American Journal of Scientific Research

ISSN 1450-223X Issue 85 (2013), pp.118-135

© EuroJournals Publishing, Inc. 2011
http://www.eurojournals.com/ajsr.htm

An Investigation of Beta and Downside Beta Based

CAPM-Case Study of Karachi Stock Exchange

Mohammad Tahir
Assistant Professor, COMSATS Institute of Information Technology
Islamabad, PhD Scholar, Universiti Teknologi Malaysia, Kuala Lumpur

Qaiser Abbas
Dean/Professor, COMSATS Institute of Information Technology, Islamabad

Shahid Mehmmod Sargana

Assistant Professor, COMSATS Institute of Information Technology, Islamabad

Usman Ayub
Assistant Professor/PhD Scholar
COMSATS Institute of Information Technology, Islamabad
E-mail: usman_ayub@comsats.edu.pk

Syed Kashif Saeed

Pakistan Institute of Engineering and Applied Sciences, Islamabad

Abstract

Sharpe’s (1964) Capital Asset Pricing Model (CAPM) assumes that the relationship
between risk and return is positive, linear and significant. However, it is not free from
controversies and one of them advocates replacing CAPM’s beta by downside beta based
on investors’ preference of downside risk. Roy (1952) debates that investor care for
downside risk and Hogan and Warren (1974) replace variance with semivariance in CAPM
as the first official version of downside risk based CAPM. Bawa (1975), Fishburn (1977)
and Bawa and Lindenberg (1977) develop and extend proxy for downside risk/beta as
Lower Partial Moment. This study empirically tests beta and downside beta based CAPM
(DCAPM). Conceptual and empirical problems related in testing alternative models are
discussed with adoption of Fama-MacBeth (1973) procedure by making it robust. This
study inspects intercept, risk-return relationship, nonlinearities and effect of residuals for
both CAPM and DCAPM. Intercept results are almost similar and they follow introduction
of zero-beta models as outlined by Black et al. (1972). Both models show rejection of
nonlinearities and effect of residuals. However, DCAPM comes out to be strong contender
compared to CAPM for risk-return relationship. These results are consistent with Estrada
(2002), Ang et al.(2004) and Post and Vliet (2004).

Keywords: CAPM, variance, downside risk, lower partial moments.

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An Investigation of Beta and Downside Beta Based CAPM-Case
Study of Karachi Stock Exchange 119

1. Introduction
A suitable asset pricing model for a stock market of a country has been an area of great interest for
researchers, academicians, corporate managers and policymakers alike. Primarily, asset pricing models
assess risk-return relationship in order to ensure value for the stakeholders in financial markets1.
Though there are more than one asset pricing models but Capital Asset Pricing Model developed by
Sharpe (1964) with its foundation in Markowitz’s (1952) Modern Portfolio Theory is simple, cost-
effective and most widely used2 asset pricing model in the world. Yet, it is most discussed topic in the
field of financial economics and for the last half a century, major portion of the literature in the field of
asset pricing is associated with the issues pertaining to CAPM. Fundamentally, it is assumed that the
relationship between risk and return is positive, linear and significant. It is also assumed that investors
are indifferent to upside and downside risks with stock returns being normally distributed (Sharpe
(1964)). However, CAPM is not free from controversies and one of them advocates replacing CAPM’s
beta by downside beta based on investors’ preference of downside risk3.
Roy (1952) debates that investor care for downside risk, or simply, safety from disaster as
foremost goal. Roy’s Safety First-rule is not used in asset pricing until Hogan and Warren (1974)
replace variance with semivariance in CAPM. They give the first official version of downside risk
based CAPM (DCAPM). Second breakthrough is made by Bawa (1975) who develops proxy for
stochastic dominance4 (SD) as Lower Partial Moment (LPM) and later, Fishburn (1977) extends it into
unlimited scope of LPM. Bawa-Fishburn LPM encompasses all classes of investors; risk-averse, risk-
seeking and risk-neutral. Additionally, it is not tied to condition of normality and is flexible to include
skewness and kurtosis as well. Moreover, Bawa and Lindenberg (1977) extend symmetric partial
moments to asymmetric generalized co-LPM or GCLPM for n-degree LPM structures accommodating
asymmetric distributions.
This study empirically tests both CAPM and DCAPM for the relationship between risk and
return as positive, linear and significant. Section one is introduction and in section two, this study
addresses issues concerning CAPM and DCAPM and then followed by their respective evidences. In
section three, it discusses data and Fama-MacBeth (1973) procedure with robust analysis to study risk-
return relationship as underlined by CAPM and DCAPM. Additionally, issues like nonstationary betas,
unobservability of true market portfolio, measurement error, portfolio sorting procedures,
heteroscedasticity and autocorrelation, investment horizon and equal-weighted portfolios are also
covered. In section four, results are discussed and last section is conclusion.

