Comparative analysis of CAPM: Evidence fromthree SouthAsian countries

Abstract

This study investigates the validity and acceptability of CAPM in three different stock exchanges in south Asian countries i.e. Karachi Stock Exchange (KSE), Bombay Stock Exchange (BSE), Chittagong Stock Exchange (CSE), The data used in this study were collected from 90 companies listed in three south Asian stock marketson monthly, quarterly and semi-annually basis. The Paired sample t- test is applied to find the difference between actual and expected returns. Results show that CAPM predicts more accurate return on monthly based investment as compared to semi-annually based investment in Karachi stock exchange. CAPM predicts more consistent returnson monthly and semi-annually based investment in Bombay stock exchange.In Chittagong; CAPM predicts more accurate return on long term investment (semiannually) as compared to short term investment (monthly). Results of comparative analysis show that KSE 30 and BSE 30 found at defensive marketandCCE 30 found at a neutral market in monthly based investment. KSE30 and CSE30 found as aggressive market and BSE30 found a neutral market for quarterly and semi-annually based investment.It is recommended thatrisk averse investors should consider KSE30 and Sensex 30 for monthly based investment, risk neutral investor should consider CSE 30 for monthly investment and Sensex 30 for quarterly and semiannually based investment,risk taker investors should consider KSE 30 and CSE 30 for quarterly and semiannually based investment.

Key words: Capital asset pricing model, Systematic risk, Unsystematic risk, Risk free rate

JEL Classification:C22, E43, G11, G12

1.1Introduction

Capital asset pricing model (CAPM) provides one of the best ways to determine the expected return along with the risk measurement in quantitative terms.CAPMcomprises of market return (return related to entire market), risk free return (return with zero risk factor) and beta (beta measure the risk associated with stocks related to the market). CAP model was originated by Treynor, Sharpe and Lintner in 1960’s. The investors who are risk averseinvestors utilize the Capital asset pricing model in order to measure the risk return relationship.

In the past many researches have been done to test the validity of CAPM. Some researchers found results in favor of CAPM validity and conclude that CAPM accurately predict the return on stock market with measuring the risk. On the other hand, some studies also found the empirical results against the validity of CAPM due to multifactor variables[1], static beta[2], time variability factor[3] and inconsistent risk return relationship[4].

A South Asian stock market is an emerging market with high volatility. There are different stocks exchanges exist indifferent Asian countries. These counties are Bangladesh, Bhutan, India,Maldives,Nepal, Pakistan, Sri Lanka, British Indian Ocean Territory, Hong Kong, Singapore, Taiwan South Korea, Thailand, Indonesia, Malaysia china and Japan. The focus is on the stock market of south Asian countries, namely; Pakistan, Bangladesh and India.These countries are dominant in representing a South Asian stock market. Each of the country’s stock markets capitalizes in more than one city. The Pakistan stock market consists of three stock exchanges, Karachi Stock Exchange (KSE), Lahore stock Exchanges (LSE), Islamabad stock exchange(ISE), Bangladesh has two stock exchanges; “Dhaka Stock Exchange (DSE), and Chittagong stock exchange (CSE). There are large numbers of stock exchanges in India, but Bombay stock exchange (BSE) is the largest one. Only three stock exchanges are considered in this study; Karachi stock exchange of Pakistan, Bombay stock exchange of India and Chittagong stock exchange of Bangladesh.

There are few most volatile stock exchanges within South Asian stock markets are Karachi stock exchange, Chittagong stock exchange, and Bombay stock exchange.Bombay stock exchange observed as volatile market when it reached to 14273.42 points on 18 may 2009 the previous closing points was 12173.46. This shows that market is highly volatile, which moves by 2100 points within one day. Similarly KSE 100 index lost 3300 points range from 9187 to 5865 in just 13 trading sessions in Dec 2008 but in next 60 days index rise up to 2638 and moves towards bullish trend. This bearish turn of the market was found due to increase in the inflation rate. During the end of 2010 Chittagong stock market changed the direction and found more volatility as it lost 1800 points within a month of January 2011. Due to this market crash a lot of investors face the overall investment lost.

The main reason of high volatility is due to its high volume. South Asian stock exchanges are capitalized with large number of investors. Due to the high volatility, investors who are risk averse need to measure the risk associated with their investment in order to diversify the risk. CAPM rationality is the main focus of this study that weather CAP model is appropriate or not with respect to the time periodin the South Asian stock market.

