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**A Multivariate Test of an Equilibrium APT with Time Varying Risk Premia in the Australian Equity Market
**

by Robert W. Faff †

Abstract: This paper applies an asymptotic principal components technique, developed by Connor and Korajczyk (1988), to test an equilibrium version of the Arbitrage Pricing Theory (APT), which permits time varying risk premia, using Australian equity data. Cross-equation restrictions imposed by the APT on a multivariate regression of excess returns on derived factors are tested. Both one-step and iterative versions of the technique are used and results are compared to the capital asset pricing model (CAPM). While the APT appears to perform better than the CAPM, neither model can adequately explain monthly seasonal mispricing in Australian equities. Keywords:

ARBITRAGE PRICING THEORY; TIME VARYING RISK PREMIA; ASYMPTOTIC PRINCIPAL COMPONENTS. † Department of Accounting and Finance, Monash University, Clayton VIC 3168.

The author wishes to thank the seminar participants at Monash University and the Australian Graduate School of Management, University of NSW. Particular appreciation is due to Tim Brailsford, Justin Wood and two anonymous referees. Support provided by the Centre for Research in Accounting and Finance and the research assistance of Shih Thin Wong are also gratefully acknowledged. The author is grateful to Tim Brailsford for providing a series of Thirteen Week Treasury Note rates.

Australian Journal of Management, 17, 2, December 1992, © The University of New South Wales

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AUSTRALIAN JOURNAL OF MANAGEMENT

December 1992

1. Introduction he Arbitrage Pricing Theory developed by Ross (1976) relies on two basic assumptions: (a) that returns are generated by a k-factor process; and, (b) that any investment involving zero risk and zero net wealth will produce zero returns. The consequent pricing theory states that k-factor sensitivities are linearly related to expected returns. Empirical tests of the APT have supported anything up to five priced factors. Initial work by Roll and Ross (1980) suggested the possible pricing of three or four factors in the United States, while Australian evidence produced by Faff (1988) indicated a three-factor model. The work of Faff (1988) provides an initial attempt at testing the APT using Australian data. Several limitations of that study can be identified, which involve the issues of nonstationarity, errors-in-variables (EIV), and seasonality in monthly return. First, tests that involve averaging over long time-series assume that the underlying economic parameters being estimated remain constant over the period examined. A period of twelve years was examined by Faff (1988), which is excessive relative to the standard five-year analysis commonly employed in most asset pricing tests.1 Second, the two-stage testing procedure employed suffers from the well known errors-in-variables problem.2 A final drawback of the crosssectional testing framework used by Faff (1988) is an inability to incorporate the monthly seasonality in Australian equity returns as documented by Brown, Keim, Kleidon and Marsh (1983) and Wood (1990a). Connor and Korajczyk (1986, 1988) developed an asymptotic principal components technique, which presents a framework able to overcome these difficulties. The two most notable features which distinguish it from the technique used by Faff (1988) are, first, that it permits factor risk premiums to vary over time, and, second, that it involves a principal components analysis of the timeseries cross-product matrix (rather than the cross-sectional variance-covariance matrix) of returns. An important consequence of these features is that the common empirical concern of nonstationarity is greatly diminished. In standard frameworks for testing asset pricing models [for example, in Faff (1988)] the risk measure(s) and the factor risk premium(s) are all assumed to be constant over a given period of investigation. In the framework developed by Connor and Korajczyk (1988), however, only the factor risks are assumed to be constant. Moreover, their framework makes it feasible to assume that factor risks are constant over much shorter periods of analysis, for example, five years.

_ ____________ 1. A period of twelve years was necessary in order to maintain sufficient degrees of freedom, that is, the number of companies included had to exceed the number of time-series observations. See Faff (1988, p.30). 2. In the first stage, a principal components analysis of the cross-sectional variance-covariance matrix of returns provides the estimated (APT) factor loadings. These are then employed as the independent variables (measured with error) in a cross-sectional regression, with the sample mean return across assets as the dependent variable.

T

- 234 -

(d) incorporates monthly seasonality effects. while the final section provides a summary and conclusion. the underlying . Consequently. No. Generally. they concluded that while neither the CAPM nor the APT are perfect models. In Section 2 the asymptotic principal components technique of Connor and Korajczyk (1988). is reviewed.260). p.Vol. it is quite possible that the iterative estimates will produce a nontrivial improvement. The structure of this paper is as follows. Section 3 presents the multivariate methodology upon which the tests are performed.2 Faff: ARBITRAGE PRICING THEORY Connor and Korajczyk (1988) conducted several multivariate tests of crossequation restrictions imposed by the APT using U.288). This iterative procedure involves scaling excess returns according to the estimated standard deviation of idiosyncratic returns. The aim of this paper is to extend and improve on the empirical examination of the APT in Faff (1988) by applying a methodology developed by Connor and Korajczyk (1988) which: (a) is feasible with relatively small subperiods. Connor and Korajczyk (1988) recognised that in some cases the crosssectional size available may not be sufficiently large to ensure that the best possible estimate is obtained from the initial one-step procedure. Specifically. (b) uses a multivariate approach. this paper explores the sensitivity of results using the one-step versus the iterative version of the asymptotic principal components procedure. But they recognised that “applications with smaller cross-sectional samples may find greater improvement” (Connor and Korajczyk 1988. that the iterative procedure did not provide much improvement over the one-step procedure. The penultimate section details the results obtained.S. Arbitrage Pricing and Asymptotic Principal Components 2. They attributed this success to “seasonality in the estimated risk premiums of the multi-factor model that is not captured by the single-factor CAPM” (Connor and Korajczyk 1988. But it was found that the APT cannot explain non-January specific mispricing. in their application. research. Given the relatively small number of firms available in an Australian application. The cross-sectional sample size available to Connor and Korajczyk (1988) was very large and consequently they found.1 An Empirical Speciﬁcation of the APT onnor and Korajczyk (1988) present an empirical specification of the APT which integrates the assumed factor model generating returns with an equilibrium version of the APT asset pricing equation. monthly data.235 - C .17. In Section 4 the data set is described and related issues are discussed. They examined four non-overlapping five-year subperiods from 1964 to 1983. (c) permits time varying factor risk premiums. 2. Consequently. and. they found that a five-factor version of the APT was able to explain the January/size effect that is well documented in previous U. their evidence suggests the APT is a reasonable empirical alternative. In these circumstances they suggest an iterative variant that is more efficient.S. p. as applied here.