2. Literature Review
2.1. CAPM-An Introduction
CAPM is independently developed by Sharpe (1964), Lintner (1965), Mossin (1966) and Treynor
(1962)5. It is based on ideal assumptions6 and has roots in Markowitz’s Modern Portfolio Theory7 and

1
Additionally, they help in pricing securities more appropriately and in anticipating portfolio risk for investors. These
models explain the market behavior, the nature of investment and can be pivotal for an institutional demand of common
stocks. Moreover, delineating cost of capital for the capital budgeting is necessary to finance them and asset pricing
models contribute in this area leading to suitable mode of financing.
2
Graham and Harvey (2001) report 73.5% of CFOs US and Brounen et al.((2004) report 45% in Europe use CAPM.
3
For details see CAPM-Exclusive Problems Exclusively Dealt (2011), From Regular-Beta CAPM to Downside-Beta
CAPM (2011) and Lower Partial Moment-Proxy of Downside Risk (2011).
4
Stochastic dominance, a powerful risk analysis tool, does not rely on certain type of distribution function. Rather, it
evaluates results in pairs via their cumulative distribution functions. An investor exhibits three types of behavior namely;
nonsatiation, risk-averseness and DARA. Quadratic utility tries to capture all three but fails in DARA’s domain. Under
these circumstances, SD provides solution as it captures all three types.
5
Sharpe wins noble prize in 1990 for his work on CAPM. Some argue that Treynor is the pioneer for CAPM as he writes his
paper Toward a Theory of Market Value of Risky Assets on CAPM in 1962 but does not publish it till 1999 (French (2003)).

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120 Mohammad Tahir, Qaiser Abbas, Shahid Mehmmod Sargana
Usman Ayub and Syed Kashif Saeed

Tobin’s 2-Fund Separation Theorem8. Although, CAPM does not depict prices9 but it is still regarded
as an asset pricing model as one can determine and forecast prices of the securities in a financial
market. It predicts positive, linear and significance relationship between risk and return and implies
that stocks strongly covary with market and exhibit high returns in contemporaneous periods (Sharpe
(1964)). It is based on ideal assumptions and some of them are stated henceforth.
CAPM assumes that investors have rational expectations10 which form the very basis of
efficient market hypothesis (EMH)11. It also assumes Expected Utility Theory12 based on von
Neumann–Morgenstern utility function (1953). Moreover, it is assumed that investors display three
major characteristics; risk-averseness, nonsatiation and decreasing absolute risk averseness (DARA).
Quadratic concave utility curve depicts investors’ behavior for the given three major characteristics
(Elton et al.(2003)). However, these foundations of CAPM have been criticized and numerous
solutions have been suggested. Some have completely rejected it while some argue presence of
anomalies resulting in extension of single-factor CAPM into multi-factor models. And most
importantly, theoretical shortcomings have been addressed and contributions towards the modified
versions of CAPM13 have been made.
A meticulous analysis yields that it is important for the investors to define, identify and allocate
value to risk as it. Theoretical framework of CAPM assumes that investors place equal weights to both
upside and downside risk however this assumption is contentious. It has been observed that investors
are willing to pay premium for stocks giving upside potential in bull markets and downside protection
in bear markets14 with care for safety from disaster as foremost goal, or simply saying, they prefer to
diversify downside risk15. Moreover, under large departure from the condition of normality,
distribution becomes severely asymmetric, thus, making difference between behavior for bear and bull
markets more pronounced (Chunachinda et al.(1997)). It can be safely deduced from the above
discussion that investors prefer downside risk and they are not limited to the class of risk-averse
investors.

2.2. Downside Risk-An Introduction

Markowitz (1952) initially proposes expected return and semivariance, proxy of downside risk, as key
parameters for portfolio investment decision. However, he discards semivariance due to resource

6
Absence of transaction costs and personal income tax, assets can be divided infinitely, an individual cannot affect stock
prices solely, investors take decisions on expected values and variance only, unlimited short sales allowed, all assets are
marketable, unlimited lending and borrowing is at risk-free rate, homogeneity of expectations (Elton et al.(2003)).
7
Markowitz (1952) proposes that investors, in mean-variance (MV) framework, try to maximize return (E) for a given risk
(V) or strive to minimize risk for a given return in his Modern Portfolio theory.
8
2-Fund Separation is presented by Tobin (1958) and purposes significant course of action to identify suitable portfolios
in efficient set by introducing concept of risk-free asset with portfolio of risky assets. It states that an investor will strive
for a utility-maximizing portfolio by combining risk-free and risky assets.
9
Rather it uses percentages.
10
Ex ante expected returns are unobservable, so instead ex post is used. To accomplish this, investor has rational
expectations is assumed i.e. rational expectations purposes that outcomes are equal to expectations. Muth (1961) proposes
rational expectation and Roberts (1959) endorses use of rational expectations in asset pricing. Fama (1965) assumes that
investors are rational and all past information is incorporated in current prices of stocks leading to market efficiency.
11
EMH asserts that financial markets are "informational efficient". An individual cannot consistently achieve stock returns
in excess of average market returns. There are three major versions of EMH namely; weak, semi-strong, and strong form
of efficiency (Haugen (2001)).
12
Expected Utility Theory primarily assumes that investors are rational and they choose and prefer an opportunity which
maximizes expected value represented as a utility function.
13
For details see Abbas et al.(2011A) and Abbas et al.(2011B).
14
as they become are risk averse for losses and risk seekers for gains. For details see Ang et al.(2002).
15
For details see Roy (1952), Kahneman and Tversky (1979), Gul (1991), Chunachinda et al.(1997), Estrada (2000, 2002
and 2007), Athayde and Flôres (2004), Post and Levy (2005) and Jondeau and Rockinger (2006).

