A DISSERTATION REPORT ON

A Study on Capital Asset Pricing Model and Feasibility of its Anomalies in Indian Market

IN PARTIAL FULFILLMENT OF REQUIREMENT OF POST GRADUATE DIPLOMA IN MANAGEMENT PROGRAMME 2009-11

Submitted To:Vimal Babu Faculty (HR)

Submitted By:Varun Narang PGDM 2009 Roll No. 29118

Northern Integrated Institute Of Learning Management Centre for Management Studies Greater Noida,
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ACKNOWLEDGEMENT ³When time, speed, skill, timing and diligence combine¶s horizons become the ultimate site.´
No task however small could be accomplished without guidance, help, and assistance. I am indebted to all persons who have contributed there worth in completion of my study.

The financial Dissertation project was successfully completed with the help, encouragement, advice, inspiration and stimulus received from my faculty Vimal Babu, Sukumar Dutta and Hima Bindu Kota

I feel deep sense of gratitude in thanking them as they sincerely helped me heaps to carry on this project to its eventual friction. My Dissertation project would have been mobilized had they not have given their invaluable guidance and consistent support at all hours.

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EXECUTIVE SUMMARY This study deals with the Effect Capital Asset Pricing Model and its anomalies in Indian Market. The Capital Asset Pricing Model (CAPM) is the most popular model of the determination of expected returns on securities and other financial assets. It is considered to be an ³asset pricing´ model since, for a given exogenous expected payoff, the asset price can be backed out once the expected return is determined. Additionally, the expected return derived within the CAPM or any other asset pricing model may be used to discount future cash flows. These discounted cash flows then are added to determine an asset¶s price. The first part of the study deals with the basic definition, advantages and application of CAPM. CAPM is tool used for risk return analysis. It helps to know the Company¶s Cost of capital. In the first part of the study CAPM calculation, CML, SML etc has been explained. In the second chapter the literary review about capital asset pricing model is stated. CAPM is based on Markowitz Modern portfolio theory. Various other scholars gave their own analysis for CAPM model. Like Fama modified CAPM and gave an alternative version called CCAPM which is Conditional Capital Asset Pricing Model. The attraction of the CAPM is that it offers powerful and intuitively pleasing predictions about how to measure risk and the relation between expected return and risk. Unfortunately, the empirical record of the model is poor²poor enough to invalidate the way it is used in applications. The CAPM¶s empirical problems may reflect theoretical failings, the result of many simplifying assumptions. But they may also be caused by difficulties in implementing valid tests of the model In the third chapter Alternative model is described and a comparison between Arbitrage Pricing Model and Captial Asset Pricing Model. . The Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT) have emerged as two models that have tried to scientifically measure the potential for assets to generate a return or a loss. They are similar in that they attempt to measure an asset's propensity to follow the overall market however APT attempts to divide market risk into smaller component risk. The fourth chapter deals with testing CAPM in Indian market .a sample of 50 companies listed on BSE are taken. The average return of all the 50 companies for 10 years is calculated. Sensex yearly Market rate is taken for 10 years. Beta of each company with respect to the market return is calculated. The result showed that higher beta firms always earn higher returns. Hence through this finding Capital asset pricing model is tested.

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In the fifth part of the study Efficient Market hypothesis is explained. All the types of Form: Weak Form, Semi Strong form and Strong form is explained. In this part the CAPM Anomalies like Small firm effect, P/E effect, D/e effect, and Seasonality effects are also explained.

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TABLE OF CONTENT Submitted To:-

Submitted By:- ...... 1

INTRODUCTION TO CAPITAL ASSET PRICING MODEL .......................................................... 6

RISK RETURN POSSIBILITIES WITH LEVERAGE ..................................................... 11 THE DOMINANT PORTFOLIO µM¶ ............................................................................... 13 THE CAPITAL MARKET LINE ...................................................................................... 15 SECURITY MARKET LINE ............................................................................................ 17 The Logic of the CAPM .................................................................................................... 20 Multifactor Models and Arbitrage Pricing Theory (APT) .................................................. 29
TESTING CAPITAL ASSET PRICING MODEL IN INDIAN STOCK MARKET .......................... 33

INTRODUCTION ............................................................................................................ 34 Methodology ..................................................................................................................... 39 CONCLUSION ................................................................................................................. 42 THREE VERSIONS OF THE EFFICIENT MARKETS HYPOTHESIS ........................... 45 COMMON MISCONCEPTIONS ABOUT THE EMH ..................................................... 47 CONCLUSIONS............................................................................................................... 55
BIBLIOGRAPHY AND ANNEXURE ......................................................................................... 56

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I INTRODUCTION TO CAPITAL ASSET PRICING MODEL Page 6 .CHAPTER .

The Capital Asset Pricing Model (CAPM) is the most popular model of the determination of expected returns on securities and other financial assets. Additionally. the CAPM is an equation that expresses the equilibrium relationship between the security¶s or portfolio¶s expected return and its systematic risk. Assumption of CAPM The capital market theory is based on the basis of Markowitz¶s portfolio model. Although the model has been extensively examined.EVOLUTION OF CAPM The CAPM was developed in the mid 1960¶s. it has been applied in wide variety of academic and institutional applications such as measuring the portfolio performance. the asset price can be backed out once the expected return is determined. modified and extended in the literature. the CAPM is a direct extension of the portfolio models developed by Sharpe and Markowitch. These discounted cash flows then are added to determine an asset¶s price. determining price of risk implicit in the current market prices and capital budgeting. for a given exogenous expected payoff. Because of this focus of the mean and standard deviation. the expected return derived within the CAPM or any other asset pricing model may be used to discount future cash flows. The model has generally been attributed to William Sharpe. the model is often referred to as Sharpe-Lintner-Mossin (SLM) Capital Asset Pricing Model. even though the focus is on expected return. Consequently. testing of marketing efficiency. This theory is based on certain assumptions as: Page 7 . It is considered to be an ³asset pricing´ model since. So. Because the CAPM is relatively a simple model. we will continue to refer to the CAPM as an asset pricing model. The CAPM explains the Relationship that should exist between the securities expected returns and their risk in terms of the means and standard deviation about security returns. identifying undervalued and overvalued securities. but John Lintner and Jan Massin also made similar independent derivations. Using Simplified assumptions. the original SLM version of CAPM still remains the central theme in the Capital Market theory as well as the current practices of Investment management.

g) It is assumed that the inflation rates are fully anticipated or in other situations it may be totally be absent thus resulting in no changes in the tax rate.. on which Markowitz portfolio theory is based. for instance. Their exact location on the efficient frontier.a) All the investors are considered to be efficient investors who like to position themselves on the efficient frontier. all investments are correctly priced on par with their risk levels. it may be possible to lend money at risk free rate by buying the risk-free securities. holders of pension funds and even religious groups do not have to pay taxes and further it has been found out that the transaction cost of many financial instruments that are traded by most of the financial institutions are less than one percent. It might sound unrealistic. treasury bills but it may not be possible to be possible to borrow money at risk free rate while stating some of the assumptions and it should be borne in mind that even by relaxing some of these assumptions. For example. c) All investors are expected to have homogeneous expectations. f) The process of buying or selling of assets does not involve any transaction costs. d) All investors have same investment time horizon. b) Investors are free to borrow or lend any amount of money at the Risk. The risk that CAPM discussed consists of two components: systematic risk and fundamental risk. i. Therefore there is a need to distinguish the difference of systematic Page 8 . their future rates of return have identical probability distributions. The assumptions. the systematic risk is a complete measure of security risk. CAPM is a model about the relationship between risk and required return of return on asset. that is. are applicable to CAPM also. the model does not change much. and embodies the two fundamental relationships: capital market line and security market line. e) All investors are assumed to be infinitely divisible making it possible to even buy or sell fractional shares of any portfolio.e. h) Another assumption of the theory is the equilibrium in the capital markets. however. say.Free Rate of Return (RFR). depends on their risk return utility function. The most important thought of CAPM is that beta. CAPM is the extension of the Markowitz portfolio theory.

it is necessary to quantify the risk usually employing the following two measures: Page 9 . The measure of risk used in the CAPM. Therefore. which is called µbeta¶. In investment analysis. so that there is no risk at all of the return on the investment being different from the expected return. This minimum level of return is called the µrisk-free rate of return¶. is therefore a measure of systematic risk. rather than on its total risk. This means that investors are assumed by the CAPM to want a return on an investment based on its systematic risk alone.and unsystematic risk in order to understand CAPM through security market line and capital market line. variation exists around the expected returns. The return that an investment is expected to fetch probably will not be the same as that actually obtained. Figure 1: Systematic and Unsystematic Risk The CAPM assumes that investors hold fully diversified portfolios. Beta and Standard Deviation Investments are risky because returns cannot be comprehended. The minimum level of return required by investors occurs when the actual return is the same as the expected return.

the return on his security becomes the return on his portfolio. the covariance between any risk free asset and risky asset will be zero as rf. Risk Free Assets Before going into detail of risk free assets one need to know about risky assets. the appropriate measure of risk would be beta. The uncertainty can be measured by the variance or the standard deviation of the expected future returns.e. which further leads to the fact that the product of any other expression with this expression will be zero. Variance around the expected return statistically can be measured by standard deviation or variance. Thus for a well diversified portfolio. In that case. This will result in the covariance of the risk free asset with any risky asset or portfolio to be also zero. Further it is to remember that the rate of return earned on such asset should be the risk free rate of return (rf).a/ f a. a risky asset is one which gives uncertain future returns. in that case the return on assets move relative to the returns on the market portfolio. By effective diversification. Similarly. Covariance of Risk free Assets with Risky Assets Let us consider the covariance of two sets of returns.a = Covf. asset specific risks are eliminated. In essence. The Standard deviation  The Beta Now. the only security he holds becomes his portfolio. A &B CovAB = ™[rA ± E(rA)][rB ± E(rB)] /n The uncertainty for the risk free asset is known. risk-averse investor view variance as the appropriate risk measure if he holds only one security. f = 0. It is an indication as to how the individual asset is contributing to the total risk of the portfolio. And the risk free assets are those whose expected risk is fully certain and thus standard deviation of such expected returns comes to zero i. Beta in fact absorbs the risk which cannot be diversified. rA ± E(rA) = 0. So. which implies that rA = E(rA) for all the periods. for. the contribution of any one of the asset \s to the riskiness of the portfolio is its systematic or non-diversifiable risk. and measure of risk in such a case is beta. Thus. for holding multiple assets. a rational. On the other hand. so f = 0. Combining a Risk free Asset with the Risky Portfolio Page 10 .