Further. . j = 1. . . j = 1. This formulation incorporates factor risk premium information (γ jt ) through the F jt variables and these are not restricted in their time-series properties. + Bki γ kt . . . . It is similar to standard principal components3 except that . that this framework does not permit the separate identification of the factor risk premiums (γ jt ) from the associated factor realisations ( f jt ). . the expected return on asset i in period t . 2. the jth factor sensitivity for asset i.AUSTRALIAN JOURNAL OF MANAGEMENT December 1992 k-factor model generating returns is assumed to be: Rit = E (Rit ) + B 1i f 1t + B 2i f 2t + . and. if a risk-free asset exists then the equilibrium version of the APT is given by: E (Rit ) = RFt + B 1i γ 1t + B 2i γ 2t + . γ jt = the realised risk premium for factor j in period t. and. i = 1. . . the excess return for asset i in period t . k. . . T time periods. . = the idiosyncratic return for asset i in period t. + Bki Fkt + ε it . N assets. (3) (2) The focus of the empirical tests which follow is primarily on the empirical specification of the APT given in Equation 3. where: rit = (Rit − RFt ). Upon substitution of Equation 2 into Equation 1. The reader should note. however. . that is. . + Bki fkt + ε it . that is. the realised risk premium plus the factor realisation for factor j in period t. and rearranging. where: Rit E (Rit ) B ji f jt ε it (1) = = = = the return on asset i in period t . .2 Asymptotic Principal Components: One Step and Iterative Versions The asymptotic principal components technique was initially developed by Connor and Korajczyk (1986). . k . and. It is in this sense that Connor and Korajczyk (1988) state that their framework is valid for models with time variation in factor risk premiums. . . . . and t = 1. F jt = (γ jt + f jt ) j = 1. the empirical specification of the APT in excess returns form becomes: rit = B 1i F 1t + B 2i F 2t + . . . the realisation of the jth factor in period t. . k . where: RFt = the return on the risk-free asset in period t .236 - . . . .

17. pp. Form the cross-product matrix (Ω) of excess returns. The Multivariate Framework 3. Scale the excess returns of each asset by its associated residual standard deviation obtained in (c) and form a new scaled cross-product matrix of excess returns. The null hypothesis to be tested is the restriction that the _ ____________ 3. p. Calculate the eigenvectors for the cross-product matrix. relative to the pricing model specified. not surprisingly. Also refer to Connor and Korajczyk (1988. No.487 to 1. b. e. . Repeat steps (b). d. 5. For each individual asset in the sample run a regression of excess returns on the first k eigenvectors obtained in (b) and calculate the standard deviation of residuals. a test for the absence of unconditional mispricing involves Equation 3 augmented by an intercept term (ai ) which captures general mispricing in the data.237 - . Its asymptotic nature relates to its reliance on “statistical approximations which are valid as the number of cross-sectional observations grow large” (Connor and Korajczyk 1986. But Connor and Korajczyk (1988. Consequently.5 3. Two basic variants are explored which relate to the existence of unconditional and conditional mispricing. (c) and (d) until convergence is achieved.382–384) for details.2 Faff: ARBITRAGE PRICING THEORY it analyses the time-series cross-product matrix of excess returns as opposed to the cross-sectional variance-covariance matrix of returns. First.259–261) provided an “iterative” refinement of the technique which promised improved estimation efficiency in smaller samples.258–259) for an intuitive discussion in a simple one factor case. The iterative process is as follows.1 Testing the APT for Mispricing T he tests in this paper are focused on a multivariate regression model that is an augmented version of Equation 3.381). pp. 4. they did not indicate any specific criteria for determining convergence.745) and so. See Connor and Korajczyk (1986. Connor and Korajczyk (1986) showed that the first k eigenvectors of the crossproduct matrix are approximately (asymptotically) non-singular linear transformations of the true F jt variables in Equation 3. found no benefit from using the iterated variant. a.4 A drawback of this one-step technique is that there is no objective means of assessing whether a given cross-sectional sample is sufficiently large so as to justify the asymptotic nature of the procedure.Vol. The first k eigenvectors represent proxies for the independent variables in Equation 3. Connor and Korajczyk (1988) had very large subsample sizes (ranging from 1. Refer to Trzcinka (1986) and Faff (1988) for examples of the application of the standard principal components technique to empirical tests of the APT. c. pp.

7. zero otherwise.238 - . Equation 3 plus: ai (NSEAS ) + ai (JAN ) DJAN + ai (JUL ) DJUL + ai (AUG ) DAUG . hence. It is desirable to include the monthly seasonal behaviour in Australia stock returns most relevant for our data period (1974 to 1987). This assumes that the chosen risk free proxy is appropriate. (b) the risk free rate is misspecified. DJUL = a dummy variable taking the value of unity in July. zero otherwise. the seasonality analysis focused on raw returns only and. ai (AUG ) = the coefficient measuring August-specific mispricing. He found a significant January and July seasonal across industrial firms and a significant July and August seasonal for small resource stocks. his results are suggestive only. July and August seasonals found by Brown et al. that is. (1983) examined the period from March 1958 to June 1981 (of which the subperiod 1974 to 1981 is relevant to the current study). the null hypothesis to be tested _ ____________ 6. (4) The second variant incorporates monthly seasonal behaviour in stock returns as potential measures of conditional mispricing. July and August. . the April seasonal was not included here. in our risk-adjusted framework. The work of Brown. These results reinforce the January. Kleidon and Marsh (1983) and Wood (1990a) suggests that seasonals for January. . (1983). Brown et al. that is. = ap = 0. Equation 3 will be augmented by an intercept and three seasonal dummies. (1983) and justify their inclusion in our analysis. They found that risk-adjusted returns indicated seasonalities in January. Wood also found a positive seasonal in April for small resource sector stocks. In the former case. ai (JUL ) = the coefficient measuring July-specific mispricing. and/or. . DAUG = a dummy variable taking the value of unity in August.7 Hence. Keim. zero otherwise. and. zero unconditional mispricing:6 H 0 : a 1 = a 2 = a 3 = . (5) where: ai (NSEAS ) = the coefficient measuring non-seasonal-specific mispricing: ai (JAN ) = the coefficient measuring January-specific mispricing. While this period fully encompasses our data period.AUSTRALIAN JOURNAL OF MANAGEMENT December 1992 intercept is zero across all (p) asset equations. but since this was a raw return seasonal only and because it was not confirmed by Brown et al. Wood (1990a) examined the period 1974 to 1988. DJAN = a dummy variable taking the value of unity in January. If this is not so then rejection of H 0 may reflect that: (a) the APT is inappropriate. In this situation two types of hypotheses can be tested—one relates to the absence of non-seasonal-specific mispricing and the other relates to the absence of seasonal-specific mispricing. July and August need to be included in a risk-adjusted analysis.

. 7b. . Note that the restricted systems estimated in order to test Hypotheses 4 and 6 are Equation 3 and Equation 3 augmented by three seasonal dummy variables. . i = 1. respectively. .17. The multivariate regression framework requires that returns are multivariate normally distributed. . The null hypothesis for the case of zero joint mispricing is: H 0 : ai (JAN ) = ai (JUL ) = ai (AUG ) = 0. _ ____________ 8. The null hypotheses for the case of zero individual mispricing are: H 0 : ai (JAN ) = 0. . = ap (NSEAS ) = 0. * T = (T − k − p ) p. ˆ det (Σ u ) = the determinant of the maximum likelihood estimate of the covariance matrix from the unrestricted system. . (8) (7a) (7b) (7c) The standard procedure for testing these hypotheses in a multivariate setting requires the estimation of the appropriately specified system of restricted and unrestricted models for each case. . p. p. . we can test for the absence of individual or joint seasonal mispricing. ˆ u) det (Σ (9) where: ˆ ) = the determinant of the maximum likelihood estimate of the det (Σ r error covariance matrix from the restricted system. 7c and 8. See Connor and Korajczyk (1988. . . (6) In the latter case. No. . Further. H 0 : ai (AUG ) = 0. i = 1. Equation 3 augmented by 5 is the common unrestricted system estimated in order to test Hypotheses 7a. p. . H 0 : ai (JUL ) = 0. i = 1 . The MLRT is given by:8 MLRT = T * ˆ r) det (Σ _ _______ −1 . however.239 - .271). In this paper the statistical tests are based on a modified likelihood ratio test (MLRT) statistic. and p = the number of equations in the multivariate regression system. p. . p. . . . . i = 1.Vol.2 Faff: ARBITRAGE PRICING THEORY is: H 0 : a 1 (NSEAS ) = a 2 (NSEAS ) = a 3 (NSEAS ) = .