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An Investigation of Beta and Downside Beta Based CAPM-Case
Study of Karachi Stock Exchange 121

constraints at that time16. Roy (1952) debates that investor care for downside risk, or simply, safety
from disaster as foremost goal. Roy’s (1952) Safety First-rule is not used in asset pricing until Hogan
and Warren (1974) who replace variance with semivariance as the first official version of downside
risk based CAPM. Second breakthrough is made by Bawa (1975) who develops proxy for downside
risk as Lower Partial Moment (LPM) based on stochastic dominance17. Later, Fishburn (1977) extends
Bawa’s (1975) LPM into unlimited scope of LPMs18. Bawa-Fishburn LPM encompasses all classes of
investors; risk-averse, risk-seeking and risk-neutral. Additionally, it is not tied to condition of
normality and is flexible to include skewness and kurtosis. Moreover, Bawa and Lindenberg (1977)
extend symmetric partial moments to asymmetric generalized co-LPM or GCLPM for n-degree LPM
structures accommodating asymmetric distributions.
Investors exhibit three types of behaviour namely; nonsatiation, risk-averseness and DARA
(Post and Vliet (2004)). CAPM is restrictive to the class of risk-averse investors. Thaler and Johnson
(1990), later supported by Levy and Levy (2002, 2004), report that investors are risk-seeking over
gains and risk-averse over losses. Shefrin and Statman (2000) explore behavioral science and report
that investors hold short and long position which depicts risk-averse and risk-seeking behavior. Hartley
and Farrell (2002) advocate global convex utility function which indicates risk-seeking behavior.
Secondly, CAPM’s quadratic utility tries to capture all the three types of behavior but fails in DARA’s
domain (Lengwiler (2004)). It cannot exhibit DARA which is essential for risk aversion as it turns
down upon reaching bliss point (Chavas (2004)).
Moreover, CAPM assumes condition of normality to qualify variance as a measure of
investors’ perception of risk (Sharpe (1964)). Contrarily, stock returns are found not to exhibit
normality. Fama (1965), Kon (1984), Affleck-Graves and McDonald (1989), Richardson and Smith
(1993), Aparicio and Estrada (1997), Susmel (2001), Hwang and Pedersen (2002) and Dufour et
al.(2003) provide evidence that returns are not normally distributed for developed market. Bekaert and
Harvey (1995, 1997), Eftekhari and Satchell (1996) and Bekaert et al.(1998) conclude that emerging
market equities demonstrate non-normality. Under large departure from normality, probability
distribution is severely asymmetric in which CAPM does not hold (Chunachinda et al.(1997), Athayde
and Flôres (2004) and Jondeau and Rockinger (2006)).
Most notably, CAPM assumes that investors are indifferent towards upside and downside risk
while evidence is present where investors portray different behavior during bear and bull markets.
They are willing to pay premium for stocks giving downside risk protection in bearish trends. Roy
(1952) advocates that investors care for downside risk only. Markowitz (1959) introduces semivariance
in portfolio theory as a possible proxy of risk. Kahneman and Tversky (1979), Tversky and Kahneman
(1992), Gul (1991), and Estrada (2000, 2002 and 2007) are supportive of different behaviors of
investors for bear and bull markets. Post and Levy (2005) stress on preference of downside risk over
variance as a measure of investors perception of risk.
Bawa-Fishburn-Lindenberg based-LPM19 addresses these theoretical weaknesses of CAPM. It
is not confined to DARA as n-order LPMs are used to envelop wide range of investor’s risk measures
defined as20:

16
Variance is simpler as semivariance requires twice number of data inputs than variance model. Lack of cost-effective computer
power, with no microcomputer till 1980s, makes semivariance model mathematically very complex (Nawrocki (1991).
17
Stochastic dominance, a powerful risk analysis tool, does not rely on certain type of distribution function. Rather, it
evaluates results in pairs via their cumulative distribution functions. An investor exhibits three types of behavior namely;
nonsatiation, risk-averseness and DARA. Quadratic utility tries to capture all three but fails in DARA’s domain. Under
these circumstances, stochastic dominance provides solution as it captures all three types.
18
LPM can have fractional degrees like 2.33 or 3.89 for different n (Nawrocki (1991).
19
Based on Bawa (1975), Fishburn (1977) and Bawa and Lindenberg (1977).
20 cov( Ri , RM | RM < τ )
Equation (1) can be adopted into downside beta as Dβi =
var( RM | RM < τ )

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122 Mohammad Tahir, Qaiser Abbas, Shahid Mehmmod Sargana
Usman Ayub and Syed Kashif Saeed

