Fall 2007

FINANCIAL MARKETS Master International and Corporate Finance (ISC Paris) and Risk Management in Finance and Insurance (University of Cergy-Pontoise) Prof. Duc K. Nguyen 25a, ISC2, ISC Paris School of Management [email protected] http://khuongnguyen.free.fr/

PROJECT 1 Measuring risk and return in financial markets and testing the validity of CAPM PROBLEM You have at your disposal a historical data file containing monthly price data for 30 stocks listed in the US Stock Exchanges, and monthly price data for the Dow Jones Industrial Average Index (which is considered as market portfolio) and the 3-month US Treasury bill (which is considered as risk-free asset and has been adjusted for obtaining the one-month rate level). After choosing five of these stocks, you are asked to do the following tasks: 1. Compute the monthly returns for each stock in your sample data1, the monthly returns on the Dow Jones Industrial Average Index and the risk-free asset. 2. Study the risk-return profile of through computing their average rates of return and associated risk (standard deviations). 3. Determine the risk-adjusted rates of return for sample data. Comment your results. 4. Estimate the historical betas of considered stocks using monthly returns over the period from January 1990 to December 1994. Does the CAPM hold for selected assets? 5. Estimate the historical betas of considered stocks using monthly returns over the period from January 1995 to December 1999. Does the CAPM hold for selected assets? 6. For each stock, test the stability of its beta over time using the regression procedure presented in the class. What do you conclude?

NOTES This project allows you to deal with real data in financial markets. Do not worry if the testing procedure shows evidence against the validity of the CAPM because your sample data is limited to a small number of stocks. By using more sophisticated procedure (i.e., Black and al., 1972 or Fama and MacBeth, 1973) and portfolio data might provide more accurate results. Additional Lectures: Black, F., Jensen, M. C. and Scholes, M. (1972). The Capital asset pricing model: Some empirical tests. Studies in the Theory of Capital Markets. pp. 79-121. New York: Praeger. Fama E., MacBeth J. (1973). Risk, Return, and Equilibrium: Empirical Tests. Journal of Political Economy, Vol. 81, Issue 3, pp. 607-636.

1

For comparative purpose, please use the log return formula ( R = ln( Pt ) ) to compute monthly returns. t Pt −1

1|Page

INSTRUCTIONS 1. Go to the following page to get the data: http://khuongnguyen.free.fr/dataproject1.xls 2. The project will be done individually. 3. Results must be presented on an A4 printed paper from MS Word document. 4. The project is due on December 18, 2007 (last class meeting). 5. If the project is done correctly, you can receive up to one (1) bonus point which will be added to your final grade. For students who do not submit their results, one (1) point will be taken away for their final grade.

2|Page