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Copy of Research Proposal

Copy of Research Proposal

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Published by: Usman_safi on Jan 04, 2010
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Capital asset pricing has always been an active area in the finance literature. The capitalasset pricing model (CAPM) of Sharpe (1964), Linter (1965) is a major analytical tool for explaining relationship between the expected return and risk. The competing model of CAPM is three-factor model of Fama and French (1993). Both are linear regression basedmodels used for the calculation of expected return.
Literature Review
Investment decisions are based on cost benefit analysis and risk rewardanalysis. The higher the risk in an investment, the higher will be the return.William Sharpe laid down the foundation of empirical asset pricing models. Theidea behind the Sharpe’s CAPM was that expected return on a security is the sumof risk free rate plus risk premium, where risk premium is the linear function(demonstrated by beta) of the co-variance between the excess return of thesecurity/portfolio and the excess return of the market (fully diversified) portfolio.The CAPM equation for the excess return is;(Ri-Rf) = a + b(Rm-Rf) + eWhere;(Ri) is the return of the security/portfolio.(Rf) is the risk free rate. (T-bill rate)(Rm) is the return of fully diversified portfolio.(b) is the slope or risk of the security.(e) is the error term.The CAPM Equation for the expected return is;E(Ri) = Rf + b(Rm-Rf) + eWhere;E(Ri) is the expected total return.(e) is the error term.In simple according to William Sharpe risk premium of security/portfoliois only related to the risk taken as compared to the market portfolio’s risk.
Jenson (1968) stated that the relationship between beta and expectedreturn can be explained by the time series regression and sole beta will beresponsible for all the variations if the value of intercept is equal to zeroDouglas (1969) is one of the earliest studies to test CAPM on individualcompanies. He found that intercepts have values much larger than risk free raterepresented by T-bill rate. Similarly Black Jensen and Scholes (1972), Blume andFriend (1973), Fama and Macbeth (1973) found the same results.Later other researchers found some more evidence that contradicted theresults of CAPM. Basu (1977) observed that CAPM under estimates the expectedreturn on stocks of firms with high earning to price ratio (Low P/E ratio). Banz(1981) found another weakness of CAPM. He observed that future earnings arehigh on stocks of small firms how ever CAPM is unable to reflect this effect inthe expected future earnings.Fama and French (1993) finally incorporated another two variables to over come the weaknesses of CAPM. They added two extra variable to CAPM, pointedout by Basu (1977) and Banz (1981). To capture the effect of size they addedRsmb (Return of small firms minus return of big firms) and to capture the effectof high earning price ratio holding companies they added Rhml (Return of High book to market ratio minus return of low book to market ratio companies).The Fama and French three-factor model for excess return is;(Ri-Rf) = a + b1(Rm-Rf) + b2(RSMB) + b3(RHML) + eWhere;(Ri) is the total return.(Rf) is the risk free rate.(Rm-Rf), (RSMB) and (RHML) are premiums.(b1), (b2) and (b3) are the sensitivities.The Fama and French three-factor model for total expected return is;
E(Ri) = Rf + b1(Rm-Rf) + b2(RSMB) + b3 (RHML) + eFama and French (1996) claimed that their model better calculates the future return for stocks because the alphas of their regressions were closer to zero.Connors and Senghal (2001) tested CAPM single factor and Fama andFrench three-factor model in India. Their sample was from CRISIL- 500 as KSE100-index in Pakistan and formed six portfolios. They compared the two models by looking at their intercepts. They tested the statistical significance of intercepts jointly by Gibbons, Ross and Shanken (GRS) test (1989). In their test the Famaand French three-factor model out performed the single factor CAPM. For CAPMthe intercepts of three portfolios were significant at the 95% confidence level. TheGRS test value for CAPM was 3.8069 with p-value of 0.0017 which shows thatthe intercepts are jointly significant and the null hypothesis can not be accepted.For three-factor model none of the intercept was zero, How-ever the GRS statisticwas 1.7478, much lower as compared to that of CAPM. The p-value was 0.1168which means null hypothesis is to be accepted. Connor and Senghal (2001)concluded that addition of two extra variables does make a difference inexplaining the variations in expected return hence three-factor Fama and Frenchmodel is superior to single-factor Sharpe’s CAPM.Drew and Veeraraghavan (2002) conducted study about the size and value premium in Malaysia. The data sample was form Bursa Malaysia (MalaysianStock Exchange) for period starting from December 1991 to December 1999.They formed six portfolios for the study of SMB and HML factors. According totheir estimation returns were 17.7% and 17.6% of SMB and HML portfoliosrespectively. How ever the market return was only 1.92%. From these results theyconcluded that extra returns brought are the effect of size and value factors andrejected any influence of data snooping.Drew and Veeraraghavan (2003) further tested the single factor and three-factor model in other countries. Besides Malaysia they studied stocks in Hong

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