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A Test of the Consumption-based Capital Asset Pricing Model in the Philippines: 1999-2010

Timothy Joseph Loterte1 Joseph Arnel Chavez Elizabeth Audrey Clemente

This paper tests the consumption-based capital asset pricing model using quarterly Philippine data. The Generalized Method of Moments (GMM) procedure is used to estimate and test the parameters of the model assuming that the utility function of the investor is restricted to be of the constant relative risk aversion (CRRA) class, otherwise known as the power utility function. Using the consumption-based capital asset pricing model, the test shows that ______________________________________________ ______________________________________________ ______________________________________________ _____________________________________________

3rd year undergraduate students, College of Business Administration, University of the Philippines. This paper was made as part of the requirements for BA 146 under Dr. Joel Yu.

I. Introduction
This paper tests the C-CAPM for the Philippines for the period 1999-2010 using quarterly Philippine data. Estimates of the subjective rate of time preference and the investors risk aversion parameter were generated assuming that the utility function of the investor is restricted to be of the constant relative risk aversion (CRRA) class. The 91-day Treasury bill rate and the Philippine Stock Exchange Index (Phisix) are used to estimate the parameters. The paper is organized as follows. The traditional consumption-based capital asset pricing theory is presented in the following section. Section III discusses the Generalized Method of Moments procedure, the econometric methodology used to estimate and test the parameters. Section IV presents the data, as well as the results. Finally, Section V discusses the implications of the study and concludes the paper.

II. The Consumption-Based Capital Asset Pricing Model
The C-CAPM is basically an asset pricing model that is entrenched in macroeconomic stochastic models. The C-CAPM provides that an infinitely-lived representative agents consumption, saving, and asset selection choices describe the behavior of asset prices and returns.2

The Investors Consumption and Portfolio Choice Problem

The optimization problem of a representative agent can be stated as follows:

= expectation operator conditional on information at time t = rate of subjective time preference = an increasing, continuously differentiable concave utility function

Lucas, Jr. is considered to be the first to develop the C-CAPM in his 1978 article.

= per capita consumption at time t The maximization of the utility function is subject to an intertemporal budget constraint


= wealth of the investor = gross return of asset I from time t to t+1 equal to 0,

Substituting the constraint into the problem and setting the derivative with respect to the first-order condition for the optimal consumption and portfolio choice is3


is the stochastic discount factor or the intertemporal marginal rate of substitution for the model. In the equation, is the rate that the investor is willing to substitute his consumption at time t+1 in exchange for his consumption at time t. By means of the definition of the covariance, restated to: , equation [3] can be

Notice that in the case of the risk-free rate, Plugging this into equation [5], the result is

. Equation [5] therefore becomes

The derivation of the equations is provided in Appendix A

III. Econometric Method

The Generalized Method of Moments (GMM) is a statistical method developed by Hansen (1982) for obtaining parameter estimates of statistical models through the generalization of the method of moments. In Econometrics and Finance, the GMM is predominantly utilized in approximating parameters of dynamic nonlinear rational expectations models from the first order conditions such as Equation 3. This implies a set of population moment conditions that are derived from the assumptions of the econometric model.

Hansens 2-step GMM Procedure

should be noted that

Let the econometric model describe a disturbance vector vector of variables observed at date t. Let represent the


be an

unknown parameter vectors. It

does not have to be homeskedastic; it can be heteroskedastic and

serially correlated. The implication of the model is that for true parameter value

In GMM, the function describes the moment or the orthogonality conditions of the econometric model which is sometimes also called the residuals of the model.


be a sample counterpart of the expected value in Equation [9].

is a concession that makes Equation [10] as close to 0 as possible.

In the general case where the moment conditions are more than the parameters, the estimator for

This is accomplished in the GMM through the selection of the estimator for such that, with respect to the estimated value, the sampling error is as small as possible in the least squares sense.

The GMM estimator is therefore obtained by choosing

to minimize

wherein the prime denotes the transposition matrix and W is a symmetric, positive definite weighting matrix. The weighing matrix W determines how each of the moment conditions are weighted in the estimation. In principle, more accurate, in this case, less noisy moment conditions, ought to be weighted more than the less accurate and uncertain ones.

The 2-Step Procedure:

estimates of .

The optimal weighting matrix,

, is derived in two stages. The first step is to obtain preliminary estimates of the parameter vector using an arbitrary or sub-optimal weighing matrix. Second, the estimates are then used to derive the optimal weighting matrix in order to arrive at the final

Step 1: Set W=I, the identity matrix and solve the least square problem Step 2: Compute and estimate as Estimate Z by


and obtain the second step estimate

IV. Data and Empirical Results

Data on the PSI returns were utilized, as well as the 90-day T-Bill rates for the 10-year period. Data on the personal expenditures were acquired from PIDS and NSCB. The table below presents the results of GMM estimation using the data described above. The instruments used in the estimation are the first to fourth lags of consumption and the real interest rate and a constant. Likewise, the standard errors below were corrected for fourth-order moving average errors. GMM Estimates of Equation 3 Estimate Standard Error J(7) 0.98663 0.05767 5.92894 0.00151 0.00897 P-value=0.5481

As can be seen, both coefficient estimates are statistically significant. The implied rate of time preference is 5.53 percent (on an annual basis). Hansens J-test finds favorable evidence for the C-CAPM as the overidentifying restrictions are not rejected.

The risk aversion coefficient of 0.058 seems to be on the low side when compared with other countries. Hamori (1992) derives a value of 0.242 for Japan. Test for overidentifying restrictions yielded good results for Japan. Lund and Engsteds (1996) country estimates for Germany, Denmark, Sweden, and UK show a range of values from -26.13 to 10.36 using four different sets of instruments for each country. The J-tests do not reject the model except for one in twenty estimates.

V. Implications

The study computes initial estimates of important parameters such as the rate of time preference that are used in conducting economic cost-benefit analysis. This study was severely constrained by asset market data. A natural extension of the test is to use stock market data at the aggregate as well as at a disaggregated level. This can however be done only if reliable time series dividend yield data can be gathered. Thus, an important empirical undertaking is an assessment of equity market data and how it can be organized to generate these data series.

Another area of investigation is to determine if there is an equity premium and if the puzzle exists for the Philippines.

Aquino, Rodolfo. 2003. Test of the CCAPM in the Philippines: 1987-2000. College of Business Administration, University of the Philippines,

Bautista, Carlos. 1998. Test of the C-CAPM for the Philippines: 1983-1997. The Philippine Review of Economics and Business, 36 No. 1: 22-32