Applying CAPM Alpha to Rank Stocks for a Quantitative Strategy

Summary

The document explains how the Capital Asset Pricing Model can be used to assess stock returns relative to market risk. Under CAPM, expected return is linked to the risk-free rate and the stock’s beta multiplied by the market risk premium. A regression of a stock’s returns against market returns can be used to estimate beta and an intercept; the document calls the difference from the CAPM relationship alpha.

It proposes using nonzero alpha as evidence of mispricing and, assuming prices eventually return to fair value, selecting stocks with lower alpha. This is a conceptual strategy outline rather than a complete trading method: it gives no sample universe, estimation window, portfolio construction, transaction-cost treatment, or backtest results. The claimed direction of mispricing for positive versus negative alpha is also presented without evidence or discussion of the model’s assumptions and estimation uncertainty.

Key ideas

• CAPM relates expected stock return to the risk-free rate and market risk premium scaled by beta.
• Regression against market returns can estimate a stock’s beta and an intercept.
• The document defines alpha as deviation from the return implied by CAPM.
• It suggests ranking stocks by alpha and buying those with lower values.
• The strategy assumes CAPM validity and eventual price correction, but supplies no empirical test.

Tags

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.