Individual Assignment - ECON5069
Sisir Ramanan
There are two questions. Answer both questions.
Question 1 is weighted at 60% and Question 2 at 40%.
Question 1
You are provided a dataset called USstocks.dta. This dataset contains monthly stock returns of 982
U.S. Companies listed in the S&P 500 index spanning the time period January, 1980 – December, 2015.
Variables contained in this dataset are described below:
• permno - Unique number that identies a company.
• year, month - Identies the time period.
• companyname - Name of the company
• ri - Monthly Returns of the company in % units.
• rm - Monthly Returns of the S&P 500 index in % units, a proxy for market return.
• rf - Monthly returns of 3 month U.S. Treasury Bills in % units, a proxy of the riskfree return.
Form 10 portfolios using the method described in Lab 2. This procedure involves running 5 year
rolling regressions to estimate beta and then sorting on these beta values to form portfolio and monthly
portfolio returns. Portfolio returns are the arithmetic average of individual stock returns. Start with
the years 1980-1984 and get portfolio returns for each month in the year 1985. Repeat this procedure
to construct portfolio returns for the sample period 1985-2015.
Unlike the dataset used in Lab 2, here you have incomplete data. Every few years, some rms drop
out due to delisting and new ones get enlisted. To adjust for this you need to impose an additional
condition when forming portfolios - For a rm to be included in a portfolio, it should have atleast 24
months of returns data. This approach is consistent with Black, Jensen and Scholes (1972).
For the 31-year sample of 1985-2015 monthly portfolio returns, conduct both the time series
regression test and the cross-sectional test, and tabulate your results. See table 1 and 2 in Lab 2
for reference. Plot and discuss estimated portfolio betas against (annulized) portfolio returns.
Based on your test results, is there enough evidence to reject the CAPM? Explain.
[60%]
1

P
Question 2
What is the equity risk premium puzzle? You do not need to derive the equations. Many solutions
to this puzzle have been proposed in the asset pricing literature – rare disasters, ambiguity aversion,
habit formation, long run risks etc to name a few. Explain any two of these solutions in not more
than 600 words.
[40%]
2