he is situated at a point µk¶.When risky assets are combined with risk free assets then the expected return of the portfolio is written as : E(ri) = Wf(rf) + (1-Wf) E(ra) Where. on the efficient frontier. Say.A f a It is further known that 2 i ) 2 f = 0 and rf.e. Page 11 . because of the correlation between the risk free asset and any risky asset A is zero. he will want to go beyond that point i. LENDING AND BORROWING AT THE RISKLESS RATE The consideration of riskless asset alters the efficient frontier considerably. RISK RETURN POSSIBILITIES WITH LEVERAGE As investor always want to increase his expected returns..a is also zero. increase his expected returns by accepting higher degree of risk. One way of doing so may be by investing in risky portfolios on the efficient frontier beyond the point µk¶. the equation would be: E( 2 i ) = Wf2 f 2 + (1-Wf)2 2 A + 2Wf(1-Wf)rf.2 1 2 Now on substituting the risk free asset for security 1 and risky asset for security 2. the standard deviation is the linear proportion of the standard deviation of the risky asset portfolio. Wf = the proportion of the portfolio invested in the risk free assets E(ra) = expected return on risky portfolio A Further it is known that the expected variance for the two asset portfolio can be wriiten as: E( 2 i ) = Wi2 2 i + 2W1W2 r1. So the above equation becomes: E( = (1-Wf)2 2 A A Or E( i) = (1-Wf) So it can be said that for any portfolio that combines a risk free asset with any risky asset. Another way is to add leverage to the portfolio by resorting to borrowing money at the risk free rate and use the proceeds to invest in risky asset portfolio at point µk¶.

along with the riskless asset f and three risky portfolios M. With the introduction of rf. Furthermore.Figure 2: Borrowing and Lending at Riskless rate Rf and investing in risky portfolio M The above figure displays the efficient frontier. points. vertical axis at the point rf. it is now possible to form portfolio that have risky assets as well as the risk free assets within them. An important implication of introducing riskless rate of lending and borrowing is the transformation of the efficient frontier. as long as E(rM) > rf investor can continually increase expected return and risk by borrowing increasing amount at rf. the efficient frontier is transformed into a linear form. combination of f with either portfolio B or portfolio M will lie along segment rfB and rfM respectively. and investing the Page 12 . represents the expected rate of return on the riskless asset f. combining any risky portfolio with riskless asset produces a linear relationship between their respective E(r). it¶s E(r) and plot on the zero risk.. portfolios containing f and the risky portfolio A will lie along the line segment rfA as shown in above figure. With the riskless asset f and the ability to borrow or lend (invest) at risk free rate rf. For example. B. all combinations of any portfolio and the riskless asset will lie along a straight line connecting their E(r). A. Since the riskless asset f has no risk (i. f = 0). in terms of expected return E(r ) and standard deviation ( ). Therefore.e. Similarly. Furthermore. plots.

investors can alter the risk/ expected return profile of any efficient portfolio to meet personal preferences for risk and expected return. That is. portfolio M is the best efficient portfolio. the below figure shows the efficient frontier with borrowing and lending portfolio: Figure 3: Borrowing and Lending at Riskless rate and Investing at Risky Portfolio M THE DOMINANT PORTFOLIO µM¶ By borrowing and lending at the riskless rate rf. This is because investors can invest in portfolio M and then borrow or lend at Rf to suit their preference.borrowed amount in portfolio M. they can create portfolio combinations along the line RfM in such a way that for a given level of risk it is possible to find a combination of M and risk free borrowing/ lending which offers a return that is higher than the one available for a portfolio on the efficient frontier. by borrowing and lending at Rf in conjunction with investing in portfolio M. The figure is illustrated as follows: Page 13 . regardless of whether investor want to borrow or lend. In the below figure.

it follows that portfolio M must be a portfolio containing all securities in the market. when compared to portfolios along lower rays drawn from Rf. therefore. This tangency drawn from Rf to m has the greatest slope for any line drawn from Rf to the efficiency set of risky portfolio. Thus portfolio along with the line will maximize E(r ) at their respective levels. point M is the efficient portfolio that maximize the value of [E(r)-rf]/ . all investors should choose efficient portfolio M in conjunction with their preference for lending or borrowing at the risk free rate Rf.Figure 4: Dominant Portfolio Because of this dominance. risk premium. it should contain all available securities. would fall and their expected returns would rise. to the efficient frontier. to any other portfolio along the efficient frontier. Page 14 . That is. Such a portfolio that contains all available securities is called Market Securities. securities that are not included would not be demanded by any investor and prices of these securities. Market Portfolio Since every investor should choose to hold portfolio M. portfolio M represent the tangent between a ray drawn from the intercept Rf. At the same point the increased expected returns would be attractive to some investors. Because all investors should choose market portfolio. If it does not. Graphically.

in terms of E(r) and . E(ri). This CML. but it also expresses the equilibrium pricing relationship between E( r) and for all efficient portfolios lying along the line. and b = [E(Rm) ± Rf]/ m. which is a line passing from Rf. the pricing relationship given by CML can be easily determined. this new linear efficient frontier is called the Capital Market Line. the above equation states that the expected return on any efficient portfolio I. in conjunction with an investment in the market portfolio M. is the sum of two component: (1) the return on the risk free investment Rf. through market portfolio M. or simply the CML. the portfolio along the previous curve efficient frontier. is illustrated in the below Figure. The slope of the CML [E(Rm) ± Rf]/ m is called the market price of the factor that distinguishes the expected return Page 15 . Thus the CML. the old curved efficient frontier is transformed into a new efficient frontier. In the above figure a = Rf. Since the equation of any line can be expressed as y=a + bx. relationship for any efficient portfolio I is provided in equation: E(ri) = Rf + {[E(Rm) ± Rf]/ m} i In other words.THE CAPITAL MARKET LINE With the ability to borrow and lend at the risk free rate Rf. Figure 6: The Capital Market Line(CML) The CML not only represent the new efficient frontier. {[E(Rm) ± Rf]/ m} i that is proportional to the portfolio¶s i. together with the old efficient frontier. where a represents the vertical intercept and B represents the slope of the line. and (2) a risk premium. The inspection of the figure indicates that all portfolios lying along the CML will dominate.

as its measure of Page 16 . Thus the efficient frontier not only produce the set of optimal portfolio in terms of risk and expected returns. the greater would be the risk premium and the expected return on the portfolio. Of Cov (I. only the most efficient in term of risk-reducing potential. since all unsystematic risk has been diversified.m) = 1. That is. The greater is the i. whether efficient or inefficient. Thus.among CML portfolios is the magnitude of the risk. the CML states that the appropriate measure of risk that is to be priced for these efficient portfolios is the level of systematic risk present I these portfolios. portfolio that are constructed of combination of risk free asset f and market portfolio M lie along the CML. but it also represent zero unsystematic risk portfolios. Of Cov (i. However CML assumes well diversified Portfolios. whose returns are perfectly. i. The CAPM utilizes the Beta. can be thought of as either total risk or systematic risk. represents their systematic risk. i. but it also represents portfolios that are efficient in a risk/expected return sense. is the sum of systematic risk. For the efficient set of portfolios along the CML.m/ 2m = [Coeff. we get. since there is no unsystematic risk present in well diversified portfolios. E(Ri) = Rf + [E(Rm) ± Rf] Recall that i = i. Therefore for these portfolios. i. Coeff. as measured by i. It is important to recognize that the CML pricing holds only for efficient portfolio that lies along its line. its systematic risk. In both the CML and CAPM. Finally it is interesting to note that the CML relationship is a special case of CAPM.m)* i}/ m For portfolios. All individual securities and inefficient portfolios lie under the curve. their total risk. the appropriate measure of risk is the systematic portion of total risk. Since total risk i. whereas the CAPM is a pricing relationship that is applicable to all securities and portfolios. E(Ri) = Rf + {[E(Rm) ± Rf]coeff. CML Vs CAPM The CML set forth the relationship between expected return and risk for efficient welldiversified portfolios. Of Cov (i. the CAPM relationship reduces to: E(Ri) = Rf + {[E(Rm) ± Rf]/ m} i m. positively correlated with the market and thus lie along the CML. or covariance systematic risk.m)* i* m]/ 2m Inserting the result into the above equation.

risk premium of an asset i. beta. SML also describes whether a particular asset is defensive or aggressive. i(E(Rm)-Rf). SECURITY MARKET LINE Security market line or market Line is another way to perceive risk return equilibrium relationship. whereas the CML is a special case of the CAPM and represents an equilibrium pricing relationship that holds only for widely diversified. Security Market Line (SML) is broader and able to treat individual securities as well as portfolios. The SML expresses the expected return on any securities or portfolio in terms of the systematic risk of the asset. if the market portfolio is drawn and the line is extended to risk free rate of return. E(Rp) = Rf + (E(Rm) ± Rf) As with CML. it serves as a reference to assess the assets. But SML explains the risk of securities in relative terms through Beta whereas the CML treats the total portfolio risk. It cannot be used to evaluate the equilibrium relationship on single securities because the standard deviation of the securities return is not the proper measure of security¶s true risk. SML is obtained. With expected return on X axis and on Y axis. since the risk of the security depend on the portfolio to which it is added and must reflect the co variability of the security¶s return with the other asset of the portfolio. In addition SML treats any security whereas CML treats efficient portfolio only. efficient portfolios. Thus. Page 17 . there is a risk free and risk component. The CML specifies the equilibrium relationship between expected risk and return for efficient portfolios. It is a line which passes through risk fre return and expected return of a market portfolio. As the beta of the markets is one. Assets for which the beta of the market is less than 1 are called defensive assets and those whose beta is greater than one are called aggressive assets. It expresses the return that should be expected in terms of securities (or portfolios). the CAPM is the general risk/ expected pricing relationship for all assets.This is the CAPM relationship.

asset A is plotted above the SML line.Figure 7: Security Market Line SML also describes whether a particular asset is underpriced. In the above figure. corresponding to the risk level.based return. It is undervalued because expected rate of return is higher than the SML. overpriced or correctly priced. Page 18 . It is expected to earn higher return. asset B is said to be overvalued as the expected rate of return is lower than the SML based return. On the other hand.