2Literature Review

2.1Theoretical Background

In the real world with every opportunity there is some cost associated with it. As investment providesan opportunity for investors to earn profit, so investments also associate with some risk factor. The Investor wants some gain on their investment while taking the risk. Some investor is like to invest those securities which contain low risk. These types of investor are known as a risk averse investor. Risk averse investors are not willing to take the risk and likely to invest in such securities that consist on less volatile return. Risk averse investors are reluctant to take the risk and do not put their investment in risky securities. For those investors risk is considered an important factor while making decision about the investment in the securities. On the other hand, those investors who want high return and put their investment regardless of risk associated are risk takers. These types of investors are willing to take risk and likely to choose securities with greater risk. This type of investor believes that more return associate with highly risky securities. Thethird type of investors are risk neutral. This type of investor is not concerned with the risk. Their only concern with the expected return without measuring the associated risk.

The Investors must be compensatedfor bearing the risk. Investors demanded for premium as their investment associated with higher risk. The theory also says that higher return is associated with higher risk. Investors expect the premium on their investment in specific stocks. But fluctuation of stock price may increase the risk and affect the expected return. There are two types of risk associated with the investment Unsystematic riskand systematic risk. Unsystematic risk is the risk which is company specific. Unsystematic risk is diversifiable risk through investment in a variety of securities.Diversification is a technique use to manage the risk through investment in a variety of securities. Systematic risk is non-diversifiable. Systematic risk related to entire market, it cannot be eliminated through diversification because there are some factors include (recession, inflation, wars and high interest rates)which affect all the firms systematically. Investors are benefited more by bearing the risk related to marketing. All the diversified investor confronts with the systematic risk rather than total risk. Before making the investment decision, investors need to measure market risk associated with each security. The focal point of the investor is to estimate the accurate risk, return relationship on their investment.

Capital asset pricing model Beta coefficient is the measure of relevant risk that contributes by each security. Stock with high standalone risk contribute more risks similar stock with a low standalone risk contribute less risk to the market index. The Beta value shows the risk within a range from 0.1 to 2. If beta equals to 0.5, it means that stock tends to be as half risky as the market risk. If beta equals to 1, it means that stock contains the risk as much as market risk. Beta equals to 2 shows that stock risk is twice of the market risk. Beta variation is shown in figure1.1.

As shown in the diagram how beta of each individual stock vary with the volatility of market return. Suppose that market contain the entire stocks known as the market portfolio represented by “Rm” plotted on x-axis and return on the individual stock’s (High = H, Average= A, Low= L) on the y-axis. As the return on the entire market rises up to 20%, return on stock H, A and L also rises and reach at 30%, 20% and 15% respectively. The graph shows that return on the entire market and return to stock A equals to 20%. At this level stock A consist beta equals to 1 which shows that stock as risky as market risk. At the same level of market return on stock H shows high risk contribution to market portfolio as this stock contain beta greater than 1. Similarly, stock L contributes low risk with beta less than 1. On the other hand beta moves in the same direction as the market goes down, but the beta moment varies depending upon the correlation between stock return and market return.

Following are the theoretical assumptions, consider in this research[5]

  • All the investors allow borrowing or lending unlimited amount.Aninvestor can borrow and lend the amount at a given interest rate which is risk free.
  • All investors have homogeneous and identical expectation about the return on their investment.
  • All assets are perfectly divisible and liquid.
  • There is no cost associated with the transaction.
  • Taxes are exempted on such transactions.
  • All investors are the price taker. There is no effect of their trade on stock price.
  • All the assets are fixed in quantitative terms.

Figure-1.1 Beta variation

2.2 Empirical Studies

Raza et al, (2014) investigates the risk and investment decisions in stock markets in Asian countries, i.e. the results shows that Capital asset pricing model predict the accurate results, not only in short term investment but also in long term investment in the Asian stock market. They recommend that the risk taker investors should pay more attention towards JKT 30, SSE 50 and HSE 35 indices for long term investment and pay more attention to JKT 30 indices for short term investment. On the other hand, risk neutral investors should concentrate on KLSE 30 index forlong term investment and should focus on KLSE 30 and HSE 35 for short term investment.

Bilgin and Basti,(2011)examine the Validity of Capital Asset Pricing Model in Istanbul Stock Exchange, Results indicate that there is no significant relationship found between betas and risk premium. They conclude that beta is not valid in Istanbul stock exchange. They recommend that separating the positive and the negative excess return in Istanbul stock exchange, the significant relationship between risks and realize return can be found.

