chapter  5
19 Pages

Multiple Regression and Market Models

ByStanley L. Sclove

The Capital Assets Pricing Model (CAPM) is an example of a market model. Market models describe the rate of return (ROR) of an asset in terms of the behavior of the market as a whole. The CAPM attempts to explain this behavior by a single variable, the excess ROR of the market. Generally, the behavior of an asset is reflected not only in the ROR of a market index, but also in other explanatory variables reflecting market characteristics. The CAPM is widely taught because of its insights into capital markets and because it is sufficient for many important applications. Fama and French introduced two other variables along with the overall market factor, resulting in a three-factor model. The variable "fund" is the excess ROR of a mutual fund; "market" is the excess ROR of a market index. The error variances may differ between Bull and Bear markets.