Unit roots in the CAPM?

Abstract

Excess returns calculated using nonstationary risk-free interest rates will also be nonstationary and this may cause an unbalanced regression problem in the estimation of Capital Asset Pricing Models (CAPM). Under such circumstances, beta coefficients could be both biased and inconsistent. The implications of these issues are investigated through a simulation study and an empirical application using data on the FTA index and the 91-day UK Treasury Bill (T-Bill) rates. Although the simulation results are alarming, the empirical analysis suggests that the problem of unbalanced regression is not likely to cause significant problems in estimating the CAPM.