Academic journal article Academy of Entrepreneurship Journal

Selection of Regions for Entrepreneurship: An Application of the CAPM

Academic journal article Academy of Entrepreneurship Journal

Selection of Regions for Entrepreneurship: An Application of the CAPM

Article excerpt


In the classic Capital Asset Pricing Model (CAPM) of Sharpe (1964) and Lintner (1965), the total return (current income plus price growth) of an asset is expressed as a linear function of non-diversifiable, systematic risk. Systematic risk is measured by the covariance of the asset's total return with the total return of a market index such as the S&P 500 Index. An important factor that contributes to total return is the growth rate of income. Focusing on the growth rate of income, rather than total return, reduces the influence from variation of discount rates. In addition it eliminates the need to know the original price, or cost, of an investment when calculating return. This opens up the possibility of testing for risk/return relations when income data is available, but not prices or initial investments. Per capita personal income by state and by county are two data sets in which only income data is available.

This paper describes an application of the CAPM to regional growth. In this application the growth rate of personal income of a particular region, such as a state, is an increasing linear function of its systematic risk. Further, systematic risk is measured as the covariance of the growth rate of the personal income of the region with the growth rate of personal income of the entire United States. The results enable ranking of the states (and counties) based on both systematic risk and on excess growth.

The contribution of the paper is two fold. First, this paper is an application of Campbell and Vuolteenaho's (2004) assertion that the CAPM holds when the data considered is relatively free from variation of discount rates (or dividend yields). The regional economic growth rate data used in this study meets this criterion. Second, the paper demonstrates, for the first time, the application of the classic CAPM notion of systematic and unsystematic risks to regional economic growth and related location decisions.

A relation between personal income growth and growth systematic risk has several implications. First, individuals and firms deciding whether to locate in a particular state can temper the attractiveness of a state's high-growth rate with that state's accompanying higher systematic risk. Particularly for firms operating in multiple states or regions, the marginal effect on the firm's overall risk exposure from locating a new facility in another state or region may be quantified by referring to the systematic part of total risk which can not be diversified away. Second, entrepreneurial individuals and firms may consciously choose to seek out states or regions with above average non-systematic risk. Because individuals can effectively choose to live and work in only one state, knowledge of region-specific characteristics that make higher than risk-adjusted average personal income growth rates possible may influence the selection of one region over another. Entrepreneurs may choose to start their business in a region with these unique characteristics to grow their revenues quickly. Third, state and regional economic policy makers can measure the effect of their actions over time on the risk/return profile of their region in comparison to all other regions. For example, policies that improve personal income growth without raising the state's systematic risk can be emphasized. Fourth, economic development professionals seeking to position their state competitively in the minds of potential new residents and investors have a new tool to consider in designing their message. They can target their message to segments that are more likely to be attracted to their area due to its growth/risk profile.

The remainder of the paper is organized as follows. In Section 2, a review of the CAPM and an explanation of why the CAPM should hold for growth rates are presented. Considerable space is devoted to this review to explain the applicability of the CAPM to regional growth data in spite of the fact that the model has generally been rejected in the asset pricing literature. …

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