CAPM and inflation (Interview)
Hallo,
Today I had an interview at a small European boutique and the interviewer told me that CAPM beta includes such factors as changes in GDP, inflation and interest rate changes.
I was quite confused since during my undergrad I was taught that beta does not include these factors and we could expand the CAPM by adding them.
I would be very grateful to you if you could help me and clarify this question.
Hallo there. Looks like your undergrad teacher bros screwed you over. Those scoundrels!
Stock returns are a function of things like dividend yield, inflation, real earnings growth (which is a function of real GDP growth), and expansion of P/E multiples. So beta captures all those things, since it's just the regression coefficient between various stock returns. Not so much interest rates directly, but perhaps indirectly I suppose.
Just take everything you learned in the classroom and throw it in the garbage! It's probably misleading.
Hahaha, looks like they did. Thank you very much for the great reply!
When your undergrad teacher said you could "expand" the CAPM by adding these things he was probably referring to the fact that you can develop "factor" models with multiple risk factors and a beta on each factor. So you could, for instance, build a model where returns are regressed against the market, GDP, interest rates, etc. This will illuminate instances where a stock is impacted by the overall market but also has more specific risk exposed to other, less general factors (e.g., a gold mining company on inflation).
But yes, if you just use the CAPM, all these factors are lumped into the Beta on the market.
^ also beta is systematic risk for a firm. Total Risk = Systematic Risk + Idiosyncratic risk. Systematic risk is just market risk and the above factors you mentioned cannot be diversified away, thus they will always exist within a security/portfolio beta.
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