The Validity of Capital Asset Pricing Model and Factors of Arbitrage Pricing Theory in Saudi Stock Exchange ABSTRACT The main purpose of this study is to investigate the ability of two alternative models in finance, Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT), to explain the excess return of a portfolio of stocks in Saudi Stock Exchange (TADAWUL). The regression analyses were conducted on the portfolio, which consists of 54 listed and actively traded stocks in TADAWUL. Comprising the ex-ante sample from the period of January 2000 and December 2005 and the ex-post sample from the period of January 2006 and December 2008, this study shows that none of the conditions of the validity of the CAPM was satisfied as …show more content…
Initiated by the economist Stephen Ross in 1976, the APT is a general theory of asset pricing and has become very important and influential in stock pricing. The APT claims that the expected return of a financial asset can be modeled as a linear function of various macro-economic factors or theoretical market indices, where sensitivity to changes in each factor is represented by a factor-specific beta coefficient. The model-derived rate of return will then be used to price the asset correctly. In other words, the asset price should equal the expected end of period price discounted at the rate implied by model. If the price diverges, arbitrage should bring it back into line. Risky asset returns are said to follow a factor structure if they can be expressed as: rj = E (rj) + bj1F1 + bj2F2 + ......+ bjnFn + (j where (rj) is the asset 's return, E(rj) is the jth asset 's expected return, (bjn) is the sensitivity of the jth asset to factor n, also called factor loading, (Fn) is a systematic factor (assumed to have mean zero), and ((j) is the risky asset 's idiosyncratic random shock with mean zero. The APT affirms that if asset returns follow a factor structure then the following relation exists between expected returns and the factor sensitivities: E (rj) = rf + bj1RP1 + bj2RP2
It is believed that Efficient Market Theory is based upon some fallacies and it does not provide strong grounds of whatever that it proposes. More importantly the Efficient Market theory is perceived to be too subjective in its definition and details and because of this it is close to impossible to accommodate this theory into a meaningful and explicit financial model that can actually assist investors in making the investment decisions (Andresso-O’Callaghan, B., 2007).
The extracted data used includes monthly returns from January 1972 to July 2011. The assets are selected so that the portfolio contains the largest, most liquid, and most tradable assets. The choice of such a variety of assets across several markets was used in order to generate a large cross sectional dispersion in average return. It helped to reveal new factor exposure and define a general framework of the correlated value and momentum effects in various asset classes.
Markowitz contribution showed that the benefits of diversification depend not just on risking individual assets but also on how the asset returns interact with each other, or the correlation between returns.
Week 1 – Introduction – Financial Accounting (Review) Week 2 – Financial Markets and Net Present Value Week 3 – Present Value Concepts Week 4 – Bond Valuation and Term Structure Theory Week 5 – Valuation of Stocks Week 6 – Risk and Return – Problem Set #1 Due Week 7* – Midterm (Tuesday*) Week 8 - Portfolio Theory Week 9 – Capital Asset Pricing Model Week 10 – Arbitrage Pricing Theory Week 11 – Operation and Efficiency of Capital Markets Week 12 – Course Review – Problem Set #2 Due
Systematic risk results from factors that affect all stocks. The risk of a project from the viewpoint of a well-diversified shareholder. This measure takes into account that some of the project’s risk will be diversified away as the project is combined with the firm’s other projects, and, in addition, some of the remaining risk will be diversified away by shareholders as they combine this stock with other stocks in their portfolios.” (Keown PG, 510)
The correlation between the market portfolio and HML and the correlation between intercept and HML is -0.335 and -0.070, which indicates a moderate negative relationship between market portfolio and HML, and weak negative relationship between intercept and HML. Also, the correlations between the market portfolio and SMB, and between the SMB and HML are 0.348 and 0.191 respectively, which means that there are some positive relationships between them.
This document is authorized for use only by Yen Ting Chen in FInancial Markets and Institutions taught by Nawal Ahmed Boston University from September 2014 to December 2014.
Financial theory accepts the belief that a share’s return should be proportional to the risk received by its holder. There is a need of a risk-return equilibrium model. Since the nativity of the efficient market hypothesis (EMH), an equilibrium model was only the Capital Asset Pricing Model (CAPM). The CAPM constitutes of two types of returns, the risk free rate of returns of the Treasury bills and beta times the return on the market portfolio. The following equation is the basis of this model:
The capital asset pricing model can be used to determine the rate of return for an asset that is risky. This model aims at assuring that investors are compensated for the risk and the value of money. Therefore, the expected return on a security is equal to the rate of a risk-free security and the risk premium. Risk premium is the minimum amount of money expected in return of an asset that is risky. The risk premium must exceed risk-free and less risky assets.
a. Objective(s). It is out of doubt that no matter how diversified the portfolio is, systematic risk can never be eliminated. The risk associated with individual stocks can be reduced, but general market risks affect almost every stock. So it is important to diversify between different asset classes and industries as well. The key is to find a medium between risk and return. The objective of this paper is to discuss importance of diversification of investment portfolio within industries and project the theory on the example of two portfolios. The first portfolio tends to be undiversified and consists of shares of companies from banking sector. The undiversified portfolio is as follows:
In order to test the validity of the CAPM, we have applied the two-step testing procedure for asset pricing model as proposed by Fama and Macbeth (1973) in their seminal paper.
The analysis of this paper will derive the validity of the Fama and French (FF) model and the efficiency of the Capital Asset Pricing Model (CAPM). The comparison of the Fama and French Model and CAPM (Sharpe, 1964 & Lintner, 1965) uses real time data of stock market to practise its efficacy. The implication of the function in realistic conditions would justify the utility of the CAPM theory. The theory suggests that the expected return demanded by investors on a risky asset depends on the risk-free rate of interest, the expected return on the market portfolio, the variance of the return on the market portfolio, and
Ever since Ross (1976) proposed the Arbitrage Pricing Theory (APT) as an alternative to the capital pricing model, many economists and investors have applied APT across different markets. Whereas the traditional capital pricing model explained asset returns with one beta, sensitivity to the market return, APT decomposes the return with a multiple number of factors. This idea became particularly popular for investors who aim to gain systematic risk other than market risk. However, the model specification aspect has been challenging to many practitioners as the theory does not require any specific sets of variables to be used (Azeez 2006).
Since CAPM was accepted and admitted in fundamental concepts by most people in financial economics, factor model researching becomes a popular topic in finance. In 1992, Eugene Fama and Ken French established the empirical foundations for the Fama & French Three-Factor Model. It is designed to capture the relation between average return and size and the relation between average return and B/M (price ratios).