Multivariate test of Sharpe-Lintner CAPM with time-varying beta

This study considers two important features of most time series analysis, i.e. nonlinearity and time-varying risk, to test the validity of Sharpe-Lintner Capital asset pricing model (CAPM). By using data on BM- and size-sorted quintile portfolios, this study resolves the problem of error-in-variables by estimating the firm-specific betas, of which the Kalman filter and the betas obtained from based-sectional analysis are used. From pooled data, this study finds time variance in the systematic risk for certain portfolios. Additionally, the proposed model rejects the Shape-Lintner CAPM. Firm BM(size) appears to be the reason for the rejection of CAPM and firm earnings in excess of predicted CAPM appear to increase(decrease) with bigger(smaller) BM(size).