II CAPM: LITERATURE REVIEW BY DIFFERENT SCHOLARS Page 19 .CHAPTER .

investors choose ³mean variance. when choosing among portfolios. an investor selects a portfolio at time t _ 1 that produces a stochastic return at t. which is the same for all investors and does not depend on the amount borrowed or lent. As a result. The CAPM turns this algebraic statement into a testable prediction about the relation between risk and expected return by identifying a portfolio that must be efficient if asset prices are to clear the market of all assets. the Markowitz approach is often called a ³mean variance model. Thus. Figure 1 describes portfolio opportunities and tells the CAPM story. investors agree on the joint distribution of asset returns from t _ 1 to t. only portfolios above b along abc are mean- Page 20 .efficient´ portfolios.´ The portfolio model provides an algebraic condition on asset weights in mean variance. measured by the standard deviation of portfolio return. The second assumption is that there is borrowing and lending at a risk-free rate. in the sense that the portfolios 1) minimize the variance of portfolio return. For example. the investor can have an intermediate expected return with lower volatility. And this distribution is the true one²that is. it is the distribution from which the returns we use to test the model are drawn. Sharpe (1964) and Lintner (1965) add two key assumptions to the Markowitz model to identify a portfolio that must be mean-variance-efficient. If there is no risk-free borrowing or lending. In Markowitz¶s model. perhaps at point a. which is called the minimum variance frontier.Capital Asset Pricing Model: Evidence and Theory The Logic of the CAPM The CAPM builds on the model of portfolio choice developed by Harry Markowitz (1959). an investor who wants a high expected return. The first assumption is complete agreement: given market clearing asset prices at t _ 1. At point T. The model assumes investors are risk averse and. given expected return. The curve abc.efficient portfolios. The horizontal axis shows portfolio risk. traces combinations of expected return and risk for portfolios of risky assets that minimize return variance at different levels of expected return. and 2) maximize expected return.) The tradeoff between risk and expected return for minimum variance portfolios is apparent. given variance. (These portfolios do not include risk-free borrowing and lending. must accept high volatility. they care only about the mean and variance of their one-period investment return. the vertical axis shows expected return.

portfolios that combine risk-free lending or borrowing with some risky portfolio g plot along a straight line from Rf through g in Figure Figure 8: Investment Oppurtunity To obtain the mean-variance-efficient portfolios available with risk-free borrowing and lending. all investors see the same opportunity set. If all funds are invested in the risk-free security²that is. Consider a portfolio that invests the proportion x of portfolio funds in a risk-free security and 1 _ x in some portfolio g. With complete agreement about distributions of returns. and they combine the same risky tangency portfolio T with risk-free lending or borrowing. a portfolio with zero variance and a risk-free rate of return. one swings a line from Rf in Figure 1 up and to the left as far as possible. they are loaned at the riskfree rate of interest²the result is the point Rf in Figure 1. Since all investors hold the same Page 21 . given their return variances.´ The punch line of the CAPM is now straightforward. Adding risk-free borrowing and lending turns the efficient set into a straight line. to the tangency portfolio T. since these portfolios also maximize expected return. T. We can then see that all efficient portfolios are combinations of the risk-free asset (either risk-free borrowing or lending) and a single risky tangency portfolio. Points to the right of g on the line represent borrowing at the riskfree rate. This key result is Tobin¶s (1958) ³separation theorem.variance-efficient. Combinations of risk-free lending and positive investment in g plot on the straight line between Rf and g. In short. with the proceeds from the borrowing used to increase investment in portfolio g.

In short. Specifically. In this equation. and _iM. iM is the covariance risk of asset i in M measured relative to the average covariance risk of assets. Thus. E(RM). RM)/ 2(Rm). which is the expected market return. The first term on the right-hand side of the minimum variance condition.««. which is just the variance of the market return. E(Ri) is the expected return on asset i. But there is another interpretation of beta more in line with the spirit of the portfolio model that underlies the CAPM. The last step in the development of the Sharpe-Lintner model is to use the assumption of risk-free borrowing and lending to nail down E(RZM). This means that the algebraic relation that holds for any minimum variance portfolio must hold for the market portfolio. is the covariance of its return with the market return divided by the variance of the market return. the risk-free rate must be set (along with the prices of risky assets) to clear the market for risk-free borrowing and lending. i= 1. Specifically. as measured by the variance of its return (the denominator of iM). Since the market beta of asset i is also the slope in the regression of its return on the market return. which we now call M (for the ³market´). (Market Beta) im = cov(Ri . if there are N risky assets. iM is proportional to the risk each dollar invested in asset I contributes to the market portfolio. N. Such a Page 22 .m. The second term is a risk premium²the market beta of asset i. (Minimum Variance Condition for M) E(Ri) = E(Rzm) + [E(Rm) ± E(Rzm)] i. _iM. it must be the value-weight market portfolio of risky assets. is a weighted average of the covariance risks of the assets in M (the numerators of iM for different assets). which means their returns are uncorrelated with the market return.portfolio T of risky assets. A risky asset¶s return is uncorrelated with the market return²its beta is zero²when the average of the asset¶s covariances with the returns on other assets just offsets the variance of the asset¶s return. the expected return on zero-beta assets. times the premium per unit of beta. the market beta of asset i. each risky asset¶s weight in the tangency portfolio. E(RZM). In economic terms. The risk of the market portfolio. is the expected return on assets that have market betas equal to zero. a common (and correct) interpretation of beta is that it measures the sensitivity of the asset¶s return to variation in the market return. In addition. the CAPM assumptions imply that the market portfolio M must be on the minimum variance frontier if the asset market is to clear. minus E(RZM). must be the total market value of all outstanding units of the asset divided by the total market value of all risky assets.

in the Sharpe-Lintner version of the model. Rf . _iM. Rf .«. E(Ri) = Rf + [ E(Rm). must equal the risk-free rate. the market portfolio is efficient. the expected return on any asset i is the risk-free interest rate. times the premium per unit of beta risk.risky asset is riskless in the market portfolio in the sense that it contributes nothing to the variance of the market return. Unrestricted risk-free borrowing and lending is an unrealistic assumption. The market portfolio is thus a portfolio of the efficient portfolios chosen by investors.Rf)] m. the resulting portfolio is the market portfolio.. the algebra of portfolio efficiency says that portfolios made up of efficient portfolios are not Page 23 . I = 1. E(RZM) must be the risk-free interest rate. the expected return on assets uncorrelated with the market. Thus. Market clearing prices imply that when one weights the efficient portfolios chosen by investors by their (positive) shares of aggregate invested wealth. and it is the expected return-risk relation of the Black CAPM. portfolios made up of efficient portfolios are themselves efficient. Fischer Black (1972) develops a version of the CAPM without risk-free borrowing or lending. The assumption that short selling is unrestricted is as unrealistic as unrestricted risk-free borrowing and lending. The Black version says only that E(RZM) must be less than the expected market return. In contrast. He shows that the CAPM¶s key result²that the market portfolio is meanvariance. if there is no risk-free asset. If there is no risk-free asset and short sales of risky assets are not allowed. which is the asset¶s market beta. N. In words. When there is risk-free borrowing and lending. But when there is no short selling of risky assets and no risk-free asset. which means that the minimum variance condition for M given above holds. In brief. E(RM) _ Rf.efficient²can be obtained by instead allowing unrestricted short sales of risky assets. back in Figure 8. E(RZM). so the premium for beta is positive. plus a risk premium. investors select portfolios from along the mean-variance-efficient frontier from a to b. the expected return on assets that are uncorrelated with the market return. With unrestricted short selling of risky assets. The relation between expected return and beta then becomes the familiar Sharpe-Lintner CAPM equation.. and the premium per unit of beta risk is E(RM) _ Rf. Rf. mean-variance investors still choose efficient portfolios²points above b on the abc curve in Figure 1. The relations between expected return and market beta of the Black and Sharpe-Lintner versions of the CAPM differ only in terms of what each says about E(RZM).

including complete agreement and either unrestricted risk-free borrowing and lending or unrestricted short selling of risky assets. is not typically efficient. Page 24 . This does not rule out predictions about expected return and betas with respect to other efficient portfolios²if theory can specify portfolios that must be efficient if the market is to clear. the cross-section of prices has information about the cross-section of expected returns. (A high expected return implies a high discount rate and a low price. And the CAPM relation between expected return and market beta is lost. Recent Tests Starting in the late 1970s. But so far this has proven impossible. The first blow is Basu¶s (1977) evidence that when common stocks are sorted on earnings-price ratios. the ratio of the book value of a common stock to its market value) have high average returns that are not captured by their betas.typically efficient. But all interesting models involve unrealistic simplifications. A stock¶s price depends not only on the expected cash flows it will provide. Ratios involving stock prices have information about expected returns missed by market betas. which is why they must be tested against data. empirical work appears that challenges even the Black version of the CAPM. Finally. in principle. Specifically. average returns on small stocks are higher than predicted by the CAPM. Banz (1981) documents a size effect: when stocks are sorted on market capitalization (price times shares outstanding). but also on the expected returns that discount expected cash flows back to the present. This means the market portfolio. Bhandari (1988) finds that high debt-equity ratios (book value of debt over the market value of equity. Statman (1980) and Rosenberg. the familiar CAPM equation relating expected asset returns to their market betas is just an application to the market portfolio of the relation between expected return and portfolio beta that holds in any mean-variance-efficient portfolio. a measure of leverage) are associated with returns that are too high relative to their market betas. evidence mounts that much of the variation in expected return is unrelated to market beta. future returns on high E/P stocks are higher than predicted by the CAPM. which is a portfolio of the efficient portfolios chosen by investors. Thus. this is not surprising. There is a theme in the contradictions of the CAPM summarized above.) The cross-section of stock prices is. In short. Reid and Lanstein (1985) document that stocks with high book-to-market equity ratios (B/M. The efficiency of the market portfolio is based on many unrealistic assumptions. On reflection.