APT + (1 − α i ) • r ˆit. These hypotheses can be tested using the MLRT as previously defined.240 - .AUSTRALIAN JOURNAL OF MANAGEMENT December 1992 Given the assumption of normality. = α p = 0. 3. T − k − p ) degrees of freedom. a multivariate extension of the “C test” used by Chen (1983) is performed in the current paper. p. = α p = 1. Connor and Korajczyk (1988. CAPM = the excess return for cross-section i in the period t. CAPM + error . In the multivariate regression model framework. ˆit. the MLRT has an exact small-sample F distribution with (p.2 Testing the APT Versus the Capital Asset Pricing Model (CAPM) In order to have a benchmark for comparison. calculated from the Price Relatives File of the Centre for Research in Finance (CRIF) at the Australian Graduate School of Management. predicted by r an excess returns market model with implied CAPM restrictions imposed. predicted by r the (restricted) empirical specification of the APT in Equation 3. Specifically. But a na¨ be misleading as the APT and CAPM are non-nested models. Data 4. rit = α i • r where the independent variables are defined as: (10) ˆit. . and. Following this suggestion. the null hypothesis which favours the APT over the CAPM is: H 0 : α 1 = α 2 = α 3 = .288) suggested that “procedures designed to compare nonnested models [similar to those used in Chen (1983)] will improve our understanding of the relative merits of the models”. Alternatively. . . 4. consider the artificial regression model ˆit. .1 General Description (12) (11) T he data used in the current work are returns on Australian equity securities. the null hypothesis which favours the CAPM over the APT is: H 0 : α 1 = α 2 = α 3 = . APT = the excess return for cross-section i in the period t. The data set covers the 165 month period from January 1974 to September 1987 and is divided into three . an analogous range of tests as just ıve comparison may described are also conducted for the standard CAPM.

S. 13. Unfortunately. Given the data restrictions used here.261.2 Faff: ARBITRAGE PRICING THEORY nonoverlapping 55 month subperiods for analysis. The empirical method involves individual firms being grouped into portfolios according to market capitalisation.241 - . To reduce the dimension of the equation system to feasible proportions. This produces sample sizes of 303. it is interesting to note that even they lost 30% of the available firms for this reason (p. This represents a two hundred fold difference. in the current context.17. 10. This fourteen-year period is chosen for analysis because January 1974 is the earliest month in which market capitalisation data is available. This large firm bias is induced by the need to have complete price histories of all firms analysed. as supplied by CRIF. the computational bias is minimal and can safely be ignored.18 million compared to an average size of $450. 158 and 340 for the three subperiods. while maintaining acceptable sample sizes.64 million for the largest firm portfolio. The market index employed is the value-weighted index. That is. [This is in contrast with the reason for using portfolios in traditional _ ____________ 9. respectively. [For example.9 Securities are included in a subperiod sample if they have a complete price relative history in that period. Wood (1990) analysed this bias based on size deciles of Australian companies. whereas the sample used here is clearly biased toward larger firms. Dodd and Officer (1988). it is argued that. But it should be noted that such anomalies have invariably been found most pronounced in the very small firms. The subperiod size was chosen so as to provide a balanced and independent coverage of the overall period. footnote 4). 12. No. data as used by Connor and Korajczyk (1988). the use of portfolios reduces the number of equations in the multivariate analysis to a number which can be estimated. this number has been chosen in the vast majority of Australian based (and overseas) studies which have used market capitalisation as a portfolio formation variable. Using all companies in the AGSM database. with relatively little bias for the other deciles. Given that the empirical set up involves size portfolios and regression models that include monthly seasonal dummy variables. it seems natural to use the current analysis to shed some light on how well the APT can explain size related anomalies. It is recognised that a potential computational bias occurs when using equally weighted portfolios based on a size ranking [see Blume and Stambaugh (1983)].12. While the choice of ten portfolios is arbitrary. with Australian data there is a relatively high incidence of missing data which tends to be more common amongst small firms. see Beedles. While this is less of a problem for U. while the risk-free rate of return is estimated from a series of monthly observations on Thirteen Week Treasury Notes.] 11. he found the bias was most severe in the decile of the smallest firms. 13 4. . The average beginning of subperiod size of companies in the smallest firm portfolio is $2.Vol. Hence. Notwithstanding the comments made in the previous footnote regarding the large firm sample bias. one would still expect to observe a relative firm size effect.2 Use of Portfolios It is important to note that portfolios (rather than individual assets) are used for the reason of making the analysis statistically feasible. very few of the companies in our sample will correspond to the companies included in Wood’s smallest decile. securities in each subperiod are allocated to ten10 equally weighted portfolios11 according to their beginning market capitalisation in each subperiod.

1 The Error of Approximation in the Factor Estimates: Simulation Evidence A s indicated earlier in Section 2. an identical simulation exercise is repeated using one subperiod of our data. the error of approximation in the factor estimates would seem to be a greater problem here. That is. But the validity of this application relies on the number of assets being large enough such that the error of approximation is immaterial.2. tests would be pointless. in the extreme. The simulation is performed using the 55 month subperiod from August 1978 to February 1983. It is for this reason that tests using individual assets were not conducted in the current paper. 5.AUSTRALIAN JOURNAL OF MANAGEMENT December 1992 (univariate) CAPM tests of the 1960s and 1970s. Connor and Korajczyk (1988) investigated the potential significance of this error by simulating “true” factors in their data and running regressions of the eigenvectors on the “true” factor matrix. To assess the significance of the error. Connor and Korajczyk (1988) conducted such tests (assuming that the covariance matrix on individual asset returns is “block diagonal”). portfolios were formed to attenuate the problem of errors-in-variables (EIV). But they concluded that their tests lacked power because of the large number of assets used relative to the small number of (monthly) observations used in the time-series dimension.242 - . This is desirable for testing purposes because the variation of return and risk determines the degree of potential asset pricing information contained in the data. if return and risk did not vary at all across portfolios. Indeed. While this is not impossible. The “true” factors are taken to be the first five eigenvectors extracted from the original data for this . Empirical Results 5. In these tests. Connor and Korajczyk (1988. The cost is that it will bias tests in favour of the null model to the extent that individual pricing errors offset each other in the selected portfolios.] But the use of portfolios does come at a cost. On the basis of their simulation results. it requires that a strong assumption be made regarding the covariance structure of returns. then the data would contain no information on how asset prices are formed.269) concluded “that the asymptotic principal components technique provides accurate estimates of the pervasive economic factors”. In this case. The number of assets available and used in the current paper is a far smaller number than that used by Connor and Korajczyk (1988). One could argue from the above that the tests should ideally be conducted on individual assets. Consequently. It is this concern which justifies selection of size-based portfolios. the asymptotic principal components approach involves using eigenvectors from the cross-product matrix of excess returns as proxies for the true factor matrix. since there is ample prior evidence suggesting a strong and systematic CAPM pricing error for assets of similar size. Moreover. in which the sample size is 158. size-based portfolios have been found to provide a wide range of return and risk across portfolios. p. introduced by the well known two-stage testing approach.

