6249 Words25 Pages

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

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

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