τ
LPM (τ , R ) = ∫ − ∞ (τ − R ) d F ( R )
in (1)
i i i
Where τ is the target return specified by investor, Ri is return of asset i, dF (Ri) is probability
density function of asset i and n is order of investor’s risk preference for ex ante. Setting LPM=1 or
n=1 indicates that risk-neutral investor. For n>1, investor is risk-averse and n<1depicts risk-taker. For
n=2, investor is semivariance conscious risk-averse. 3 and 4 depict skewness and kurtosis, respectively.
Bawa-Fishburn-Lindenberg based-LPM has four distinct advantages over CAPM framework.
Firstly, it encompasses all the classes of investors; risk-averse, risk-seeking and risk-neutral; and
incorporates skewness and kurtosis in equation (1) for n values of 3 and 4 respectively. Secondly, it
can use fractional degrees like 2.33 or 3.89 for different n making Bawa-Fishburn-Lindenberg based-
LPM more receptive to sensitivity analysis. Thirdly, it introduces asymmetric covariance as
generalized or asymmetric co-LPM or GCLPM for n-degree LPM structures21 in which covariance
between securities i and j is not necessarily equal to covariance between j and i (Bawa (1975), Fishburn
(1977), Bawa and Lindenberg (1977), Nawrocki (1991, 1999), Harlow (1991), Estrada (2002) and
Abbas et al.(2011A)).
Lastly, Bawa-Fishburn-Lindenberg based-LPM introduces downside risk as a measure of
investor’s perception of risk. τ is the target return which is specified by an investor. τ is flexible as it
can take any value depending on the preference of the investor. Bawa and Lindenberg (1977) suggest
that τ is equal to risk-free interest rate. However, later versions assume τ for any value according to
investor’s choice (Nantell and Price (1979), Harlow and Rao (1989), Harlow (1991) and Estrada
(2002)). These distinct advantages make Bawa-Fishburn-Lindenberg based-LPM an excellent choice
as a single asset pricing model. Moreover, it does not contravene CAPM’s assumption especially
Tobin’s (1958) 2-Fund Separation Theorem (Hogan and Warren (1974), Bawa and Lindenberg (1977),
Harlow and Rao (1989) and Estrada (2002)). However, evidence for both variance based CAPM and
downside risk based LPM single asset model22 has to be investigated.

2.3. CAPM and its Evidence

Early evidence favours CAPM showing positive, linear and significant risk-return relationship Beaver,
Ketler and Scholes (1970), Hamada (1972), Galai and Masulis (1976) Black, Jensen and Scholes
(1972), Fama and MacBeth (1973) and Blume and Friend (1973) favour risk-return relationship as
defined by CAPM. After seventies, as research progresses, controversies arise contrary to prior
evidence. Evidence from developed markets is generally against CAPM except for German Stock
Exchange. Rozeff and Kinney (1976), Basu (1977), Roll (1977), Ross (1977), Ball (1978), French
(1980), Stattman (1980), Banz (1981), Reinganum (1981), Bhandari (1988), Shleifer and Vishny
(1992), Fama and French (1992), Jagannathan and Wang (1996), Lettau and Ludvigson (2001) and
Petkova and Zhang (2003) add to the long list that reports evidence against CAPM.
In Asian markets and emerging markets, results for CAPM are mixed. Aggarwal et al.(1988),
Chan et al.(1991), Cheung and Wong (1992), Daniel et al.(1997), Huang (1997), Chui and Wei (1998)
and Hodoshima et al.(2000) report for different Asian and emerging markets that the risk-return
relationship as underlined by CAPM does not hold. Contrarily, Ariff and Johnson (1990), Gillan (1990),
Kim et al.(1992), Ma and Shaw (1990), Wong and Tan (1991), Xu (2001) and Chen (2003) report
evidence supporting CAPM for different Asian and emerging markets. These results are not conclusive
pertaining to suggest the trend of findings of CAPM for different Asian and emerging markets.

21
For symmetric returns, semivariance criteria do not differ from variance, however, if returns show asymmetric pattern
then covariance between securities i and j is not equal to covariance between j and i unlike CAPM’s covariance which
assumes equality in either case (Nawrocki (1991, 1999)).
22
From now DCAPM.

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An Investigation of Beta and Downside Beta Based CAPM-Case
Study of Karachi Stock Exchange 123

2.4. Downside Risk and its Evidence

Evidence for downside risk is mostly concentrated in the developed markets. Emerging markets have
been only given more attention to downside risk in the last decade or so. Quirk and Saposnik (1962),
Mao (1970), Klemkosky (1973), Hogan and Warren (1974), Bawa (1975), Harlow and Rao (1989),
Harlow (1991), Grootveld and Hallerbach (1999), Harvey (2000), Balzer (2001), Ang et al.(2002,
2006), Post and Vliet (2004) and Bali et al.(2009) report that downside risk holds in different
developed markets. Moreover, it is also reported that downside risk based CAPM (DCAPM) performs
better compared to variance based CAPM.
Estrada (2002), Estrada and Serra (2005), Galagedera and Brooks (2007) and Galagedera and
Jaapar (2009) report their findings in favour of downside risk for different emerging markets.
However, emerging markets provide a more challenging ground as these markets are not developed
and have characteristics of high volatility and turnover. Another characteristic of emerging markets is
that they are peculiar and they do not show uniformity of characteristics among them23. However, due
to feature of high volatility and turnover, Bawa-Fishburn-Lindenberg based-LPM, proxy of stochastic
dominance, is more adoptive to this feature as stochastic dominance does not rely on a certain type of
distribution function.

3. Data and Methodology

3.1. Data
First major study in KSE-Pakistan for CAPM is by Ahmad and Zaman in 1999. They use GARCH-M
model to test the risk-return relationship and conclude that stock return follow cyclical trend. Ahmad
and Qasim (2004) claim that positive shocks are more pronounced compared to negative ones for same
market. Iqbal and Brooks (2007) report presence of non-linear risk-return relationship. Javid and
Ahmad (2008) test CAPM in conditional settings and advocate use of conditional-CAPM compared to
conventional CAPM. Recently, Iqbal et.al.(2010) compare single-factor CAPM with Fama-French
multi-factor CAPM and conclude that the latter is more convincing for Pakistan market. However, all
of them do not address issue of investors’ preference of downside risk and are restrictive to variance as
a measure of risk.
This study chooses Karachi Stock Exchange (KSE)-Pakistan as a sample. KSE24 is an
important25 emerging market showing typical characteristics of high turnover26 and high price
volatility27. 84 listed-companies listed in KSE are taken as a sample with a estimation window from
2000 to 2010 as the history of KSE-100 index is short. Only those companies are selected which are
listed throughout this period following Javid and Ahmad (2008). To validate results, our empirical
analysis encompasses monthly data as underlined by previous studies like Fama and MacBeth (1973)
and Fama and French (1992).

