IMPACT OF MACROECONOMIC FACTORS ON STOCK MARKET

RETURNS OF KSE 30 INDEX

Assignment: Theories used to explain model
Obaid Ur Rehman
Reg#MMS193016
Mohammad Kamran Aziz
Reg#MMS193031

Spring-2020
Submitted to
Dr. S.M.M Raza Naqvi
Department of Management and Social Sciences,
CUST, Islamabad.
 Theories used to explain model
1. Arbitrage pricing theory (APT):
In this paper we use the Arbitrage pricing theory (APT) developed by Ross (1976). Chen et
al. (1986) first illustrated that economic forces affect discount rates, the ability of firms to
generate cash flows, and future dividend pay-outs, provided the basis for the belief that a
long-term equilibrium existed between stock prices and macroeconomic variables.
Arbitrage Pricing Theory is more flexible than the CAPM. The CAPM only takes into
account one factor, Market Risk while the APT formula has multiple factors. It takes a
considerable amount of research to determine how sensitive a security is to various
macroeconomic risks. The factors as well as how many of them are used are subjective
choices, which means investors will have varying results depending on their choice.
However, four or five factors will usually explain most of a security's return. APT factors are
the systematic risk that cannot be reduced by the diversification of an investment portfolio.
The macroeconomic factors that have proven most reliable as price predictors include
unexpected changes in inflation, gross national product (GNP), corporate bond spreads and
shifts in the yield curve. Other commonly used factors are gross domestic product (GDP),
commodities prices, market indices, and exchange rates.
The APT model defines that the forecasted rate of return on assets depends on volatility to
macroeconomics variables which points out that factor risk takes more significant in assets
pricing (Gilles et.al 1990). APT is comparatively a moderate diverse technique to analysis the
assets prices model. It may cover different non market variables which influence the assets
prices. It bases on the one price law: “two assets which are the identical may not be sold at
various prices. Advancement is the utility and its assumption which were using by CAPM
model are not essential”. (Elton et al. 2003) Arbitrage pricing theory (APT) is based on the
idea that an asset's returns can be predicted using the linear relationship between the asset’s
expected return and a number of macroeconomic variables that capture systematic risk. It is a
useful tool for analysing portfolios from a value investing perspective, in order to identify
securities that may be temporarily mispriced. In the context of APT, macro-economic factors
are used as measure of economy wide risk factors. Asset pricing theory says that all the
factors which affects the prospect investment choices in a risk averse economy therefore
should produce risk premier (Merton, 1972; Ross, 1976). Economic forces influence the
Stock returns, and various economic forces (N. F. Chen, Roll, & Ross, 1986). Flannery and
Protopapadakis (2002) says that firm’s cash flows affect the macroeconomic factors. The
APT model indicates that return of assets is the linear function of different macroeconomic
variables and the changes occur in these variables are represented by specific factor’s
coefficient.
In their recent study to validate the model, (Fama & French, 2004), fronts the portfolio theory
that investors choose portfolios that are said to be mean-variance-efficient, and found along
the efficient frontier for portfolios. The CAPM assumes that any portfolio that is mean-
variance-efficient and lies on the efficient frontier is also equal to the market portfolio. The
implications of this, according to the authors, are that the relation between risk and expected
return for any efficient portfolio must also hold for the market portfolio, if equilibrium is to
be maintained in the asset market.
 2. Capital Asset Pricing Model:
According to the capital asset pricing model (CAPM), the marketplace compensates investors
for taking systematic risk but not for taking specific risk. This is because specific risk can be
diversified away. When an investor holds the market portfolio, each individual asset in that
portfolio entails specific risk, but through diversification, the investor’s net exposure is just
the systematic risk of the market portfolio. In (Ross, 1976), where the return on an asset is
specified as a function of a number of risk factors common to that asset class. The model
assumes that investors take advantage of arbitrage opportunities in the broader market; thus,
an asset’s rate of return is a function of the return on alternative investments and other risk
factors. The APT in contrast to CAPM acknowledges several sources of risk that may affect
an asset’s expected return. The model, as with the CAPM, is subject to certain assumptions;
the first of these being that investors may borrow and lend at the risk-free rate, there are no
taxes and short selling of securities is unrestricted. The second assumption assumes that a
wide variety of securities exist, thus risk unique to those securities may be diversified away,
and lastly, investors are risk averse who aim to maximize their wealth.
CAPM has its basis in the construction of an efficient market portfolio that maximizes return,
given a level of risk. The expected return of an individual security is a function of its risk
covariance with the market. The model stipulates that the expected return on a stock is
determined by the risk free interest rate and a risk premium which is a function of the stock’s
responsiveness to the overall movement in the market that is its beta coefficient.
In more recent empirical works on asset pricing has identified a number of variables that help
explain cross sectional variation in stock returns in addition to the market risk variable. Roll
(1977) argued that the market portfolio should in theory include all types of assets that are
held by anyone as an investment including works of arts, real estate, human capital etc. but
said, in practice, such a market portfolio is unobservable and people usually substitute stock
index as a proxy for the true market portfolio. Unfortunately, it has been shown that this
substitution is not innocuous and can lead to false inferences as to the validity of the CAPM.
It has been said that due to the non observability of the true market portfolio, the CAPM
might not be empirically testable.
The CAPM is seen as parsimonious and commonly employed by equity analysts, but requires
a precious identification of the portfolio against which the asset is compared. On the other
hand, Mosley and Singer(2007) contends that, APT accommodates multiple sources of risk
and alternative investment, the model suffers from a similar challenge of identification since
many factors, both international and domestic could influence an assets performance. The
model, as with the CAPM, is subject to certain assumptions; the first of these being that
investors may borrow and lend at the risk-free rate, there are no taxes and short selling of
securities is unrestricted. The second assumption assumes that a wide variety of securities
exist, thus risk unique to those securities may be diversified away, and lastly, investors are
risk averse who aim to maximize their wealth.
CAPM and APT can be jointly workable and usable in a model even if the return on the
market portfolio is not one of the factors because of the compatibility between the two
CAPM and APT, even if the factors are not Portfolio return at all. Therefore in this study will
employ these two theories, CAPM and APT to determine the impacts of macroeconomic
variables (interest rate, inflation rate and exchange rate) on the returns KSE 30 index.