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Capital asset pricing has always been an active area in the finance literature. The capital
asset pricing model (CAPM) of Sharpe (1964), Linter (1965) is a major analytical tool for
explaining relationship between the expected return and risk. The competing model of
CAPM is three-factor model of Fama and French (1993). Both are linear regression based
models used for the calculation of expected return.

Literature Review
Investment decisions are based on cost benefit analysis and risk reward
analysis. The higher the risk in an investment, the higher will be the return.
William Sharpe laid down the foundation of empirical asset pricing models. The
idea behind the Sharpe’s CAPM was that expected return on a security is the sum
of risk free rate plus risk premium, where risk premium is the linear function
(demonstrated by beta) of the co-variance between the excess return of the
security/portfolio and the excess return of the market (fully diversified) portfolio.
The CAPM equation for the excess return is;
(Ri-Rf) = a + b(Rm-Rf) + e
(Ri) is the return of the security/portfolio.
(Rf) is the risk free rate. (T-bill rate)
(Rm) is the return of fully diversified portfolio.
(b) is the slope or risk of the security.
(e) is the error term.

The CAPM Equation for the expected return is;

E(Ri) = Rf + b(Rm-Rf) + e
E(Ri) is the expected total return.
(e) is the error term.
In simple according to William Sharpe risk premium of security/portfolio
is only related to the risk taken as compared to the market portfolio’s risk.
Jenson (1968) stated that the relationship between beta and expected
return can be explained by the time series regression and sole beta will be
responsible for all the variations if the value of intercept is equal to zero
Douglas (1969) is one of the earliest studies to test CAPM on individual
companies. He found that intercepts have values much larger than risk free rate
represented by T-bill rate. Similarly Black Jensen and Scholes (1972), Blume and
Friend (1973), Fama and Macbeth (1973) found the same results.

Later other researchers found some more evidence that contradicted the
results of CAPM. Basu (1977) observed that CAPM under estimates the expected
return on stocks of firms with high earning to price ratio (Low P/E ratio). Banz
(1981) found another weakness of CAPM. He observed that future earnings are
high on stocks of small firms how ever CAPM is unable to reflect this effect in
the expected future earnings.

Fama and French (1993) finally incorporated another two variables to over
come the weaknesses of CAPM. They added two extra variable to CAPM, pointed
out by Basu (1977) and Banz (1981). To capture the effect of size they added
Rsmb (Return of small firms minus return of big firms) and to capture the effect
of high earning price ratio holding companies they added Rhml (Return of High
book to market ratio minus return of low book to market ratio companies).
The Fama and French three-factor model for excess return is;
(Ri-Rf) = a + b1(Rm-Rf) + b2(RSMB) + b3(RHML) + e
(Ri) is the total return.
(Rf) is the risk free rate.
(Rm-Rf), (RSMB) and (RHML) are premiums.
(b1), (b2) and (b3) are the sensitivities.

The Fama and French three-factor model for total expected return is;
E(Ri) = Rf + b1(Rm-Rf) + b2(RSMB) + b3 (RHML) + e
Fama and French (1996) claimed that their model better calculates the future return for
stocks because the alphas of their regressions were closer to zero.

Connors and Senghal (2001) tested CAPM single factor and Fama and
French three-factor model in India. Their sample was from CRISIL- 500 as KSE
100-index in Pakistan and formed six portfolios. They compared the two models
by looking at their intercepts. They tested the statistical significance of intercepts
jointly by Gibbons, Ross and Shanken (GRS) test (1989). In their test the Fama
and French three-factor model out performed the single factor CAPM. For CAPM
the intercepts of three portfolios were significant at the 95% confidence level. The
GRS test value for CAPM was 3.8069 with p-value of 0.0017 which shows that
the intercepts are jointly significant and the null hypothesis can not be accepted.
For three-factor model none of the intercept was zero, How-ever the GRS statistic
was 1.7478, much lower as compared to that of CAPM. The p-value was 0.1168
which means null hypothesis is to be accepted. Connor and Senghal (2001)
concluded that addition of two extra variables does make a difference in
explaining the variations in expected return hence three-factor Fama and French
model is superior to single-factor Sharpe’s CAPM.