23
www.MSCI.com
24
Total of 651 companies are listed with KSE having a market capitalization of $35 billion on July 30,2011.
25
Due to strong institutions like KSE, Pakistan’s economy has been included in four emerging markets list by Dow Jones.
This list represents those economies that are expected to contribute to global growth. This shows the confidence that
institutions like KSE-Pakistan have future growth potential.
26
KSE experiences a high turnover and high price volatility during the last decade. Despite the small size of the market, it
experiences high turnover of 323% as compared to NYSE having turnover 65% in 2006. KSE-100 index rises by 650%
from 2001 to 2005 while Bombay (Mumbai) Stock Exchange (BSE30) experiences a rise of 137% for the same period.
27
KSE is declared as Best Performing Stock Market of the World by Business Week in 2002. Bullish trend appears to have
developed from 2002 to 2005 and is busted in March 2005. However, KSE recovers and crosses 15,000 barrier first time
in its history in April 2008. However, in May 2008, SBP increases interest rates unexpectedly to address high inflation,
KSE crashes and consequently, in August, 2008 the floor is halted. Afterwards, trading is allowed to resume on
December 15, 2008 and amazingly, KSE recovers 20-25% of its decline in index till March 12, 2009.

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124 Mohammad Tahir, Qaiser Abbas, Shahid Mehmmod Sargana
Usman Ayub and Syed Kashif Saeed

3.2. Methodology-Fama-MacBeth Procedure with Robustness

Fama MacBeth28 (1973) procedure is most widely used and historically important method to test
CAPM. It widespread acceptance is primarily motivated to fact that FMac (1973) allow betas to vary
with time29 (Campbell et al.(1997) and Elton et al.(2003)). FMac (1973) procedure also caters for
measurement error by building portfolios in a peculiar way30. Moreover, they use beta of previous time
period as an instrumental variable to cater for selection bias31. These reasons make FMac (1973) two-
step approach an obvious choice to test CAPM and DCAPM. FMac (1973) use two-step approach by
forming pre-ranking beta portfolios and testing for post-ranking beta portfolios. This study adopts
FMac (1973) procedure and makes necessary changes to better serve the results of this study. Firstly,
first pass32 of FMac (1973) procedure is performed which is based on the Black, Jensen and Scholes
(1972) methodology as follows:
Rit − RFt = αi + βi (RMt − RFt ) + εit (2)
where Rit is return of stock i at time t, RFt is return of treasury bills, αi is y-intercept, βi is beta of stock i
and εit is the error term. It is supposed that mean of residuals of asset i at time t is zero; E(εit) = 0 and
covariance between risk premium and residuals is also equal zero; cov(RMt-RFt, εit) = 0.
Firstly, this study estimates betas of the respective stocks and the first eighty stocks are
selected. 40 stock portfolios are created using beta estimates and these portfolios are resorted based on
downside beta to yield 20 stock portfolios based Fama MacBeth (1973)33. In all, 82 portfolios are built
and ranked from highest to lowest downside beta portfolios. This procedure is repeated again by firstly
sorting stocks on downside beta into portfolios and then resorts these portfolios on beta basis to yield
82 portfolios ranked from highest to lowest beta portfolios. These two sets of portfolios of 82 each are
used in first pass as defined in equations (1) to yield beta and downside beta of portfolios for the
former and the latter set respectively.
Moreover, stocks are sorted on relative downside beta to form 82 portfolios to perform FMac
(1973) regressions to make sure that downside beta is not reflecting regular beta. Moreover,
incremental effect of downside beta can be assessed. Relative DB is defined as the difference between
DB and beta. This approach has two major advantages namely; it specifies sorting criteria and
secondly, it disentangles effects of effects of high correlation between beta and downside beta34. This
study uses equal-weighted portfolios for portfolio construction35. This study adopts Newey-West

28
From now FMac.
29
Testing CAPM is difficult as betas are non-stationary over time. Fama and MacBeth (1973) propose flexible solution to
allow for time-varying risk measures with time-varying risk premiums. This approach is most appealing as it depicts real
data more correctly when it is used in rolling regression.
30
Friend and Blume (1970), Black et al.(1972) and Fama and MacBeth (1973)) improve precision of estimated betas by
working on portfolios rather than individual stocks. Compared to beta estimates for individual stocks, estimates for
portfolio beta lead to reduction in measurement error.
31
Grouping procedure reduces statistical power of estimated betas by shrinking them. To cater for this, an instrumental
variable is introduced which is highly correlated with true beta and can be independently observed thus resolving problem
of selection bias ((Black et al.(1972), Fama and MacBeth (1973), Huang and Litzenberger (1988) and Elton et al.(2003)).
32
In first pass, time series estimation is performed in which portfolio returns are regressed against market returns to obtain
risk measures like beta and downside beta.
33
Chen and Martin (1980) and Tole (1981) report that the larger the size of portfolio, the stable the beta will be of that
portfolio. Thus portfolio size is directly proportional to stationary of respective portfolios betas. Elton and Gruber (1977)
advocate 10-15 stocks, Evans and Archer (1968) propose that around 10 stock portfolio, Fama MacBeth (1973) propose
20 stock portfolio and Statman (1987) asserts 30-40 stock portfolio to be an appropriate portfolio size. This study uses
20-stock portfolios as trade-off point between portfolio size and diversification following Fama MacBeth (1973).
34
For details see Post and Vliet (2004) and Ang, Chen and Xing (2004).
35
Equal-weighted are preferred over value-weighted portfolios; firstly, Fama (1998) concludes that anomalies seem to
decrease and disappear frequently when event studies are based on value-weighted portfolios. Secondly, Harvey and
Siddique (2000) assert that coskewness is strongest for equal-weighted portfolios. Thirdly, Roll (1981), Ohlson and
Rosenberg (1982), Grinblatt and Titman (1989) and Korajczyk and Sadka (2004) conclude that equal-weighted portfolios

