Estimate The Index Model For Each Firm Over Five Years

Estimate the index model for each firm over the full five-year period

Go to Connect and link to Chapter 7 materials, where you will find a spreadsheet with monthly returns for GM, Ford, Toyota, the S&P 500, and Treasury bills. (LO 7-1) a. Estimate the index model for each firm over the full five-year period. Compare the betas of each firm. b. Now estimate the betas for each firm using only the first two years of the sample and then using only the last two years. How stable are the beta estimates obtained from these shorter subperiods?

Sample Paper For Above instruction

The analysis of firm-specific risk and its relationship with systematic market movements is fundamental in investment analysis and capital market research. Estimating the index model, primarily the Capital Asset Pricing Model (CAPM), involves understanding the beta coefficient, which measures a stock's sensitivity to market returns. This paper aims to estimate the betas for General Motors (GM), Ford, and Toyota over the full five-year period and compare these betas with those derived from shorter-term subperiods, such as the first two years and the last two years of the data sample.

Using the data provided in the Connect Chapter 7 spreadsheets, the initial step is to perform a regression analysis for each firm against the market index, the S&P 500. The model takes the form:

Ri = α + β RM + ε

where Ri is the return on the individual stock, RM is the market return, α is the intercept, β is the beta coefficient, and ε is the error term. The estimated β provides insight into the stock's systematic risk relative to the overall market.

In the full five-year analysis, the regression results may indicate that GM has a beta of approximately 1.2, Ford around 1.0, and Toyota about 0.8. These values suggest different sensitivities to market movements, with GM being slightly more aggressive and Toyota more defensive. The stability of these estimates over shorter subperiods is critical for investment decisions, as high beta variability reflects changing risk profiles over time.

When re-estimating betas using only the first two years' data, the results might reveal, for instance, GM's beta increasing to 1.3, suggesting higher sensitivity in that period. Conversely, in the last two years, GM's beta could decrease to 1.1, indicating lower systematic risk. Similarly, Ford's beta may show minimal variation, stabilizing around 1.0, while Toyota's beta might fluctuate between 0.75 and 0.85. Such fluctuations can stem from changes in operational leverage, market conditions, or industry-specific factors.

The implications of these findings are significant for investors and portfolio managers. Stable beta estimates affirm the reliability of risk assessments, whereas significant variability underscores the need for dynamic risk management strategies. Short-term beta estimates are often more volatile due to fewer data points and transient market conditions, emphasizing the importance of considering longer periods for robust analysis.

In conclusion, estimating the index model over different periods reveals that beta coefficients can vary based on the timeframe analyzed. While long-term estimates tend to be more stable, shorter-term betas are susceptible to fluctuations, which investors should consider when making risk assessments and portfolio optimization decisions.

References

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