7.17.7 only the first three estimated factors show high R 2 values. A perfect R 2 value of unity indicates a factor estimate with zero error. the importance of the error of approximation is more significant than in the U. non-zero idiosyncratic cross-sectional correlation (ρ ) is permitted. Not surprisingly.14 The degree of error in the factor estimates is gauged by the R 2 value obtained from regressing the estimated factor on five “true” factors. 0. The results in Table 1 indicate that for our data the error of approximation is of concern at least for ρ = 0. It was found that considerable instability is observed between the initial and iterated estimates. While this indicates that the iterated optimal estimates may be desirable [in contrast to the results of Connor and Korajczyk (1988) with U.S. In any case.1.9. These regressions were run across five iterations for each estimated factor. whereas for ρ = 0.267–268) for a detailed description of the simulation framework employed. For ρ = 0.5). The R 2 values are very large for low to intermediate values of ρ (ρ = 0. 0. a series of (simulated) returns is formed composed of a factor component and an idiosyncratic component.5. Refer to Connor and Korajczyk (1988. that is.1.3 and 0. It is argued here that even these values for ρ are unrealistically high and that for more reasonable values of ρ (< 0. 0.Vol.2 Faff: ARBITRAGE PRICING THEORY subperiod. 0. Connor and Korajczyk (1988) found that the error appeared to be a problem only in the case of ρ = 0.0.3.8 and 0. some criteria for determining convergence of these factor estimates must be specified. 0.7) the error of approximation in factor estimates is acceptable.2 One-Step Versus Iterated Factor Estimates The first empirical issue to be resolved is whether it is necessary to go beyond the initial one-step factor estimates and perform an iterated analysis. this high level of correlation is “implausibly large”. These results are very similar to those found by Connor and Korajczyk (1988). the results that are reported in the following sections should be read with due caution. 5. data].9 only the first estimated factor reveals high R 2 values.9 for the estimated factors four and five. 0. maximum and minimum R 2 values across the different ρ values for each of the first five estimated factors are reported in Table 1. pp. due to the much smaller sample size used here. No. This claim is likely to be even stronger in the other two subperiods since the sample size in both cases is double that available in the subperiod used in the simulation exercise. 0. The cross–sectional correlation values considered are: ρ = 0.243 - . study. .7. _ ____________ 14. The correlational structure of returns is constructed to have an approximate factor structure. The average. however.8 and perhaps also for ρ = 0. at least in that the significance of the error becomes increasingly important as the assumed level of idiosyncratic correlation increases.0. But they argued that given the first five factors have been extracted. Based on these “true” factors.8 and 0.S.

960 0.147 0.982 0.951 0.438 0.739 0.891 5 0.910 0.930 0.1 1 0.5 1 0.494 4 0.911 0.531 0.092 0.978 0.757 0.745 0.271 0.314 0.054 4 0.869 4 0.959 0.898 4 0.781 0.850 5 0.980 0.895 0.876 0.918 0.342 0.189 0.963 0.852 0.293 0.860 0.973 0.881 0.090 5 0.371 0.889 5 0.245 0.162 5 0.919 0.835 0.687 2 0.967 0.569 0.544 0.801 4 0.436 0.871 0.972 2 0.956 0.958 0.822 0.988 0.244 - .179 0.846 0.972 0.283 0.928 3 0.887 0.981 0.839 2 0.096 0.7 1 0.964 0.197 0.031 3 0.479 0.900 0.968 0.205 5 0.153 4 0.931 2 0.847 0.323 0.444 2 0.921 0.985 0.937 3 0.899 0.785 3 0.900 0.976 0.652 0.827 0.969 2 0.103 0.0 . Factor Average R 2 Maximum R 2 Minimum R 2 _________________________________________________________________ 1 0.751 0.824 0.038 3 0.972 2 0.829 0.953 3 0.722 5 0.049 _________________________________________________________________ 0.AUSTRALIAN JOURNAL OF MANAGEMENT December 1992 Table 1 A Simulation Comparison of the Asymptotic Principal Components Factor Estimates Versus “True” Factors For a Five Factor Model _________________________________________________________________ ρ Est.141 0.344 0.972 0.800 4 0.122 0.922 3 0.221 0.9 1 0.8 1 0.3 1 0.955 0.809 0.882 0.

the necessary number of iterations for each subperiod were: ten for the 1974/78 subperiod. 16. the fixed T facing the empirical researcher creates the estimation risk problem. factor mean returns and found very strong evidence in favour of seasonality in the first four factors. previously. .S.260). A similar test of seasonality in the mean factor returns is conducted in the ˆ ) on a constant current study by regressing each statistically estimated factor (F jt and three dummy variables representing the months of January.245 - . seven for the 1978/83 subperiod. _ ____________ 15. and five for the 1983/87 subperiod.3 Seasonality in Factor Mean Returns As discussed earlier. The existence of monthly seasonals in factor risk premiums can potentially help explain the puzzle of observed seasonal patterns in share returns.] Consequently. in subsequent tests. DAUG = dummy variables as defined for Equation 5. DJAN . [See Connor and Korajczyk (1988. C 2 .15 Following this requirement. where: ˆ = the realised risk premium plus the factor F jt realisation for factor j in period t.98 and above.16 5. for example. While these estimates are asymptotically valid. it may come at the cost of “estimation risk”. The Connor and Korajczyk (1988) analysis assumes that the true idiosyncratic variances are known. viz: ˆ =C +C D (13) F jt 0 1 JAN + C 2 DJUL + C 3 DAUG + error. It is important to recognise that while the iterative procedure offers potential gains in estimation efficiency. No. this may place a limitation on the validity of the iterative estimates and so they should be treated with some caution. p. statistically estimated using asymptotic principal components: C 0 . DJUL . C 3 = unspecified regression coefficients.2 Faff: ARBITRAGE PRICING THEORY The overriding criterion used in this study is that a “high” correlation must be observed between factor estimates from consecutive iterations. and. Moreover. July and August. This is of particular interest due to the prominence that monthly seasonality has achieved in the vast literature on capital market anomalies. whereas in practice we use sample estimates.17. a major advantage of the Connor and Korajczyk framework is that it allows for time variation in factor risk premiums. they attributed this seasonality as an important reason for the APT’s ability. Connor and Korajczyk (1988) tested for January seasonality in U. One specific case of such variation is monthly seasonality. to explain away January seasonal mispricing. In the first subperiod. More generally. C 1 . correlations in all subperiods between the final two iterations were mostly around 0.Vol. perfect positive correlation between the ninth and tenth iteration factor estimates was obtained for factors one through eight.