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An Investigation of Beta and Downside Beta Based CAPM-Case
Study of Karachi Stock Exchange 125

estimator adjusted GMM36 for problem of heteroscedasticity and autocorrelation in FMac (1973) first
pass for estimation window of 48 months37. This makes estimated parameters more robust as they are
corrected for heteroscedasticity and autocorrelation. For cross-sectional second pass, this study use
White estimator38 to make the t-stat robust. Choice of appropriate lags in GMM and Newey-West is
important. GMM with three lags for each dependent and independent variable along with intercept is
most appropriate that is used in this study39. All results are estimated in Eviews 5 and 7.
Subsequently, FMac (1973) perform second pass40 for each month via cross-sectional analysis
of portfolio beta and portfolio return. And eventually, they test for intercept and portfolio beta
parameter, non-linearity and idiosyncratic underlying framework for their famous two-pass regression
approach41. To study relationship between expected return and beta, FMac (1973) use following
equation for this purpose:
^ ^
R Pt = λ 0 t + λ 1t β P + ε Pt (3)
^ ^
Where RPt is portfolio returns, λ 0t is intercept, λ 1t depict risk-return relationship, β P is portfolio
beta and ε Pt residuals for portfolio p at time t.
Nonlinearity is determined by adding β P2 as additional term for three-dimensional axis with
RPt on y-axis while β P and β P2 on other two axis. It is added as follows:
^ ^ ^
RPt = λ 0 t + λ 1t β P + λ 2 t β P2 + ε pt (4)
For residual variance, another term RVP is adding to check whether it affects stocks prices or
not. The relationship is shown as:
^ ^ ^
RPt = λ 0t + λ 1t β P + λ 3t RVP + ε pt (5)
where RVP is residual variance of portfolio p.
In last, all parameters are added and their combine effect is measured and reported defined as42:
^ ^ ^ ^
RPt = λ 0t + λ 1t β P + λ 2t β P2 + λ 3t RVP + ε pt (6)
where is defined as M
with an M is number of stocks in a portfolio j.
RVP= ∑j =1
σ 2
(ε j ) / M

FMac (1973) estimate their coefficient statistics for specific lamdas as:

have higher returns than counter-part. Lastly, absence of linear relationship has been attributed to smaller stocks (Ang et
al.(2004)).
36
GMM is developed by Hansen (1982) and is used to estimate parameters applied where full shape of distribution is not
known.
37
Newey-West adjusted parameters corrects for both heteroscedasticity and autocorrelation (Newey and West (1987))
Cochrane (2005) advocates the use of generalized method of moments (GMM) as it handles problem of endogeneity.
38
White's variance-covariance estimator adjusted for OLS is used to overcome cross-sectional heteroscedasticity (White
(1980)).
39
Greene (2003) advocates use of four lags in GMM and can be less if moving averages is used. This study initially applies
three lags and checks for their J-statistics and concludes that three lags is an appropriate figure. This is performed to test
validity of over-identifying restrictions with the condition that instruments are more than parameters. Lag estimation for
Newey-West estimator is automatically made inbuilt system in Eviews 5 and 7.
40
In second pass, cross-sectional estimation is performed in which estimated risk measures from the first pass are regressed
against portfolio returns.
41
Selection bias is also addressed that arises due to grouping procedure of Black et al.(1972) technique. Estimated portfolio
betas/downside betas/relative downside betas of previous time period are used as an instrumental variable to rank stocks
into portfolios to avoid this problem.
42
For testing DCAPM, β P will be replaced by D β P defined as portfolio downside risk. For testing CAPM and DCAPM
based on relative downside risk, β P will be replaced by Dββ P and Dβ Dβ P respectively defined as relative downside
risk sorted on portfolio beta and downside beta respectively. Downside beta is calculated from equation (1) in discrete form.