the ratio X/P can reveal differences in the cross-section of expected stock returns. Stambaugh. Kothari. On one side are the behavioralists. arbitrarily affected by differences in scale (or units). while low B/M is associated with growth firms (Lakonishok. and the CAPM is dead in its tracks. Shanken and Sloan (1995) try to resuscitate the Sharpe-Lintner CAPM by arguing that the weak relation between average return and beta is just a chance result. they confirm that size. Their view is based on evidence that stocks with high ratios of book value to market price are typically firms that have fallen on bad times. clouded by statistical uncertainty (a large standard error). The second story for explaining the empirical contradictions of the CAPM is that they point to the need for a more complicated asset pricing Page 25 . Using the cross-section regression approach. Shleifer and Vishny. debtequity and book-to-market ratios add to the explanation of expected stock returns provided by market beta. But the strong evidence that other variables capture variation in expected return missed by beta makes this argument irrelevant. and the numerators are just scaling variables used to extract the information in price about expected returns. If betas do not suffice to explain expected returns. two stories emerge. earnings-price. They also find that different price ratios have much the same information about expected returns. resulting in stock prices that are too high for growth (low B/M) firms and too low for distressed (high B/M. however. Such ratios are thus prime candidates to expose shortcomings of asset pricing models. 1982.however. the market portfolio is not efficient. This is not surprising given that price is the common driving force in the price ratios. The estimate of the beta premium is. But with a judicious choice of scaling variable X. Explanations: Irrational Pricing or Risk Among those who conclude that the empirical failures of the CAPM are fatal. 1995). 1986) that the relation between average return and beta for common stocks is even flatter after the sample periods used in the early empirical work on the CAPM. Fama and French. so-called value) firms. When the overreaction is eventually corrected. 1981. the result is high returns for value stocks and low returns for growth stocks. Lakonishok and Shapiro. 1994. Fama and French (1996) reach the same conclusion using the time-series regression approach applied to portfolios of stocks sorted on price ratios. Investors overextrapolate past performance. The behavioralists argue that sorting firms on book-to-market ratios exposes investor overreaction to good and bad times. Fama and French (1992) update and synthesize the evidence on the empirical failures of the CAPM. Fama and French (1992) also confirm the evidence (Reinganum.

In the CAPM. For example. Fama and French (1993) take a more indirect approach. Merton¶s (1973) intertemporal capital asset pricing model (ICAPM) is a natural extension of the CAPM. but also with the opportunities they will have to consume or invest the payoff. ICAPM investors consider how their wealth at t might vary with future state variables. Like CAPM investors. perhaps more in the spirit of Ross¶s (1976) arbitrage pricing theory. multifactor efficiency implies a relation between expected return and beta risks. investors are concerned not only with their end-of-period payoff. Fama (1996) shows that the ICAPM generalizes the logic of the CAPM. and returns on high book-to-market (value) stocks covary more with one another than with returns on low book-to-market (growth) stocks.´ which means they have the largest possible expected returns. including labor income.model. But ICAPM investors are also concerned with the covariances of portfolio returns with state variables. given their return variances and the covariances of their returns with the relevant state variables. Moreover. ICAPM investors prefer high expected return and low return variance. An ideal implementation of the ICAPM would specify the state variables that affect expected returns. but it requires additional betas. Fama and French (1995) show that there are similar size and book-to-market patterns in Page 26 . and expectations about the labor income. the higher average returns on small stocks and high book-tomarket stocks reflect unidentified state variables that produce undiversifiable risks (covariances) in returns that are not captured by the market return and are priced separately from market betas. if there is risk-free borrowing and lending or if short sales of risky assets are allowed. consumption and investment opportunities to be available after t. the prices of consumption goods and the nature of portfolio opportunities at t. along with a market beta. The CAPM is based on many unrealistic assumptions. Thus. optimal portfolios are ³multifactor efficient. They argue that though size and book-to-market equity are not themselves state variables. the assumption that investors care only about the mean and variance of one-period portfolio returns is extreme. In support of this claim. to explain expected returns. they show that the returns on the stocks of small firms covary more with one another than with returns on the stocks of large firms.1. As a result. In the ICAPM. The ICAPM begins with a different assumption about investor objectives. That is. investors care only about the wealth their portfolio produces at the end of the current period. when choosing a portfolio at time t . market clearing prices imply that the market portfolio is multifactor efficient.

as well as by the CAPM. Following Carhart (1997).E(Rit) ± Rf = [E(Rmt) ± Rf] + isE(SMBt) + ih HMLt +eit The three-factor model is now widely used in empirical research that requires a model of expected returns The three-factor model is hardly a panacea. one response is to add a momentum factor (the difference between the returns on diversified portfolios of short-term winners and losers) to the three-factor model. 1996) propose a three-factor model for expected returns. Moreover. Page 27 . This momentum effect is distinct from the value effect captured by book-to-market equity and other price ratios. Three Factor Model:. Stocks that do well relative to the market over the last three to twelve months tend to continue to do well for the next few months. Fama and French (1993.the covariation of fundamentals like earnings and sales. and stocks that do poorly continue to do poorly. the momentum effect is left unexplained by the three-factor model. Its most serious problem is the momentum effect of Jegadeesh and Titman (1993). Based on this evidence.

CHAPTER ­ III CAPM AND APT: COMPARISONS AND INTERRELATIONSHIP Page 28 .

F denotes systematic risk factor.(6) In the equation.Multifactor Models and Arbitrage Pricing Theory (APT) All the multifactor asset pricing models try to explore the risk contribution of systematic factors effective on expected returns by constructing linear multiple regression equations that are expected to best represent the relationship between risk factors and asset returns. c) The stochastic process explaining how asset returns exist can be explained by a linear K-factor model. Ross (1976: 341-360). All these attempts would make the existing arbitrage opportunity suddenly disappear. investors would immediately react in order to benefit from that situation by buying the asset in the market where it has been undervalued and then selling where the asset has been relatively overvalued. The most important one of the multifactor prediction models is the Arbitrage Pricing Theory which was developed by Stephen A. This theory has been considered an alternative to the Capital Asset Pricing Model and does not presume the presence of a fully efficient market. Ross starts his model explanation with a single factor model resembling the CAPM and formulates the risk-return relationship using the following single equation (Bolak. rp = E(Rp) + pF --------------------------------. which means that they prefer more wealth to be less. i refers to the expected rate of return on the asset i. The prediction error arising from the effect of idiosyncratic factors is symbolized with ei. But. If any arbitrage opportunity existed. d) Market does not allow for arbitrage opportunities arising from the violation of the law of one price. 2001: 270): ri = i + iF +e I -----------------------------------.(7) Page 29 . the actual rate of return is abbreviated by ri. and i represents the sensitivity of the asset¶s returns to the risk factor. there are a few assumptions mentioned below on which the theory is based: a) The capital market fits the conditions of perfect competition. The return estimation equation turns out to be in a new form presented below. b) Investors are rational under certainty conditions. The theory assumes that all the firm-specific risk factors (ei) can be fully eliminated if a portfolio has been sufficiently diversified and therefore systematic risk component becomes the only case for portfolios.

E (RP) is the expected rate of return on portfolio.(E(Rfi) ± rf) -----------------------. 2007: 113). 2004: 278). Most of the findings reported in these studies have provided results Page 30 . have been preferred as the representatives of potential systematic risk factors. and the difference between the average return of the companies with high book to market ratios and the average return of those with low book to market ratios (Hu.( 8) In the above equation. three predetermined systematic risk factor are considered. in the field of asset pricing has cast strong concern in investigating the superiority of these models to each other. APT and CAPM. The ThreeFactor Model is another replication of the multifactor APT models. major macroeconomic indicators such as interest rate. The difference term in parenthesis is called the risk premium of the factor portfolio. In most of the relevant studies performed. The second remarkable theory in the relevant literature employing multifactor modeling procedure is the Three-Factor Model proposed by Fama and French (1993: 3. As different from the APT models. the theory suggests the use of multiple variables as determinants on systematic risk in order to cover all the effects of potential systematic risk factors. This situation is seen as a bottleneck for the implementation of the theory because examining separate factor portfolios not correlated to each other is so difficult a business to succeed. market risk premium (the return of market portfolio in excess of risk free return). the difference between the mean rates of return of small and big-scaled companies. Following the introduction of these theories to the literature. a huge number empirical studies were carried out aiming to compare their performance. p.56). E (RFi) is referred to as the expected rate of return on ith factor portfolio. gross domestic product (GDP). The presence of two main theories.i constitutes the sensitivity of portfolio¶s return to the factor portfolio i. The exploration of not correlated factor portfolios is a task similar to searching for explanatory variables fulfilling the statistical requirement of absence of linear multicollinearity (Maddala. A factor portfolio is a portfolio whose return distribution has no correlation (zero correlation) with those of other factor portfolios. and rf represents risk free rate of return. Expected return on any financial asset is finally formulated as in the Equation 8: E(Rp) = rf + ™ p. A typical multifactor APT Model is similar to linear multiple regression models. To get closer to the reality. inflation.i.It is a simplifying assumption to say that there is only one systematic risk factor affecting asset returns.