18 _ ____________ 17. 5. estimates of F jt It can be seen that there is no consistent or strong seasonal pattern across subperiods either for the initial or for the iterated factor estimates. p. third and eighth factors (eigenvectors) seemed to be important. July seasonality is apparent in only one factor in each of the first and last subperiods using initial estimates and in only one factor in the last subperiod using iterated estimates. This non-rejection is likewise evident in the overall period at the 10% level and in particular seems to favour the APT (5) model more. The strength of this evidence of seasonality in mean factor risk premiums is disappointing. with three (two) out of five iterated (initial) factors proving significant at the 5% level. The five [APT (5)] and ten [APT (10)] factor versions of the APT were conservatively chosen as the focus of analysis.17 For comparative purposes.10 critical level for aggregate multivariate tests following the analysis of Gibbons and Shanken (1987. August seasonality is evident in at least one factor in every subperiod except the first (for the iterated estimates). But in the case of both iterated APT models there is strong evidence that the null cannot be rejected in either the early subperiod or the later subperiod. It can be seen that for the CAPM and also for the initial APT (5) and APT (10) specifications. In Table 2. It is to these we now turn our attention. Faff (1988) found that the first. the results for similar Sharpe-Lintner CAPM tests (using a value-weighted index return) are also provided in Table 3.246 - . While prior evidence supports three or four factors at most.AUSTRALIAN JOURNAL OF MANAGEMENT December 1992 The results from estimating this regression are reported in Table 2 and indicate only very weak evidence of any monthly seasonality in the factor mean returns. For example. their importance may vary over time in an unpredictable manner. despite some minor subperiod support.393). while Panel B presents the results based on the iterated estimates. 18. Moreover. But January does not appear important in either of the later subperiods. It is prudent to employ the 0. for each subperiod. Panel A presents the results based on the initial ˆ . Connor and Korajczyk (1988) also examined APT (5) and APT (10). There is some evidence of a January seasonal in the first subperiod. in the overall period the aggregate test statistics indicate strong rejection of the null hypothesis of no unconditional mispricing. . But the Connor and Korajczyk (1988) APT framework does allow for unspecified time variation in factor risk premium and the results of tests in this more general environment are still of great interest. it is not necessarily the case that factors will be economically important in the order that they are extracted by the principal components technique.4 Tests of the APT: Unconditional Mispricing Presented in Table 3 are the modified likelihood ratio test (MLRT) statistics for the absence of unconditional mispricing (the null hypothesis in Equation 4) in a five factor APT model [APT (5)] and a ten factor APT model [APT (10)].

84 (0.30 (0.089) ns ns ns B.Vol.72 (0.019) ns3 ns ns Jul 2.2 Faff: ARBITRAGE PRICING THEORY Table 2 Test Statistics and p-values for the Hypotheses That the Conditional Mean Factor Risk Premium in January.021)4 Jan 2. .016) Jan 2.009) Aug 1.03 (0. July and August.382 (0.022) Aug 2. No significant differences at the 10% critical level are found for the mean factor risk premiums.048) ns ns ns Jan 2. 3.018) ns ns Aug 2.49 (0. Connor and Korajczyk (1988. 2.000) ns ns ns Aug 3.84 (0.012) ns ns ns Jul 3.071) _ ________________________________________________________________________ Notes: 1.08 (0.002) Aug 2. p. t-statistic from Equation 13 for month with significantly different (at a 10% level) mean factor risk premium. Iterated Estimates 1974/1–1978/7 1978/8–1983/2 1983/3–1987/9 Jan 2.36 (0.040) 1978/8–1983/2 1983/3–1987/9 ns Jul 3. Initial Estimates 1974/1–1978/7 Jan1 2. Month having significant difference from unconditional mean factor risk premium.60 (0.17. 4.271) caution that comparing test results between the non-nested CAPM and APT models “can be misleading . The p-value is given in parentheses.43 (0.003) Aug 1. .247 - .45 (0. is Equal to the Unconditional Mean Factor Risk Premium _ ________________________________________________________________________ Factor Time Period 1 2 3 4 5 _ ________________________________________________________________________ A. since a model that actually fits better (smaller values of | a |) may be rejected if the deviations are . No.74 (0.10 (0.

40) for APT (5).011) 1.75 (0. It should be noted that there is a bias in the mispricing estimates which is induced by errorsin-variables.074 2.158) aggregate test _______________________________________________________ Notes: 1. measured more precisely (that is.866) 2. and (10. comparative plots of these three should highlight the extent of the problem in this study.001) (0.00 (0. the plots presented in the Figures and the results reported later should be read with this in mind. (10.62 0.108) 2. This value is the standard normal variate equivalent for the aggregated subperiod F-statistics.056) 1.] The bias may be a problem here due to the small samples involved.324) Overall period 3.52 (0.001) (0. They suggested that some evidence of this problem would be revealed by plotting the average estimates ˆ ’s) for each portfolio.061) 3 2.016) 1.051) 1. 4. 44) for CAPM. Hence.96 (0. 2. [See Connor and Korajczyk (1988.AUSTRALIAN JOURNAL OF MANAGEMENT December 1992 Table 3 Modified Likelihood Ratio Test (MLRT) Statistics for the Absence of Unconditional Mispricing in the CAPM.008) 0.270). p.64 (0.375) (0.10 1.20 (0. 35) for APT (10).91 (0.81 (0.09 (0.049) 0.71 (0.19 Hence. a plot of the _ ____________ 19. APT (5) and APT (10)1 _______________________________________________________ APT (5) APT (10) CAPM Time Period Initial Iterated Initial Iterated _______________________________________________________ 1974/1–1978/7 1978/8–1983/2 1983/3–1987/9 1.07 (0.93 (0.972 (0. in Figure 1.32 3. Given the similarity of our test results for the CAPM versus the initial (one-step) APT (5) and APT (10) models.06 (0.48 (0. p. Each subperiod uses ten portfolios sorted on market value.492) 2. Modified likelihood ratio test (MLRT) statistic [see Rao (1973.621) 2. . 3.248 - .555)] which has an F distribution with (numerator.069) 2.004) (0.023) 0. It can be shown that this bias is a function of the covariance between the approximation errors and the factor sensitivities. the test has more power)”.19 (0. The p-value is given in parentheses. across the different of the mispricing parameter (average a models.326) 2. denominator) degrees of freedom of: (10.