Electronic copy available at: https://ssrn.com/abstract=2241416

126 Mohammad Tahir, Qaiser Abbas, Shahid Mehmmod Sargana
Usman Ayub and Syed Kashif Saeed

T
− 1 ^
λ j =
T
∑λ
t =1
jt (7)

and
T 2
− 1 ^ −
(8)
σˆ ( λ j ) = ∑
T (T − 1) t =1
( λ jt − λ j )

and then they form t-stat as:

t  λ j  = λ j / σˆ  λ j 
− − −
(9)
   
−
They calculate t-stat using (8) and consequently test hypothesis H01 as λ = 0 ; intercept is not 0
−
different from zero with restriction tested for two-sided test. H02 as λ = 0 ; there are no nonlinearities in
2
−
SML with restriction tested for two-sided test. H03 as λ 3 = 0 ; residual risk does not affect returns with
−
restriction tested for two-sided test. H04 as λ1 > 0 ; there is risk-return relationship with restriction tested
for one-sided test.
H01 advocates that the intercept is not different from zero as FMac (1973) takes excess returns
defined as difference of stock returns and risk-free rate. A failure to reject means preference by zero-
beta model. Rejection of H02 means that risk-return relationship is linear as implied by the theory. H03
commits to notion that market operates as a fair game. And H04 is most important for positive risk-
return relationship. This study adopts FMac (1973) procedure and estimates equations 5.2 through 5.5
for beta to study relationship between expected return and beta. Then it replaces beta by downside beta
and again estimates equations 5.2 through 5.5 to study relationship between expected return and
downside beta. In the end, this study introduces relative downside beta as measure of risk and estimates
equations 5.2 through 5.5 to study relationship between expected return and relative downside beta.

4. Results for Fama and MacBeth Procedure

4.1. Fama and MacBeth Portfolios Sorted on Downside Beta/Beta
Examining Panel A of Table 143, this study observes that intercept is rejected for CAPM at 10%
significance level for both full sample and subsample of 2007-08 and 2009-10. However, λ1 >0 cannot
be rejected. DCAPM also yield similar results but its intercept is rejected at 5% significance level. This
study can safely say that both CAPM and DCAPM show positive risk-return relationship but intercept
is significantly different from zero implying replacing of regular single asset pricing model to zero-
beta/DB asset pricing model. Panel B reports results for intercept, risk-return relationship and
nonlinearities in SML for both CAPM and DCAPM. Intercept is rejected in subsample of CAPM at
10% significance level while it is rejected at 1% significance level for total sample and at 5% for two
subsamples. λ1 is rejected in subsample of CAPM at 10% significance level but not for DCAPM. There
are no nonlinearities in both the models. This study can safely say that DCAPM show positive risk-
return relationship but CAPM misses at 10% significance level. Following results of Panel A, zero-
beta/DB asset pricing model is advocated for intercept problem.
Table 1 reports results for intercept, risk-return relationship and effect of residuals on returns in
Panel C. λ0 is not rejected at any level of significance for CAPM but it is rejected at 1% significance
level for full sample and 5% and 10% for subsamples for DCAPM. λ1 is not rejected for any level for
both models. λ3 is rejected for DCAPM for subsample of 2007-08 at 10% significance level showing
residuals affecting stock returns. This study can safely say that both CAPM and DCAPM show positive
risk-return relationship however, DCAPM shows residual effect which is further investigated. Panel D
shows results for all parameters; intercept risk-return relationship, nonlinearities and effect of residuals.
Intercept follows similar trend as identified in previous panels. CAPM reveal nonlinear relationship for

43
All tables are given in appendix A.

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An Investigation of Beta and Downside Beta Based CAPM-Case
Study of Karachi Stock Exchange 127

subsample 2009-10 at 10% level. Residual effect is safely assumed to be negligible especially for
DCAPM which shows some sign in Panel D. λ1 >0 holds for both CAPM and DCAPM but only to be
replaced by their respective zero-beta versions. However, beta is also contributing to DB and its effect
has to be nullified. So this study uses relative DB in Fama-MacBeth regressions to make the results
robust and to observe incremental effects of DB.

4.2. Fama and MacBeth Portfolios Sorted on Relative Downside Beta

In Panel A of Table 2; this study observes that intercept is rejected for CAPM at 5% significance level
for full sample and at 1% for subsample. However, λ1 >0 is rejected for CAPM at 10% level for total
sample and 5% for subsample. DCAPM also yield similar result for rejection of intercept but λ1 >0
holds for it. This study can safely say that DCAPM show positive risk-return relationship but intercept
is significantly different from zero. However, CAPM does not hold for the sample used in this study
for significance level of 1% and 5%44. Table 2, Panel B reports results for intercept, risk-return
relationship and nonlinearities in SML for both CAPM and DCAPM. Intercept is rejected in total as
well as subsample of both CAPM and DCAPM. λ1 is rejected in total sample of CAPM and subsample
of DCAPM at 10%. There are no nonlinearities in both the models. This study can comment that both
models show deviation at 10% significance level. However, this study can also comment that 5% level
is not breached by both models in Panel B.
Panel C reports results for intercept, risk-return relationship and effect of residuals on returns.
λ0 is rejected at 5 and 10% level of significance for CAPM and DCAPM in different samples. λ1 is
rejected at 10% for CAPM in subsample and at same level for DCAPM in total sample. λ3 is not
rejected for either models paving the way for negligible effect of residuals on stock returns. This study
can comment that both models show deviation at 10% significance level for their risk-return
relationship. However, this study can also comment that 5% level is not breached by both models in
Panel C following Panel B results. Panel D shows results of all parameters; intercept risk-return
relationship, nonlinearities and effect of residuals. Intercept follows similar trend as identified in
previous panels. λ0 is rejected at 5 and 10% level of significance for CAPM and DCAPM for complete
sample. For both CAPM and DCAPM, λ1 is not rejected at any level of significance in total sample as
well as in subsample. λ2 and λ3 are not rejected for either models paving the way for the absence of
nonlinearities and negligible effect of residuals on stock returns.
Summing up, results for incremental effect of DB advocate DCAPM as strong contender for
risk-return relationship to hold and CAPM being the weaker one for rejecting λ1 >0 at 5% level of
significance. However, if this study chooses 10% level of significance, then DCAPM is not winner but
relatively it is better. Secondly, the rejection of λ0 = 0 is a common feature in all results which favours
zero-versions of asset pricing models. This result is consistent with earlier studies of Black (1972),
Stambaugh (1982), Gibbons (1982) and Shanken (1985).