In another research carried out by Sun and Zhang (2001: 617) in America using the data of eight forestry-related companies¶ financial performance. he also stated that the same judgment couldn¶t be made for the stock market in Turkey. Comparison of CAPM and APT CAPM requires something more than APT to support its prediction that sensitivity to one economic force.favoring the APT models against the CAPM even in the emerging markets. the factors other than the market index considered under APT would also have influences that market index as it would have affected the security. some empirical results were reported favoring the better performance of the APT models as compared to CAPM. In either case.the force reflected in the returns to the market portfolio. if the unanticipated changes in economic factor were highly correlated. The development of the CAPM risk-return relationship is more involved than the APT relationship. it seems more than Page 31 . If it were so. There are few studies that suggest the superiority of CAPM over APT. Further. may perhaps be good enough even if APT provides a better description of how markets generate returns.is the only determinant of expected or required return on an asset. then stock sensitivity to any one factor like market index could well represent sensitivity to all factors. As a unique study arguing the applicability of the APT models. the CAPM model would be a satisfactory proxy for the multi-index model. On the other hand. APT views several economic forces as the systematic determinants of actual returns on an asset. CAPM¶s assumption that sensitivity to the market is the only required indicator of risk. But the relationship itself is the same as APT would have if there was only one pervasive economic force influencing the return generation process. the market index would capture that effect too. But. Hence. so that sensitivity to a single market index would do as good a job as any multi-factor model in explaining the expected return differences among assets. However. This is because. Altay (2005: 217 ± 237) pointed out that unexpected interest rate and inflation changes proved to be statistically significant determinants on stock returns in Germany. and thus the only determinant of expected or required return. different sensitivities of each asset to the collection of economic forces could µnet out¶. The multifactor APT models could provide better results than the CAPM in the Indian Stock Market on monthly and weekly returns data.

Apart from these. the empirical results.variance zero beta security) and the market portfolio. even though the zero beta version of the basic CAPM provides a theoretical model that is consistent with the empirical anomalies of the basic CAPM. Page 32 . To sum up. APT does not overcome all of the objectives. empirical tests of any form of the CAPM is questioned by many researchers owing to the reliance of the theory on an unobservable market portfolio. Nevertheless. in general indicate an intercept that exceeds the returns on the riskless asset and a market risk premium that is lower than its theoretical value. the CAPM is characterized by simplicity as it expresses. it is the first model to challenge CAPM and has a real chance of replacing it. While most tests indicate a relatively linear relationship between realized returns and their systematic risks. However. The feature that makes APT of greater potential value to decision makers lies in its attempt to explain the risk-return relationship using several factors instead of a single market index. Furthermore.likely those stocks have different sensitivity to various economic factors and that unanticipated changes in economic factors do not have much correlation. empirical tests of the basic CAPM have not been fully supportive of the theory. the pricing relationship in terns if just two elements ± the riskless asset ( or the minimum. and it has some shortcomings of its own.

IV TESTING CAPITAL ASSET PRICING MODEL IN INDIAN STOCK MARKET Page 33 .CHAPTER .

CAPM has been one of the most challenging topics in financial economics. These market return characteristics make it possible to have an empirical investigation of the pricing model on differing financial conditions thus obtaining conclusions under varying stock return volatility. Lintner [1965] and Mossin [1966]. and in some cases extraordinary. This new interest has undoubtedly been spurred by the large. returns offered by these markets. The reason is that the model provides the means for a firm to calculate the return that its investors demand. The purpose is to examine thoroughly if the CAPM holds true in the capital market of India. Although the CAPM has been predominant in empirical work over the past 30 years and is the basis of modern portfolio theory. accumulating research has increasingly cast doubt on its ability to explain the actual movements of asset returns. Simply stated. One of the most important developments in modern capital theory is the capital asset pricing model (CAPM) as developed by Sharpe [1964]. Existing financial literature on the Athens stock exchange is rather scanty and it is the goal of this study to widen the theoretical analysis of this market by using modern finance theory and to provide useful insights for future analyses of this market. Tests are conducted for a period of ten years (2001-2011). Practitioners all over the world use a plethora of models in their portfolio selection process and in their attempt to assess the risk exposure to different assets. Almost any manager who wants to undertake a project must justify his decision partly based on CAPM. This model was the first successful attempt to Page 34 . CAPM suggests that high expected returns are associated with high levels of risk. CAPM postulates that the expected return on an asset above the risk-free rate is linearly related to the non-diversifiable risk as measured by the asset¶s beta. Empirical appraisal of the model and competing studies of the model¶s validity Empirical appraisal of CAPM Since its introduction in early 1960s.TESTING THE CAPITAL ASSET PRICING MODEL INTRODUCTION Investors and financial researchers have paid considerable attention during the last few years to the new equity markets that have emerged around the world. which is characterized by intense return volatility (covering historically high returns for the Indian Stock market as well as significant decrease in asset returns over the examined period).

and place them into their respective categories. to estimate the project¶s cost of capital and the expected rate of return that investors will demand if they are to invest in the project. This kind of approach is found in the area of portfolio decision-making. For example. In this case empirical analysis is needed to evaluate the assets. The model was developed to explain the differences in the risk premium across assets.show how to assess the risk of the cash flows of a potential investment project. Page 35 . in particular with regards to the selection of assets to the bought or sold. the CAPM predicts the expected risk premium for an asset. Methods of statistical analysis need to be applied in order to draw reliable conclusions on whether the model is supported by the data. A second illustration of the latter methodology appears in corporate finance where the estimated beta coefficients are used in assessing the riskiness of different investment projects. The theory itself has been criticized for more than 30 years and has created a great academic debate about its usefulness and validity. the empirical testing of CAPM has two broad purposes (Baily et al. Given the risk free rate and the beta of an asset. To accomplish (ii) the empirical work uses the theory as a vehicle for organizing and interpreting the data without seeking ways of rejecting the theory. assess their riskiness. To accomplish (i) tests are conducted which could potentially at least reject the model. [1998]): (i) to test whether or not the theories should be rejected (ii) to provide information that can aid financial decisions. The model states that the correct measure of the riskiness of an asset is its beta and that the risk premium per unit of riskiness is the same across all assets. According to the theory these differences are due to differences in the riskiness of the returns on the assets. It is then possible to calculate ³hurdle rates´ that projects must satisfy if they are to be undertaken. This part of the paper focuses on tests of the CAPM since its introduction in the mid 1960¶s. analyze them. The model passes the test if it is not possible to reject the hypothesis that it is true. and describes the results of competing studies that attempt to evaluate the usefulness of the capital asset pricing model (Jagannathan and McGrattan [1995]). In general. investors are advised to buy or sell assets that according to CAPM are underpriced or overpriced.

Using monthly return data and portfolios rather than individual stocks. Black et al tested whether the cross-section of expected returns is linear in beta. The author concluded that the average returns on stocks of small firms (those with low market values of equity) were higher than the average returns on stocks of large firms (those with high market values of equity). Lintner [1965] and Mossin [1966]. they examined whether there is a positive linear relation between average returns and beta. One of the earliest empirical studies that found supportive evidence for CAPM is that of Black. the CAPM predicts that the expected return on an asset above the risk-free rate is linearly related to the non-diversifiable risk. Banz [1981] tested the CAPM by checking whether the size of firms can explain the residual variation in average returns across assets that remain unexplained by the CAPM¶s beta. the relation between the average return and beta is very close to linear and that portfolios with high (low) betas have high (low) average returns. The authors found that the data are consistent with the predictions of the CAPM i. which is measured by the asset¶s beta. Moreover. In its simple form. The purpose of the above studies was to find the components that CAPM was missing in explaining the risk-return tradeoff and to identify the variables that created those deviations.e. Another classic empirical study that supports the theory is that of Fama and McBeth [1973]. He challenged the CAPM by demonstrating that firm size does explain the cross sectional-variation in average returns on a particular collection of assets better than beta. This finding has become known as the size effect. Page 36 .The classic support of the theory The model was developed in the early 1960¶s by Sharpe [1964]. thereby enhancing the precision of the beta estimates and the expected rate of return of the portfolio securities. By combining securities into portfolios one can diversify away most of the firm-specific component of the returns. Jensen and Scholes [1972]. This approach mitigates the statistical problems that arise from measurement errors in beta estimates. the authors investigated whether the squared value of beta and the volatility of asset returns can explain the residual variation in average returns across assets that are not explained by beta alone Challenges to the validity of the theory In the early 1980s several studies suggested that there were deviations from the linear CAPM risk return trade-off due to other variables that affect this tradeoff.

However.The research has been expanded by examining different sets of variables that might affect the risk return tradeoff. Christensen and Mendelson [1992] and Black [1993] support the view that the data are too noisy to invalidate the CAPM. Rosenberg. Stattman [1980]. Amihudm. they show that when a more efficient statistical method is used. They showed that Banz¶s findings might be economically so important that it raises serious questions about the validity of the CAPM. The Academic Debate Continues The Fama and French [1992] study has itself been criticized. Black [1993] suggests that the size effect noted by Banz [1981] could simply be a sample period effect i. Page 37 . this idea has been challenged by Fama and French [1992]. these types of market indexes do not capture all assets in the economy such as human capital. In particular. the size effect is observed in some periods and not in others. and the ratio of a firm¶s book value of equity to its market value (e. In general the studies responding to the Fama and French challenge by and large take a closer look at the data used in the study. Despite the above criticisms. Instead they show that the lack of empirical support for the CAPM may be due to the inappropriateness of basic assumptions made to facilitate the empirical analysis.e.g. Hamao. the earnings yield (Basu [1977]). Fama and McBeth find a positive relation between return and risk while Fama and French find no relation at all. Jagannathan and Wang [1993] argue that this may not be necessary. leverage. the estimated relation between average return and beta is positive and significant. most empirical tests of the CAPM assume that the return on broad stock market indices is a good proxy for the return on the market portfolio of all assets in the economy. Fama and French [1992] used the same procedure as Fama and McBeth [1973] but arrived at very different conclusions. Kothari. Reid and Lanstein [1983] and Chan. For example. these deviations are not so important as to reject the theory. the general reaction to the Fama and French [1992] findings has been to focus on alternative asset pricing models. was to support the view that although the data may suggest deviations from CAPM. Shaken and Sloan [1995] argue that Fama and French¶s [1992] findings depend essentially on how the statistical findings are interpreted. Lakonishok [1991]) have all been utilized in testing the validity of CAPM. However. In fact.