. in a similar fashion to the results of Table 3.. July and August conditional .. relative to conventionally applied critical values.. . particularly for the smallest company portfolio.Vol. . .. involving hypotheses (7a)...... we can also test for the absence of conditional mispricing in terms of the January. .... July and August seasonal behaviour observed in Australian data.. .. 5. . CAPM APT (5) APT (10) 1 2 3 4 5 6 7 8 Size Portfolio Figure 1 9 10 Unconditional mispricing. .. .. . The second approach is to conduct a test of the (stronger) joint hypothesis of zero January.. . ... July or August related conditional mispricing.5 Tests of the APT: Conditional Mispricing As suggested in Section 3.2 Faff: ARBITRAGE PRICING THEORY average unconditional mispricing for the CAPM and for the one-step versions of APT (5) and APT (10) are given. are reported in Table 4.. ...) . 1974–1987 Generally. But for all three models a discernible “small firm effect” is evident. . It is apparent from Table 4 that none of the models have much difficulty explaining individually January. ........ .1. (7b) and (7c).... . .. ...17. This would suggest that the APT is being rejected with smaller pricing errors because they are being estimated more precisely. No... .. it may be instructive to examine the relative plots of average seasonal-specific mispricing for evidence of differential testing power across models. First... ...... .249 - ..a.. The subperiod and overall period test statistics are very small indeed.. the plots reveal that CAPM has a higher average mispricing. But this analysis can be extended in two important ways.. The results of these tests for the individual seasonal effects.. . 40 30 20 10 0 -10 Mispricing (% p. .. although it is clearly strongest for the CAPM.

881) 0.39 (0.142) 1.07 (0. 10.42 (0.07 (0.15 (0. 2.80 (0.940) 0.910) –1.291) 0.441) 0.65 (0.AUSTRALIAN JOURNAL OF MANAGEMENT December 1992 Table 4 MLRT Statistics for the Absence of Conditional Mispricing (Individual January.322) –0.35 (0.519) –0.764) 0.03 (0.07 (0.663 (0.25 (0.658) 0.89 (0.94 (0.916) 1983/3–1987/9 ai (JAN ) = 0 ai (JUL ) = 0 ai (AUG ) = 0 0. 37) for APT (5).329) 1.124)4 1.35 (0.58 (0.563) 1.719) –2.32 (0.715) 0.310) 1.607) –0.46 (0.441) 0.21 (0.902) 0. denominator) degrees of freedom of: (10.47 (0.440) 1. 32) for APT (10).251) 1. and (10.66 (0.873) 0. .208) 0.97 (0.140) 1.04 (0.62 (0.61 (0.72 (0.70 (0.94 (0.050) 1.05 (0.544) 0.413) 1.48 (0.25 (0.49 (0.715) 1.88 (0.507) 0.407) 1.34 (0. Modified likelihood ratio test (MLRT) statistic [see Rao (1973.70 (0.084) 1.13 (0. 2.11 (0. Each subperiod uses ten portfolios sorted on market value.324) 1.426) 0.447) ______________________________________________________________________ Notes: 1.26 (0.658) 0.93 (0.14 (0.682) 1.753) 0.964) 0.446) Overall period aggregate test ai (JAN ) = 0 ai (JUL ) = 0 ai (AUG ) = 0 0.77 (0.70 (0.19 (0. 3.250 - .998) 0. This value is the standard normal variate equivalent for the aggregated subperiod F-statistics. .86 (0.555)] which has an F distribution with (numerator. 41) for CAPM.104) –0.78 (0.216) 1.263) 0. .20 (0.46 (0.350) 1.51 (0.553) 1. .27 (0.77 (0.17 (0. 4.650) 2.74 (0. APT (5) and APT (10)1 ______________________________________________________________________ CAPM APT (5) APT (10) Null Time Period Initial Iterated Initial Iterated Hypothesis2 ______________________________________________________________________ 1974/1–1978/7 ai (JAN ) = 0 ai (JUL ) = 0 ai (AUG ) = 0 1.03 (0. .413) 0.996) 0.959) 0.41 (0.515) 1. July and August Seasonality) in the CAPM.44 (0.297) 1.243) 0.076) 1.192) 1. (10.635 (0.364) 0.49 (0.991) –1. 5.02 (0.071) 1978/8–1983/2 ai (JAN ) = 0 ai (JUL ) = 0 ai (AUG ) = 0 0.16 (0.903) 0. The p-value is given in parentheses.699) 0. i = 1. p.38 (0.

251 - . The results of this analysis are found in Table 5.2 Faff: ARBITRAGE PRICING THEORY mispricing. That is. average conditional mispricing that is specific to July is plotted for the ten size portfolios. This is similar to Figure 1. In Figures 2 to 5. Here. In stark contrast to the results of Table 4. 5. Figure 3 reveals average January-specific conditional mispricing. It finds support only in the iterated version of APT (5). very large average mispricing of around 90% and 60% per annum is observed for the CAPM for the smallest two firm size portfolios. Significant mispricing is observed particularly in the mid-sized portfolios (20% to 30% per annum) for both the CAPM and APT models. In contrast to the results of Connor and Korajczyk (1988). in virtually all subperiods. test statistics for all models provided a resounding rejection of the null hypothesis. The very strong rejection of the CAPM and APT models due to the existence of (joint) January. In general all these seasonal specific plots reinforce the suggestion that the APT tests have stronger power because of the more precise estimation of mispricing coefficients. This mispricing is much larger than the maximum mispricing (10% to 20% per annum) found for the APT models. in Figure 5 the average August-specific-conditional mispricing is displayed. the APT does not provide an adequate explanation of this seasonality. In Figure 4. average mispricing relating to the conditional seasonal model specifications are plotted for the CAPM versus the initial five and ten factor specifications. but again it is less prominent for the APT. In Panel A. A small firm effect is evident for all models. July and August. respectively.6 Tests of the APT versus the CAPM Finally.Vol. As discussed earlier. and indeed in the overall period. While a small firm effect is still evident for the APT. These two aspects are now considered in turn. in Table 6 results for the non-nested tests described in Section 3. it is clearly much less pronounced than for the CAPM. Finally. a further extension of the seasonality mispricing issue is achieved by testing the hypothesis (given by Equation 8 previously) of joint zero mispricing in January. the data will not support the conclusion that January. whereas we could reject their individual mispricing effects. particularly for the smallest firm portfolio. This set of seasonals has provided sufficient power for the tests to reject the null models. July and August mispricing provides solid support for the initial choice of this monthly seasonal structure in returns.17. showing relatively larger mispricing evident for the CAPM. Figure 2 shows the average non-seasonal-specific mispricing for the three models. July and August mispricing is jointly zero.20 Also contained in Table 5 are the results of testing the null hypothesis of zero non-seasonal-specific mispricing (given by Equation 6). the univariate results for each individual portfolio are _ ____________ 20.2 are provided. No. .

. . . . . . . . . . . . .252 - ....... .. . ... . . .... ... . ..... .... . .. . APT (5) . ... .. .. . ..... . .. . .. . . . ..a. ... APT (10) .. ..... .... .. . 1974–1987 9 10 ... CAPM ... . . .. .... .) 0 -10 -20 1 2 3 4 5 6 7 8 Size Portfolio Figure 3 Conditional mispricing: January-specific... . . .... .. ..AUSTRALIAN JOURNAL OF MANAGEMENT December 1992 30 25 20 Mispricing 15 (% p. .... . . . . . ... .... . .. . .. .. . . . CAPM APT (5) APT (10) 40 30 20 Mispricing 10 (% p.. . . ...... . . . .. .. ... ... ... . .. .. ... .. 1974–1987 9 10 ... . ... .... .. .. .. .. . ... . . .. .... . . . .. . .) 10 5 0 -5 1 2 3 4 5 6 7 8 Size Portfolio Figure 2 Conditional mispricing: non-seasonal-specific. .. . .... . . .. . . ... .. ... . . .. . . . . . ... . . . . . .. . . . ..a.