Raza et al(2011), investigate the capital asset pricing model in Karachi stock exchange by using the time series data from 2004 to 2011. They use paired sample t- test techniques to find difference between the actual and expected return. They conclude that capital asset pricing model can predict stock return more accurately on short term investment as compared to predict stock return on long term investment. They recommend that investors should pay more attention on CAP model to predict the return based on investment for a short time period.

Theriouet al,(2010)tests the relation between beta and returns in the Athens stock exchange. They used paired t-test techniques. Results show that there is a significant relationship between betas and return in up or down market when using an asset pricing model. They conclude that beta is positively correlated with realize returns in up market and negatively correlated in down market. They recommend that financial and insurance companies and all listed companies in ASE should use the CAPM to estimate the risk, return relationship and for making the number of portfolios

Hanif and Bhatti,(2010) examine the validity of the capital asset price model in Karachi stock exchange by using monthly data of the securities listed in KSE from the year of 2003 to 2008. They found that CAPM is applied to calculate the accurate return for a limited timeperiod only. The Results show that there are only 28 observations supporting the CAP model out of 332. They conclude that CAPM is not reliable in predicting the required return and risk relationship.

Hanif,(2010) Test the application of capital asset pricing model for tobacco sector companies listed on the Karachi stock exchange by coveringthree years data from 2004 to 2007. The results reveal that CAP model does not predict the accurate return of tobacco industry Pakistan. They conclude that the CAP model shows different results with respect to required return and beta shows more accurate results for only monthly basis as compare to weekly and daily basis. They conclude against the validity of CAPM on Pakistan tobacco industry. They recommend multi-factor model can be used to determine the expected return and risk.

Nikolaos, (2009) evaluates the validity of the capital asset pricing model in British stock exchange by data of eighteen years from January 1980 to February 1998. Their research covered monthly stock data of 39 different companies listed in London stock exchange. They found results against the validity of the CAPM in British stock market. They recommend that investors should consider beta for asset management and incorporate artificial intelligence for asset pricing model

Hui and Christoper,(2008) investigate the validity of the CAPM in Japan and United Statesstock market by using 11 years data of 95 securities listed in Japan and United States stock exchanges. Their result does not support CAPM validity in Japan and U.S. stock exchanges. They conclude that Capital asset pricing model does not predict accurately return in Japan and U.S stock markets.

Iqbal and brooks,(2007) examines the applicability of the capital asset pricing model to predict the stock return on Karachi stock exchange by using the daily, weekly and monthly data covering the period from September 1992 to April 2006. The results reveal that the risk, return relationship is found to be non-linear.They recommend that investors should consider the non-linear factor before making an investment decision.

Guan et al,(2007)theseexamines the stability of beta and CAPM validity by using the annuallydata of stocks listed in NYSE, AMEX, and NASDAQ from the year 1967 to 1997.The result shows that CAPM predict accurate expected return. Beta is found to be acceptable in explaining the cross sectional return by reducing the beta measurement and idiosyncratic variable. They recommend that beta must consider in measuring the risk associated with securities.

Galagedera,(2007) investigate the capability of traditional CAPM in explaining the security returns and risk associated with the security. They found result against the validity of CAPM, with the evidence that systematic risk fails to explain the variation of cross asset in expected return due to positive excess return market return. They recommend that higher order co-moment should incorporate as an alternative to the single-factor CAPM and should assume the indirect relationship between portfolio return and beta during the down market in order to get more accurate results.

Schrimpf,(2007)investigate the CAPM ability in German stock exchange by covering the period of 33 years from 1969 to 2002. They found that unconditional CAPM is insignificant in explaining the cross section return.They conclude that CAPM with Term spread provide favorable results in explaining the cross section return in German stock exchange.

Michailidiset al,(2006) tests the validity of the CAP modelonthe Athens stock market by using weekly data for fourteen years from January 1998 to December 2002 of hundred companies listed onthe Athens stock exchange. Results neglect the basic statement about the direct relation between risk and return. They also found the there is no effect of residual risk of expected returns because of which CAPM is not effectively capture all the important determinant.

Fraser and Hamelink,(2004) comparatively analyze the CAPM with GARCH Model by using the data of securities listed onthe London stock exchange from 1975 to 1976. Results show that GARCH model is valid to predict the stock return more accurately than CAPM.

Ocampo, s(2004)test the validity of CAPM in the Philippine equities market by using the monthly stock dataof securities listed in the Philippine stock market from the year 1992 to 2002. The result shows that beta has a more significant effect in explaining the return under the conditional method as compared to traditional method. They recommend that investors can be rewarded when they make a stock portfolio with high beta in up market and low beta in low down market.