All the securities included in the portfolio are traded on the Bombay Stock Exchange on the continuous basis throughout the full BSE trading day. variance.Engle. When one considers a time-varying return distribution. Sample Selection and Data Sample Selection The study covers the period from January 2001 to January 2011.F. P/E.Other empirical evidence on stock returns is based on the argument that the volatility of stock returns is constantly changing. For the Purpose of the study. P/E ratio. I have selected only 50 stocks out of 100 securities because of various constraints like Data unavailability. This time period was chosen because it is characterized by intense return volatility with historically high and low returns for the Indian Stock Market. the usual estimates of return. variance. Each series of stocks consists of 10 observations of yearly closing prices. The most widely used model to estimate the conditional (hence time. De-listing of the stocks from the Index etc. leverage etc. all the models above aim to improve the empirical testing of CAPM. There have also been numerous modifications to the models and whether the earliest or the subsequent alternative models validate or not the CAPM is yet to be determined. Page 38 . 50 stocks were selected from the pool of securities of 100 stocks. provide an unconditional estimate because they treat variance as constant over time. The stock varies in size. one must refer to the conditional mean. In contrast. and average squared deviations over a sample period. The selected sample consists of 100 stocks that are included in a sampling frame to make the portfolio. To summarize. and covariance that change depending on currently available information.varying) variance of stocks and stock index returns is the generalized autoregressive conditional heteroscedacity (GARCH) model pioneered by Robert. The selection of stocks varies on the basis of market capitalization. financial Leverage.

i i + i (Rmt . The BSE Composite Share index is used as a proxy for the market portfolio.Rft) + eit is the estimate of beta for the stock i . the Indian Government Bonds is used as the proxy for the risk-free asset. Methodology The first step was to estimate a beta coefficient for each stock using weekly returns during the period of January 1998 to December 2002. All stock returns used in the study are adjusted for dividends as required by the CAPM. yearly) might result in changes of beta over the examined period introducing biases in beta estimates. R ft is the rate of return on a risk-free asset. The beta was estimated by regressing each stock¶s yearly return against the market index according to the following equation: Rit -R ft = Where. R it is the return on stock i (i=1«100). This index is a market value weighted index.Data Selection The study uses weekly stock returns from 50 companies listed on the Bombay Stock Exchange for the period of January 2001 to January 2011. high frequency data such as daily observations covering a relatively short and stable time span can result in the use of very noisy data and thus yield inefficient estimates. On the other hand. Furthermore. and reflects general trends of the Indian stock market. Returns calculated using a longer time period (e. is comprised of the 60 most highly capitalized shares of the main market.)=r mt R R ] Page 39 . the study utilizes yearly stock returns. and eit is the corresponding random disturbance term in the regression equation. [Equation 1 could also be expressed using excess return notation.)= it ft it R R r and ft mt ( .g. The yield on the Indian Government Bonds is specifically chosen as the benchmark that better reflects the short-term changes in the Indian financial markets. R mt is the rate of return on the market index. The yields were obtained from the Reserve Bank of India website. The data are obtained from BSE Stock Data Base and from PROWESS Database In order to obtain better estimates of the value of the beta coefficient. where ( .

121698 0.202891 0.073134 1.466867 1.090135 1. Reddy Lab HP HUL Housing Dev Fin Cor ITC ICICI Bank Infosys Tech Larsen & Turbo Mahanagar Telephone M&M ONGC Maruti Suzuki Page 40 .583617 0.466225 0. for the assets used in this study.51 0. The beta of the individual security is given below: Company Table 1: Beta of individual securities (Companies) Beta Company 3.039579 2.83813 0.687173 0.21 0. Useful remarks can be derived from the results of this procedure. Rit = Return of individual stock i for time period (t = 1 «« 10) Pit = closing price of the stocks of current year Pi(t-1) = closing price of the stock of previous year.928988 1.34148 2.Here the beta is calculated for all the individual stocks for 10 years using Regression tool in MS Excel.660744 0.989952 0.365135 4.70 1.101799 ABB ACC Ambuja Cements BHEL BPCL Bharti Airtel Cipla Glaxosmith Grasim HDFC Hero Honda Hindalco Industry GAIL Dr.348161 0.08628 1.761257 1.264626 1.775173 1.8134 1. The returns of individual stock are calculated on the basis of: Rit = [Pit ± Pi (t-1)]/ P(t-1)i Where.53 0.44455 1.68 1.01929 0.127525 PNB Ranbaxy HCL Reliance industries Satyam Bajaj Electricals Wipro Zee Unitech Tata Comm Tata Power Tata Motors Sun Pharma Sterlite SAIL SBI Siemen Abbot Adani Enterprise Raymonds Novartis Aditya Birla Titan Kotak Berger Paints Beta 1.550618 2.417147 1.46 1.336327 2.28 0.300307 0.535358 1.641285 2.126948 0.875433 0.62 1.08628 2.435777 0. Empirical results and Interpretation of the findings The first part of the methodology required the estimation of betas for individual stocks by using observations on rates of return for a sequence of dates.040378 1.87 0.91 0.705396 0.744671 1.298222 0.48625 1.

53 1.039579 3.20909 17.46 30.68 0.65091 38.91 0.090135 Return 4.231818 Page 41 . Most of the beta coefficients for individual stocks are statistically significant at a 95% level and all estimated beta coefficients are statistical significant at a 90% level.300307 2.96818 -6.660744 1. Higher = Higher Rit The beta and return of individual securities are: Table 2: Average Return and Beta of all Securities Beta Return Company 4.70 0.08628 1.02182 -0.819091 12.34148 1.62 0.264626 2.775173 0.298222 2.54091 21.46 0.84 4.27636 3.83813 0.87 0.42727 23.07727 60.89273 56.55909 48.28 1.48182 49.928988 0. the theory indicates higher risk (beta) is associated with higher returns which is the basic hypothesis of the study.55818 52.466867 0. Reddy Lab Ranbaxy Infosys Tech ONGC Novartis Hero Honda Ambuja Cements Abbot BPCL Mahanagar Telephone Cipla Tata Comm Glaxosmith ITC Sun Pharma HP Satyam HUL Company Sterlite ABB SAIL Tata Motors M&M Adani Enterprise Bajaj Electricals Wipro Siemen GAIL Larsen & Turbo Kotak Grasim Hindalco Industry Unitech Aditya Birla HCL Tata Power BHEL Bharti Airtel ICICI Bank Maruti Suzuki Raymonds PNB Berger Paints Beta 1.42909 Zee Titan Housing Dev Fin Cor SBI ACC Reliance industries HDFC Dr.435777 1.57455 47.365135 0.06727 18.08628 2.535358 1.2240.13 24.91 24.29909 22.60636 26.62818 28.60364 13.12455 39.482727 9.84455 40.51 0.25364 40.950909 5.989952 2.27909 11.21 1.875433 0.44455 1.5 9.101799 89.56727 48.The range of the estimated stock betas is between 0.090 the minimum and 4.089091 20.073134 1.348161 0.79364 19.88545 67.583617 1.040378 1.761257 0.53273 42.87545 -6.72 0.202891 1.48091 -0.17364 18.687173 2.417147 0.48625 1.121698 1.641285 0.744671 0. HYPOTHESIS According to the CAPM theory.039 the maximum with a standard deviation of 0.336327 0.01929 0.23636 31.127525 1.705396 1.550618 0.8134 0.466225 1.354545 70.43364 33.68364 38.729091 34.126948 1.73727 78.95455 43.65273 20.08 12.

The beta coefficient o the 50 securities indicate that higher beta portfolio are related with higher return. In order to diversify away most of the firmspecific part of returns thereby enhancing the precision of the beta estimates. The findings of the article are not supportive of the theory¶s basic hypothesis that higher risk (beta) is associated with a higher level of return.23). however. However. The study used monthly stock returns from 100 companies listed on the Athens stock exchange from January 2001 to January 2011. CONCLUSION The article examined the validity of the CAPM for the Greek stock market. the fact that the intercept has a value around zero weakens the above explanation. The results obtained lend support to the linear structure of the CAPM equation being a good explanation of security returns. the securities where combined into portfolios to mitigate the statistical problems that arise from measurement errors in individual beta estimates. excess returns. explains excess returns.e Rit = 89.039) and Sterlite also provide highest return among all other Page 42 . The high value of the estimated correlation coefficient between the intercept and the slope indicates that the model used. The model does explain.e security (i. For example: the highest beta in the indices is of Sterlite (i. = 4.The result of the study supports the hypothesis.