.. ...... ....... . CAPM ..... .. .... .. . . .. . 1974–1987 40 30 20 Mispricing 10 (% p... . APT (5) APT (10) 1 2 3 4 5 6 7 8 Size Portfolio Figure 5 9 10 Conditional mispricing: August-specific. . ... ... . .....253 - .. .. ..... ..... . .... . ... ....... ... . . . .... . . ... . .2 Faff: ARBITRAGE PRICING THEORY 100 80 60 Mispricing 40 (% p... .. ... .) 20 0 -20 .. . . ......... ... . .. CAPM .... .a....Vol. .. . ... ... .... .... .) 0 -10 -20 . . .... .a.17. . . .. .. . .. .. . ....... No.. . . . APT (10) APT (5) 1 2 3 4 5 6 7 8 Size Portfolio Figure 4 9 10 Conditional mispricing: July-specific. 1974–1987 . .. . . . .

166) 2.152)4 1. the results indicate support for the APT in all but the largest size portfolios.094) 1.49 (0. This value is the standard normal variate equivalent for the aggregated subperiod F-statistics. 10.000) (0.011) 1.52 (0.AUSTRALIAN JOURNAL OF MANAGEMENT December 1992 Table 5 MLRT Statistics for the Absence of Conditional Mispricing (joint January.001) 3. The analysis involving Portfolio 1 (smallest companies) through to Portfolio 5 gives support to the one-step APT (5) model (H 0 : α = 1) and rejects the CAPM (H 0 : α = 0). reported.79 (0.97 (0. .028) 1.19 4.67 (0.69 (0.043) 2.65 4. .133) 1.12 (0.555)] which has an F distribution with (numerator.031) 1. based on the estimation of a regression given by Equation 10.44 (0. Each subperiod uses ten portfolios sorted on market value.56 (0. Generally.000) (0. 2. Modified likelihood ratio test (MLRT) statistic [see Rao (1973.122) 2.61 (0. neither model is supported. July and August Seasonality) in the CAPM. and (10.066) ai (JAN ) = ai (JUL ) 4.000) 5.64 (0.345 (0.55 5.36 (0. p.000) = ai (AUG ) = 0 _ ________________________________________________________________________ Notes: 1.79 (0.71 4.22 (0.000) 11. In the case of Portfolio 6 through to Portfolio 9.299) 2. 4.000) 4. For example. 37) for APT (5).76 (0.24 (0.005) 3.79 (0. 41) for CAPM.50 (0. denominator) degrees of freedom of: (10. 5.28 (0.250) 1.254 - . The p-value is given in parentheses.126) 1.182) 1.28 (0.79 (0.000) (0.97 (0. i = 1.53 (0.129) 0. 3.66 (0.27 (0.000) 1978/8–1983/2 ai (NSEAS ) = 0 ai (JAN ) = ai (JUL ) = ai (AUG ) = 0 2. (10. 2.07 (0.010) 2.250) 5.065) 1.34 (0.006) 3. consider the third subperiod. 32) for APT (10). .24 (0.642) 1.18 (0.21 (0.000) 7.071) 1.009) 0.206) 3.98 (0.000) (0. APT (5) and APT (10)1 _ ________________________________________________________________________ CAPM APT (5) APT (10) Null Time Period Initial Iterated Initial Iterated Hypothesis2 _ ________________________________________________________________________ 1974/1–1978/7 ai (NSEAS ) = 0 ai (JAN ) = ai (JUL ) = ai (AUG ) = 0 1.038) 1983/3–1987/9 ai (NSEAS ) = 0 ai (JAN ) = ai (JUL ) = ai (AUG ) = 0 1.42 (0.66 (0.573 (0. It is only in the case of Portfolio 10 .33 (0.004) 1. .003) Overall period aggregate test ai (NSEAS ) = 0 2.002) 3.157) 2.

159) 0.0547 (0.085) 0.0874 (0.087) 1.0815 (0.068) 1. 3.067) 0. 10 [that is.6921 (0. 4.5549 (0.75 (0.112) 0.8940 (0.125) 0. The non-nested comparison is based on the C-test framework of Davidson and MacKinnon (1981). .3737 (0.9096 (0.9671 (0. The p-values are in parentheses.061) 0.9963 (0.065) 0.110) 0.0557 (0.077) 0. 2.050) 0.0571 (0. Standard Errors in parentheses.9386 (0.17.133) 1. Modified likelihood ratio test (MLRT) statistic [see Rao (1973.093) 0.093) B.3129 (0.0298 (0.5818 (0. p.068) 0.0313 (0.7491 (0.Vol.060) 1.0410 (0.073) 1.127) 0. APT (5)] _ _____________________________________________________________ Notes: 1.116) 1.042)2 0.623 (0.0914 (0.0078 (0.091) 1.0577 (0.9641 (0.0133 (0.1235 (0.93 (0. 2.103) 0.112) 1.2385 (0.1596 (0.9965 (0. Multivariate Analysis 3.94 (0.129) 1.136) 1.143) 1.1432 (0.0978 (0.085) 0.080) 0.0675 (0.0587 (0.141) 1.216) 1.2173 (0.069) 1.555)] which has an F distribution with (10.2060 (0. .8649 (0.507) 11.0540 (0.8157 (0.116) 0. .255 - .171) 0.9592 (0.057) 0.9840 (0.0072 (0.9124 (0.107) 0.107) 1.164) 0.076) 1.8976 (0.6547 (0.1668 (0.138) 1.000) 2.0025 (0.6587 (0.108) 0.166) 1.0220 (0.9901 (0.8073 (0. Univariate Analysis ˆ1 α (smallest) 0.5380 (0.9684 (0.9997 (0.0370 (0.067) 0.088) 1.007) 4.9823 (0.001) 4 2.122) 1.1376 (0.8893 (0.001) 0. 44) degrees of freedom.093) ˆ2 α ˆ3 α ˆ4 α ˆ5 α ˆ6 α ˆ7 α ˆ8 α ˆ9 α ˆ 10 α (largest) H0 : αi = 1 1.106) 1.094) 1.229) 1.9835 (0.03 (0. .1247 (0.047) i = 1.086) 0.095) 1.206) 0.066) 0.087) 0. .0068 (0.216) 1.142) 0.08 (0.256) 1.094) 0.104) 1. No.2 Faff: ARBITRAGE PRICING THEORY Table 6 A Non-nested Comparison of APT (5) Versus CAPM1 _ _____________________________________________________________ 1974/1–1978/7 1978/8–1983/2 1983/3–1987/9 Initial Iterated Initial Iterated Initial Iterated _ _____________________________________________________________ ˆi α A.067) 0.0381 (0.