Drew and Veeraraghavan (2002) conducted study about the size and value
premium in Malaysia. The data sample was form Bursa Malaysia (Malaysian
Stock Exchange) for period starting from December 1991 to December 1999.
They formed six portfolios for the study of SMB and HML factors. According to
their estimation returns were 17.7% and 17.6% of SMB and HML portfolios
respectively. How ever the market return was only 1.92%. From these results they
concluded that extra returns brought are the effect of size and value factors and
rejected any influence of data snooping.

Drew and Veeraraghavan (2003) further tested the single factor and three-
factor model in other countries. Besides Malaysia they studied stocks in Hong
Kong, Korea and Philippines. There they also concluded that size and value
premium do exist which is not captured by CAPM.

Billou (2004) conducted tests of CAPM and Fama and French three-factor
model in Canada. He constructed two data sets for these tests, first set included
monthly returns of 25 portfolios from 1926 to 2003, and the second set included
returns of 12 industries. He also updated the original study of Fama and French
(1996), which was form 1963 to 1993. How-ever Billou (2004) updated this by
extending the data up to 2003.

The tests to determine the superiority of a model were based on combined

values of alpha or mean absolute value of alpha (MAVA) and GRS test to check
the statistical significance of joint alphas. In the updated study of Fama and
French (1996) by Billou (2004), CAPM’s MAVA was 0.30 and for three-factor
model it was 0.13. Also the three-factor model also gave high R-square. Out of 25
portfolios 12 were having significant alphas as compared to 6 significant alphas of
three-factor model. The GRS statistic result was 4.07 for CAPM and 3.64 for
Fama and French Model both having p-value closer to zero. Hence the null
hypothesis can not be accepted.

The results of 25 portfolios were like this; For CAPM the MAVA was
0.23 versus 0.19 of Fama and French Model. Again Fama and French model gave
high R-square as compared to CAPM. For CAPM 10 out of 25 alphas were
statistically significant and for Fama and French model only six alphas were
statistically significant. Again GRS test showed that joint values of alphas in both
models are statistically significant at 3.31 for CAPM and 3.08 for Fama and
French Model. The p-value for both was closer to zero hence the null hypothesis
is rejected again for both models.
For the 12 industry regressions, the results were a bit different. Here
CAPM performed slightly better. CAPM gave 0.11 as the MAVA while for three-
factor model it was 0.14. The GRS statistic was 1.90 as compared to 3.59 of the
three-factor model. Mean value of R-square was 0.75 for CAPM and 0.77 for
three-factor model.

Billou (2004) concluded with imprecise conclusion. He suggested that to

decide about the superiority of a pricing model, the decision and evidence shall be
based on one type of portfolio grouping rather than testing at different sets.

Purpose of the study

This study is aimed to compare the effectiveness of these two leading asset-pricing
models, the single factor Sharpe’s CAPM and Fama and French’s three-factor model on
Pakistani equity markets for individual companies. This will be done by empirically
testing which model better calculates the expected return?
Effectiveness of the models can be judged by several methods.
The purpose of the study and report is to fulfil the requirements for Master of Business
Administration (MBA) at the Institute of Management Sciences, Peshawar.

Scope of the study

The study is applicable only to Pakistan’s equity market (KSE).
Research report will be for the period of 2004-2009.
The study will be based on 25 companies from Karachi stock exchange.
All the data used in the research is secondary data and has been acquired from the web.

Limitations of the study

To take more than 25 companies of the Karachi Stock Exchange is too difficult to be
covered completely in two months. Time Constraints, thus, constitutes a major
constraint for this report.
In my research report I did not include year 2008 because it abnormal year during which
the market has been freeze for more than 3 months.

Methodology of the study

In this study I will employ two different methods for the purpose of comparison of the
two asset pricing models. The reason for choosing two different methodologies is to over
come the weaknesses of one method, more over to cross check the outcomes of each
method and to strengthen the evidence in support of a model.
In the first step I will run regression on time series data of each individual company. For
this purpose excess returns of the firms will be regressed against the market’s excess
return for CAPM.
In the second step I will run a panel regression of these twenty five firms for the same
period of five years. Panel regression is constructed by using time series and cross
sectional data at a time. Running panel regressions will give one regression out put for
each model.

Delimitation of the study

This report is useful for the students of management in general and for those interested in
Investment and finance in particular. It will also be helpful for further research in future
and by submitting this report I will learn practically that how a research is to be conduct.