CHAPTER.V EFFICIENT MARKET HYPOTHESIS ANF ITS ANAMOLIES Page 43 .

including investment managers. and are expected to increase in value in the future.e. Many investors.priced" stocks. many people spend a significant amount of time and resources in an effort to detect "mis. They use a variety of forecasting and valuation techniques to aid them in their investment decisions. Consequently. The main engine behind price changes is the arrival of new information. and particularly those that will increase more than others. this would result in a $10 million gain. any edge that an investor possesses can be translated into substantial profits. If a manager of a mutual fund with $10 billion in assets can increase the fund¶s return. Security prices adjust before an investor has time to trade on and profit from a new a piece of information. by 1/10th of 1 percent. The EMH asserts that none of these techniques are effective (i. noted Harvard financial economist Michael Jensen writes ³there is no other proposition in economics which has more solid empirical evidence supporting it than the Efficient Market Hypothesis. as more and more analysts compete against each other in their effort to take advantage of over. The efficient markets hypothesis (EMH) suggests that profiting from predicting price movements is very difficult and unlikely. the current prices of securities reflect all available information at any given point in time.´ while investment maven Peter Lynch claims ³Efficient markets? That¶s a bunch of junk. A market is said to be ³efficient´ if prices adjust quickly and. no other theory in economics or finance generates more passionate discussion between its challengers and proponents. the advantage gained does not exceed the transaction and research costs incurred). Obviously. April 1995). The key reason for the existence of an efficient market is the intense competition among investors to profit from any new information. The ability to identify over. on average. believe that they can select securities that will outperform the market..and Page 44 . there is no reason to believe that prices are too high or too low. to new information. without bias. crazy stuff´ (Fortune. Consequently. For example.and underpriced stocks is very valuable (it would allow investors to buy some stocks for less than their ³true´ value and sell others for more than they were worth). Arguably. after transaction costs. Naturally. As a result. and therefore no one can predictably outperform the market.EFFICIENT MARKET HYPOTHESIS AND ITS ANAMOLIES INTRODUCTION Many investors try to identify securities that are undervalued.

by its very nature. financial researchers distinguish among three versions of the Efficient Markets Hypothesis. mostly by chance. On the other hand. That is. many financial analysts attempt to Page 45 . nobody can detect mispriced securities and ³beat´ the market by analyzing past prices. However. The most crucial implication of the EMH can be put in the form of a slogan: Trust market prices! At any point in time. only a relatively small number of analysts will be able to profit from the detection of mispriced securities. Consequently. Therefore stock prices are said to follow a random walk. prices of securities in efficient markets reflect all known information available to investors. the expected return from a security is primarily a function of its risk. the likelihood of being able to find and exploit such mis-priced securities becomes smaller and smaller. There are. There is no room for fooling investors. the information analysis payoff would likely not outweigh the transaction costs. changes in prices are expected to be random and unpredictable.e. According to capital markets theory. liquidity. Weak Form Efficiency The weak form of the efficienct markets hypothesis asserts that the current price fully incorporates information contained in the past history of prices only. i. Thus. and as a result. all investments in efficient markets are fairly priced. on average investors get exactly what they pay for. The price of the security reflects the present value of its expected future cash flows. or that even the likelihood of rising or falling in price is the same for all securities. different kinds of information that influence security values. while prices are rationally based. THREE VERSIONS OF THE EFFICIENT MARKETS HYPOTHESIS The efficient markets hypothesis predicts that market prices should incorporate all available information at any point in time. For the vast majority of investors. is unpredictable. one should not be able to profit from using something that ³everybody else knows´. and risk of bankruptcy. depending on what is meant by the term ³all available information´. Fair pricing of all securities does not mean that they will all perform similarly. however. because new information. The weak form of the hypothesis got its name for a reason ± security prices are arguably the most public as well as the most easily available pieces of information.under-valued securities. In equilibrium. which incorporates many factors such as volatility.

say. Arguably. announced merger plans. financial researchers have found empirical evidence that is overwhelming consistent with the semi-strong form of the EMH. acquisition of such skills must take a lot of time and effort. Semi-strong Form Efficiency The semi-strong-form of market efficiency hypothesis suggests that the current price fully incorporates all publicly available information. earnings and dividend announcements. and therefore against the value of technical analysis. In addition. research journals etc. etc.past stock price series and trading volume data. professional publications and databases. Page 46 . expectations regarding macroeconomic factors (such as inflation. etc. major newspapers and company-produced publications. This technique is called technical analysis. local papers. The empirical evidence for this form of market efficiency. but also macroeconomists. but also data reported in a company¶s financial statements (annual reports. the relevant public information may include the current (published) state of research in pain-relieving drugs. After taking into account transaction costs of analyzing and of trading securities it is very difficult to make money on publicly available information such as the past sequence of stock prices. in order to gather all information necessary to effectively analyze securities. is pretty strong and quite consistent. Nevertheless. As we will see later.generate profits by studying exactly what this hypothesis asserts is of no value . In fact. income statements. The assertion behind semi-strong market efficiency is still that one should not be able to profit using something that ³everybody else knows´ (the information is public). It may not be sufficient to gain the information from. For example. for the analysis of pharmaceutical companies. Public information includes not only past prices. this assumption is far stronger than that of weak-form efficiency. the public information does not even have to be of a strictly financial nature. the ³public´ information may be relatively difficult to gather and costly to process. unemployment). filings for the Security and Exchange Commission. experts adept at understanding processes in product and input markets.). Semi-strong efficiency of markets requires the existence of market analysts who are not only financial economists able to comprehend implications of vast financial information. One may have to follow wire reports. the financial situation of company¶s competitors.

Despite its relative simplicity. in liquid markets with many participants. Therefore. this hypothesis has also generated a lot of controversy. incorrect interpretations. In other words. Yet we can see that some of the successful analysts (such as George Soros. After all. The rationale for strong-form market efficiency is that the market anticipates. The main difference between the semi-strong and strong efficiency hypotheses is that in the latter case. much of the criticism leveled at the EMH is based on numerous misconceptions. or Peter Lynch) are able to do exactly that. Similarly. both public and private (sometimes called inside information). However. prices should adjust quickly to new information in an unbiased manner. nobody should be able to systematically generate profits even if trading on information not publicly known at the time. Warren Buffett. Not surprisingly. in an unbiased manner. EMH has received a lot of attention since its inception. this implication does not sit very well with many financial analysts and active portfolio managers. future developments and therefore the stock price may have incorporated the information and evaluated in a much more objective and informative way than the insiders. We know that the constant arrival of information makes prices fluctuate. Not surprisingly. We present some of the most persistent ³myths´ about the EMH below. though. Arguably. empirical research in finance has found evidence that is inconsistent with the strong formof the EMH. EMH does not imply that investors are unable to outperform the market.Strong Form Efficiency The strong form of market efficiency hypothesis states that the current price fully incorporates all existing information. such as stock markets. EMH must be incorrect. and myths about the theory of efficient markets. It is possible for an investor to ³make a Page 47 . the strong form of EMH states that a company¶s management (insiders) are not be able to systematically gain from inside information by buying company¶s shares ten minutes after they decided (but did not publicly announce) to pursue what they perceive to be a very profitable acquisition. the EMH questions the ability of investors to consistently detect mispriced securities. the members of the company¶s research department are not able to profit from the information about the new revolutionary discovery they completed half an hour ago. COMMON MISCONCEPTIONS ABOUT THE EMH As was suggested in the introduction to this chapter. Myth 1: EMH claims that investors cannot outperform the market.

It should be noted. What EMH does claim. EMH must be incorrect There are two principal counter-arguments against the equivalency of ³dart-throwing´ and professional analysis strategies. With a group of 10.99%. Each individual investor may have dismal odds of beating the market for the next 10 years. Therefore. rather than after the fact. that an investor who picks stocks ³randomly´ has a 50% chance of ³beating the market´. even if markets are efficient. for example. the chance of seeing at least one who outperforms the market in every of next ten years is 99. that some investors could outperform the market for a very long time by chance alone. for the sake of simplicity. while others may like less risky investment strategies. a virtual certainty. finding one very successful investor. after the ten years. investors generally have different ³tastes´ ±some may. This is the case with the state lottery. the chance that there will be at least one investor outperforming the market in each of the next 10 years sharply increases as the number of investors trying to do exactly that rises. Optimal portfolios should provide the investor with the combination of return and risk that the investor finds desirable. which means that their services are valuable.000 investors. Imagine.000 investors. even if he or she is investing purely randomly ± is very high if there are a sufficiently large number of investors.killing´ if newly released information causes the price of the security the investor owns to substantially increase. but the probability that someone will win is very high. is that one should not be expected to outperform the market predictably or consistently. Yet we tend to see that financial analysts are not ³driven out of market´. The theory would only be threatened if you could identify who those successful investors would be prior to their performance. For such an investor. Yet the likelihood of. ³Throwing darts at the financial page will produce a portfolio that can be expected to do as well as any managed by professional security analysts´. the probability of finding one ³ultimate winner´ with a perfect 10year record is 63%. though. Soros. The existence of a handful of successful investors such as Messrs. First. the chance of outperforming the market in each and every of the next ten years is then 0. Myth 2: EMH claims that financial analysis is pointless and investors who attempt to research security prices are wasting their time. though. in which the probability of a given individual winning is virtually zero. and Lynch is an expected outcome in a completely random distribution of investors.5. prefer to put their money in high-risk ³hi-tech´ firm portfolios. Buffett. In a group of 1. A randomly chosen portfolio Page 48 . However.

any profits achieved by the analysts while trading on "mispriced" securities must be reduced by the costs of financial analysis. the incurred costs are covered by the achieved gross trading profits. one can say that financial analysis is actually the engine that enables incoming information to get quickly reflected into security prices. the chasing of "mispriced" stocks would indeed be pointless and they should stick with passive investment. However. bid-ask spread. In equilibrium. scientific achievements. Second. the advantage gained is not sufficient to outweigh the cost of their advice. etc. For the majority of other investors. In general. purchases of computers. The competition among investors who actively seek and analyze new information with the goal to identify and take advantage of mis-priced stocks is truly essential for the existence of efficient capital markets. software. such as with index mutual funds. and minute. There is some evidence that some professional investment managers are able to improve performance through their analyses. As we have already discussed.may not accomplish this goal. including brokerage costs. loads. EMH must be incorrect. as well as many resources into data gathering. In fact. causing continuous adjustment of prices to information updates. Therefore. and reduced returns. process. financial analysts have to be able to gather. So why don¶t all investors find it optimal to search for profits by performing financial analysis? The answer is simple ± financial research is very costly. In fact. Yet one can observe prices fluctuating (sometimes very dramatically) every day. In addition. The constant fluctuation of market prices can be viewed as an indication that markets are efficient. this may be by pure chance. on average. analysts who frequently trade securities incur various transaction costs. the economy. financial analysis is far from pointless in efficient capital markets. They have to invest a lot of time and effort in sophisticated analysis. For mutual funds and private investment managers these costs are passed on to investors as fees. there will be only as many financial analysts in the market as optimal to insure that. Myth 3: EMH claims that new information is always fully reflected in market prices. New information affecting the value of securities arrives constantly. and evaluate vast amounts of information about firms. Therefore. and market impact costs. industries. as well as the transaction costs involved. observing that prices did not Page 49 . hour. and more importantly.