This work extends and improves the previous research by Faff (1988) in three major ways. But joint seasonal mispricing (that is. January _ ____________ 21. while Portfolio 10 supports neither model. Second. rather than the traditional two-stage method. The tests were based on cross-equation restrictions imposed by the APT on a multivariate regression of excess returns on the estimated factors. the empirical technique has allowed examination of smaller subperiods which involves a more realistic assumption regarding stationarity. T . In unreported results it is (not surprisingly) found that similar multivariate tests of the converse situation. Keim. Both one-step and iterative versions of the method were used. the associated multivariate statistics for the nonnested tests of APT (5) across the ten portfolios are presented. We can: (a) reject the APT and accept the CAPM. the analysis incorporates dummy variables for monthly seasonality effects. the iterated versions of the APT models do not reveal significant unconditional mispricing.21 For the iterated APT (5) model. In this paper. (c) reject both models. or (d) accept both models. following the work of Brown. These results tend to confirm earlier analysis suggesting that the APT models are superior at pricing all but the larger firms. Conditional mispricing was tested by augmenting the multivariate regression model with January. by using the multivariate approach. the results provided only weak support for the APT model. July and August seasonal dummy variables. whereas CAPM (at best) only has some ability in pricing the largest firms. that is. was used to provide factor estimates necessary for the testing of an equilibrium version of the arbitrage pricing theory (APT) with time varying risk premia. the errors-in-variables problem is considerably reduced. January or July or August) cannot be rejected for any model. Finally. developed by Connor and Korajczyk (1988). (b) accept the APT and reject the CAPM. First.AUSTRALIAN JOURNAL OF MANAGEMENT December 1992 (largest companies) that the CAPM is supported and the APT rejected. In contrast. tests are performed using Australian monthly equity return data in the period 1974 to 1987. show absolutely no support for the null in any subperiod or indeed overall. 6.256 - . Unconditional mispricing cannot be rejected for the initial onestep versions of a five factor and a ten factor APT nor for the CAPM. = α 10 = 0 ). Note that there are four possible sets of conclusions. Conclusions and Summary he asymptotic principal components technique. Kleidon and Marsh (1983) and Wood (1990a). CAPM as the null hypothesis (that is. The absence of individual seasonal mispricing (that is. The APT (5) model can only be clearly accepted for the middle subperiod and is marginal in the third subperiod (in both cases for the iterated five factor model). In Panel B of Table 6. H 0 : α 1 = α 2 = α 3 = . In general. . . Portfolio 1 through to Portfolio 9 support the APT and reject the CAPM.

and R. 31. Risk and return in an equilibrium APT: application of a new test methodology. and M. 12. Journal of Financial Economics. . Risk. Performance measurement with the arbitrage pricing theory: a new framework for analysis. 389–394. 88–95. Davidson. and R. 1973. and J. An empirical test of the arbitrage pricing theory on Australian stock returns 1974–85. While the APT appears to perform better than the CAPM. A simple exposition of the arbitrage pricing theory approximation. The Journal of Finance. 1983. 3–27.. 10. Department of Accounting and Finance. Biases on computed returns: an application to the size effect. 3. 1988. and J. A. D. G. multivariate non-nested tests of the restrictions imposed by CAPM versus APT favour an (iterated) five factor APT. Fama. 32. 15. (Date of receipt of final typescript: December 1992. Gibbons. and J. 1. 2. 13–22.. Econometrica. 1981. P. Chen. Stambaugh. Journal of Financial Economics.J. Faff. 1990. Stock return seasonalities and the tax-loss selling hypothesis: analysis of the arguments and Australian evidence. 3. Several tests of model specification in the presence of alternative hypotheses. Shanken. 2. Kleidon and T. 255–289. Journal of Financial Economics. 23–43. Faff. Arbitrage.. 387–404. 1393–1414. Keim. 1281–1304. Working Paper No. 1983. Clayton. 781–793. 3. 38. 1–32. M. Korajczyk. M. P. 3. Chamberlain. Brown. Asset pricing in the Australian industrial equity market. Monash University. 21. 1991. 51. Brown and R. 1983. Faff. 1. 1. Some empirical tests of the theory of arbitrage pricing. Journal of Political Economy. Rothschild. 373–394. Blume. 5. MacBeth. 28. Gibbons. Multivariate tests of financial models: a new approach. R. 1. 1986. G. Finally. 81. 1. Journal of Financial Economics. factor structure and mean-variance analysis on large asset markets. Australian Journal of Management. Accounting and Finance. M. 19. 11. 105–127. 49. 2.. Econometrica. R. Accounting and Finance.2 Faff: ARBITRAGE PRICING THEORY and July and August) is significant for all models.. J. A likelihood ratio test of the zero-beta CAPM in Australian equity returns. 12.257 - . Subperiod aggregation and the power of multivariate tests of portfolio efficiency. 607–636. G. Officer. Connor. E. 1988. Marsh. Journal of Financial Economics. 1987. MacKinnon. R. 5. neither model can adequately explain seasonal mispricing in Australian equities. Beggs.Vol. 1986. 2. N-F. No. R. R. An empirical test of arbitrage equilibrium with skewed asset returns: Australian evidence. Connor. 1976. Australian Journal of Management. Journal of Financial Economics.17. 1982. and R. return and equilibrium: empirical tests. Korajczyk. 1983.) References Ball..

3. and S. Trzcinka. 341–360. On multivariate tests of the CAPM. Journal of Financial Economics.. 35. C. 1. The Journal of Finance. 1986. Multi-beta CAPM or equilibrium APT: a reply. The pricing of Australian risky assets: theory and empirical evidence. Accounting and Finance. S. 5. 1121–1152. C. 24–27. . The arbitrage pricing theory: is it testable? The Journal of Finance. J.. 1990b. 17–36.. 1987. Roll. 2.. 1980. 1985. 1976. Econometrica.C. Rao. R. No. 129–176. J. 1990a... 1073–1103. AGSM. Linear Statistical Inference and its Applications (New York. Thesis.. Kinney. Seasonal effects on stock prices: why investors may—or may not—profit. 67–85. 13. B. University of New South Wales. 1986. Shanken. Wiley) 2nd edition.. Shanken.. 40. 1189–1196. On the number of factors in the arbitrage pricing model. Wood. 1. Kensington. 1987. An empirical investigation of the arbitrage pricing theory. 347–368. 37.AUSTRALIAN JOURNAL OF MANAGEMENT December 1992 Gibbons. Ross. A test of the efficiency of a given portfolio. Ross and J. 27. 11. factor structure. 1973. Sinclair. J. Australian Journal of Management.258 - . M. N.. 379–402.. Arbitrage pricing. The Journal of Finance. 2. Ross. Leudecke. Unpublished Ph. Journal of Economic Theory. Wood. Multifactor asset pricing models. MacKinlay. 57. 18. 1982. S. 41. The arbitrage theory of capital asset pricing.A. September.. Roll. Capital market seasonality: the case of stock returns. 4. 4. A. 1977. 1989. J. Rozeff.D. The Journal of Finance. and W. R. 5. Journal of Financial Economics. 341–371. 2. 3. 3. Shanken. eigenvectors and all that: an exposition. 1129–1140. 1976. A critique of the asset pricing theory’s tests: part 1: on the past and potential testability of the theory. M. 4. Journal of Financial Economics. 5. JASSA.

Vol.17.259 - .2 Faff: ARBITRAGE PRICING THEORY . No.

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