Question

The FOMC holds eight regularly scheduled meetings per year. At these meetings, the Committee reviews economic and financial conditions and determines the appropriate stance of monetary policy. They make important interest rate announcements. Based on the dates when these scheduled events occur from 1997 until 2019, does CAPM work? Does CAPM work in non-event period? Please explain.

Answer 1

The CAPM model works on the basis of systematic risk in the market and it assumes that the portfolio is diversified enough to ignore the non-systematic risk of the security. The required return according to the CAPM model is:

Risk free rate + Beta*(Market return- Risk free rate)

Here when the federal open market committee sets the interest rate in its policy announcement then the treasury bill rate is affected by that interest rate and similarly all other maturity treasury securities. Treasury bonds are used as proxy for risk free rate in the CAPM model and because of the change in interest the market return is also affected by that and market return is used to calculate the market risk premium in the CAPM model so in a way we can say that CAPM model does work and it reflect the market sentiments. Even if we take the case of non-event period, still the policy rate would be set by the FOMC and that will affect the treasury rates and that in turn will be used to calculate the required rate and similarly market return will also be affected so CAPM models seems to be working in non-event period also.