market efficiency can be achieved even if only a relatively small core of informed and skilled investors trade in the market. Not all investors have to be informed.g. we would expect Consistent with this theory. and able to constantly analyze the flow of new information. A positive serial correlation indicates that higher than average returns are likely to be followed by higher than average returns (i. zero correlation. even though statistically significant. by Brock. In fact.e.. across other time periods and other countries. Fama (1965) found that the serial correlation coefficients for a sample of 30 Dow Jones Industrial stocks. Lakonishok. while a negative serial correlation indicates that higher than average returns are followed. EVIDENCE IN FAVOR OF THE EFFICIENT MARKETS HYPOTHESIS Since its introduction into the financial economics literature over almost 40 years ago. on average. a tendency for continuation). were too small to cover transaction costs of trading. majority of this research indicates that stock markets are indeed efficient. the majority of common investors are not trained financial experts. a tendency toward reversal). A number of studies have attempted to test this hypothesis by examining the correlation between the current return on a security and the return on the same security over a previous period. If the random walk hypothesis were true. This is an incorrect statement of the underlying assumptions needed for markets to be efficient. The vast The weak form of market efficiency: The random walk hypothesis implies that successive price movements should be independent. EMH must be incorrect. and LeBaron (1992) finds evidence to the contrary.. Myth 4: EMH presumes that all investors have to be informed.change would be inconsistent with market efficiency. by lower than average returns (i. Page 50 .. the efficient markets hypothesis has been examined extensively in numerous studies. Subsequent studies have mostly found similar results. skilled. Therefore. while the majority of investors never follow the securities they trade. since we know that relevant information is arriving almost continuously.e. recent evidence (e. Another strand of literature tests the weak form of market efficiency by examining the gains from technical analysis. Still. While many early studies found technical analysis to be useless.

100% wrong. are 3% per year. and thus. The Strong Form Empirical tests of the strong-form version of the efficient markets hypothesis have typically focused on the profitability of insider trading. However. the findings are consistent with weak-form market efficiency. subsequent research has found that the gains from these strategies are insufficient to cover their transaction costs. A more recent paper by Rozeff and Zaman (1988) finds that insider profits. after deducting an assumed 2 percent transactions cost. Over-reaction and Under-reaction The efficient markets hypothesis implies that investors react quickly and in an unbiased manner to new information. they have not received uniform acceptance. It implies that investors should not be able to profit consistently by trading on publicly available information. Many investment professionals still meet the EMH with a great deal of skepticism. has attracted the most attention. Thus. all publicly available information is reflected in the stock price. legendary portfolio manager Michael Price does not leave anybody guessing which side he is on: ³«markets are not perfectly efficient.´ (taken from Investment Gurus by Peter Tanous) We will discuss some of the recent evidence against efficient markets. then insiders should not be able to profit by trading on their private information. If the strong-form efficiency hypothesis is correct. If a market is semi-strong form efficient. For example. In two widely publicized studies. Consequently. Jaffe (1974) finds considerable evidence that insider trades are profitable. it does not appear to be consistent with the strong-form of the EMH EVIDENCE AGAINST THE EFFICIENT MARKETS HYPOTHESIS Although most empirical evidence supports the weak-form and semi-strong forms of the EMH.They find that relatively simple technical trading rules would have been successful in predicting changes in the Dow Jones Industrial Average. The academics are all wrong. The Semi-strong Form The semi-strong form of the EMH is perhaps the most controversial. It¶s black and white. DeBondt and Thaler present contradictory Page 51 .

Some apparent anomalies. Page 52 . explanations are examined by appropriate analysis. Another study reported that stocks with high returns over the past year tended to have high returns over the following three to six months (short-term momentum in stock prices). These findings received significant publicity in the popular press. This is not evident until alternative Value versus growth A number of investment professionals and academics argue that so called ³value strategies´ are able to outperform the market consistently. Some indicate market over-reaction to However. value strategies involve buying stocks that have low prices relative to their accounting ³book´ values. throughout the 1900s. which ran numerous headlines touting the benefits of these so-called contrarian strategies. the effect is present in other countries and has persisted information. A variety of other anomalies have been reported. Dredging for anomalies is a rewarding occupation. Prices of companies experiencing positive earnings surprises tend to drift upward. However. dividends. This ³momentum´ effect is a fairly new anomaly and consequently significantly more research is needed on the topic. this anomaly has yet to be explained. and others under-reaction. Some of these findings are simply related to chance: if you analyze the data enough. you will find some patterns. After more than thirty years of research. may be a by-product of rational (efficient) pricing. while prices of stocks experiencing negative earnings surprises tend to drift downward. the findings tend to disappear. Typically. recent research indicates that the findings might be the result of methodological problems arising from the measurement of risk. One of the most enduring anomalies documented in the finance literature is the empirical observation that stock prices appear to respond to earnings for about a year after they are announced. they have not survived the test of time. They find that stocks with low long-term past returns tend to have higher future returns and vice versa .evidence. Once risk is measured correctly. The results appear to be inconsistent with the EMH. Although the issues are complex. This ³post-earnings-announcement drift´ was first noted by Ball and Brown in 1968 and has since been replicated by numerous studies over different time periods and in different countries. such as the long-term reversals of DeBondt and Thaler. or historical prices.stocks with high long-term past returns tend to have lower future returns (longterm reversals).

these results may represent strong evidence against the EMH. Small Firm Effect Rolf Banz uncovered another puzzling anomaly in 1981. market participants consistently overestimate the future growth rates of glamour stocks relative to value stocks.In a provocative study. Rather. Lakonishok. However. the authors argue . The results were particularly suprising because for years financial economists had accepted that systematic risk or Beta was the single variable for predicting returns. where security prices accurately reflect all relevant and recent information. weekly and monthly trends. while September is traditionally a down month. Consequently. this return differential cannot be attributed to higher risk (as measured by volatility) . Current research indicates that this finding is not evidence of market inefficiency. Schleifer. Subsequent research indicated that most of the difference in returns between small and large stocks occurred in the month of January. Surprisingly. current research indicates that the anomalous returns may be caused by a selection bias in a popular commercial database used by financial economists. many well-documented seasonal effects continue to exist in many markets. It was also interesting that nearly the entire advantage of the value stocks occurred in January each year. y Monthy Effect The markets tend to have strong returns around the turn of the year as well as during the summer months. while the average returns on large stocks were too low. we'll take you through some of these existing seasonal anomalies and show you how to take advantage of stock market seasonality by timing your buying and selling decisions according to daily.value stocks are typically no riskier than glamour stocks. He found that average returns on small stocks were too large to be justified by the Capital Asset Pricing Model. Page 53 . but rather indicates a failure of the Capital Asset Pricing Model Seasonality Effect Even in efficient markets. and Vishny find evidence that the difference in average returns between stocks with low price-to-book ratios (³value stocks´) and stocks with high price-to-book ratios (³glamour stocks´) was as high as 10 percent year. In this article.

goals. The January Effect is predicated on the idea that these stocks. which have been sold off to realize the tax losses. The January Effect is a result of tax-loss selling which causes investors to sell their losing positions at the end of December. At the beginning of January. and by minimization of investment costs and taxes. tax bracket. IMPLICATIONS OF MARKET EFFICIENCY FOR INVESTORS Much of the existing evidence indicates that the stock market is highly efficient. pushing up prices of mostly small cap and value stocks. This does not mean that there is no role for portfolio management. etc). investors return to equity markets with a vengeance. tax. investors have little to gain from active management strategies. Bargain hunters step in and load up on these laggards and this creates buying pressure in the market. The appropriate mixture of securities may vary according to the age. This phenomenon occurs between the last trading day in December of the previous year and the fifth trading day of the new year in January. but they can reduce returns due to the costs incurred (management. Investors should follow a passive investment strategy. and risk aversion of the investor. This is a particularly puzzling anomaly because. Page 54 . transaction.y January Effect The month of January in the stock market has strong significance in predicting the trend of the stock market for the rest of the calendar year. as Monday returns span three days. the day-of-the-week effect or the Monday seasonal) refers to the tendency of stocks to exhibit relatively large returns on Fridays compared to those on Mondays. y Weekend Effect The weekend effect (also known as the Monday effect. one would expect returns on a Monday to be higher than returns for other days of the week due to the longer period and the greater risk. if anything. and consequently. will be at a discount to their market value. which makes no attempt to beat the market. Such attempts to beat the market are not only fruitless. employment. the portfolio manager must choose a portfolio that is geared toward the time horizon and risk profile of the investor. according to "Stocks for the Long Run. In addition. Returns can be optimized through diversification and asset allocation.

Unfortunately for these so-called ³investment gurus´.and over-reaction in security markets. However. each year investment professionals publish numerous books touting ways to beat the market and earn millions of dollars in the process. Although no theory is perfect. the overwhelming majority of empirical evidence supports the efficient market hypothesis. these investment strategies fail to perform as predicted. The vast majority of students of the market agree that the markets are highly efficient. after taking risk and transaction costs into account. The intense competition between investors creates an efficient market in which prices adjust rapidly to new information. Ultimately. it¶s important to note that these studies are controversial and generally have not survived the test of time. In other words. the efficient markets hypothesis continues to be the best description of price movements in securities markets Page 55 . The opponents of the efficient markets hypothesis point to some recent evidence suggesting that there is under. Consequently. investors receive a return that compensates them for the time value of money and the risks that they bear ± nothing more and nothing less.CONCLUSIONS The goal of all investors is to achieve the highest returns possible. Indeed. on average. active security management is a losing proposition.

CHAPTER ­ VII BIBLIOGRAPHY AND ANNEXURE Page 56 .

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