Mossin, and John Lintner who built on the idea of diversification as introduced by the works of Harry Markowitz.

CAPM attempts to prices securities by examining the relationship that exists between expected returns and risk. The model implies that investors always combine two types of assets or securities; a risk-free asset and a risky asset in the form of a market portfolio of various assets. CAPM further posits that investors expect to be rewarded for holding these risky assets according to the risk inherited for holding on to such assets. After all, such kind of risk cannot be diversified (market-related usually referred to as systematic risk) and as a result, investors need to be compensated for taking on such “undiversifiable” risks. It is intuitive when you think about. Let’s look at this example:

An investor can buy risk free asset like treasury bills of any stable government. If such an investor opts to buy some investment package from company ABC instead of this risk free assets, then such an investor ought to be compensated for this decision. According to CAPM, company ABC does by this by offering the returns of the treasury bill plus an incentive usually referred to as market premium/excess market returns (Market Return-Risk Free Rate) for the given level of risk (Beta) the investors…