5. Summary
Capital Asset Pricing Model (CAPM) is simple, cost-effective and most widely used asset pricing
model in the world. Yet, it is most discussed topic in the field of financial economics45. It predicts
positive and linear relationship between risk and return and assumes that stock returns are normally
distributed. It is assumed that investors are indifferent to upside and downside risks (Sharpe (1964)).
Roy (1952) debates that investor care for downside risk, or simply, safety from disaster as foremost
goal defined as Safety First-rule. Bawa (1975) who develops proxy for Roy’s Safety-First rule based
on stochastic dominance as Lower Partial Moment (LPM). Later, Fishburn (1977) extends it into

44
This result is consistent with findings of previous studies like Javid and Ahmad (2008) and Iqbal et.al.(2010).
45
Graham and Harvey (2001) report 73.5% of CFOs US and Brounen, Abe de Jong and Koedijk (2004) report 45% in
Europe use CAPM.

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128 Mohammad Tahir, Qaiser Abbas, Shahid Mehmmod Sargana
Usman Ayub and Syed Kashif Saeed

unlimited scope of LPM and Bawa and Lindenberg (1977) extending it to asymmetric LPMs. Bawa-
Fishburn-Lindenberg LPM encompasses all classes of investors; risk-averse, risk-seeking and risk-
neutral. Additionally, it is not tied to condition of normality and is flexible to include skewness and
kurtosis as well. When incorporated in CAPM framework, Bawa-Fishburn-Lindenberg LPM replaces
regular beta by downside beta as downside risk based CAPM or DCAPM.
This study empirically tests beta based CAPM and downside beta based DCAPM. First this study
discusses conceptual and empirical problems related to these models. As DCAPM has similar
assumptions as of CAPM, so this study sticks to basic underlying methodology of testing CAPM i.e.
Fama-MacBeth (1973) procedure. This study inspects intercept, risk-return relationship, nonlinearities
and effect of residuals for both CAPM and DCAPM. Intercept results are almost similar and they
advocate and follow rejection of null hypothesis. CAPM and DCAPM hold similar ground pertaining to
nonlinearities and effect of residuals. Our results also reveal that risk-return relationship holds up,
however, DCAPM comes out to be strong contender compared to CAPM for risk-return relationship.
These results are consistent with Grootveld and Hallerbach (1999), Harvey (2000), Estrada (2002), Ang
et al.(2004) and Post and Vliet (2004). Intercept rejection leads us to zero-beta single asset pricing model
as outlined by earlier studies of Black (1972), Stambaugh (1982), Gibbons (1982) and Shanken (1985).
This study can conclude and advocate the replacement of variance by downside risk as a
suitable risk measure in a single asset pricing model. Downside risk based single asset pricing model
will help in pricing securities more appropriately and anticipating portfolio risk for investors.
Downside risk framework will also aid in determining the nature of investment. It will determine
market behavior in a better way as compared to other single asset pricing models. DCAPM can be
pivotal as key determinant for institutional demand for KSE stocks. Moreover, delineating cost of
capital for capital budgeting is necessary to finance them. DCAPM can also contribute in this area
leading to a suitable model of financing.
However, no study is complete and accordingly, this study recommends suggestions for future
researchers. This study is primarily limited to monthly data and can be easily extended to daily and
weekly observations. Use of conditional and multi-factor models in downside risk framework, not used
in this study, will perhaps enhance the performance of DCAPM. Tracking Error in downside risk
framework, if introduced, can make the model multi-dimensional and more receptive to market forces.
Finally, behavioral approach can be incorporated to asset pricing as this field is steadily gaining attention
among researchers and practitioners alike. This world still lays unexplored with vast frontiers to conquer.

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Appendix A
Table 1: Results for Fama-MacBeth Regression based on Beta/DB Sorting

RPt = λ0 + βP λ1 + εPt RPt = λ0 + DβP λ1 + εPt

Panel A
λ0 λ1 λ2 λ3 λ0 λ1 λ2 λ3
2005-10 0.014*** -0.001 -0.019** 0.001
(-1.921) (-0.560) (-2.465) (0.342)
0.006 0.001 0.003 0.001
2005-06 (0.513) (-0.017) (0.295) (0.441)
2007-08 -0.023*** -0.005 -0.033** 0.001
(-1.781) (-0.795) (-2.204) (-0.113)
2009-10 -0.026*** 0.001 -0.026** 0.001
(-1.783) (0.167) (-1.994) (0.199)
RPt = λ0 + βP λ1 + βP2 λ2 + εPt RPt = λ0 + DβP λ1 + DβP2 λ2 + εPt
Panel B
λ0 λ1 λ2 λ3 λ0 λ1 λ2 λ3
-0.012 -0.003 0.001 -0.019** 0.001 0.001
2005-10
(-1.409) (-0.635) (0.008) (-2.501) (-0.248) (0.532)
0.005 -0.001 0.001 0.002 0.001 0.000
2005-06
(0.442) (-0.123) (0.543) (0.205) (0.315) (0.665)
-0.011 -0.018*** 0.002 -0.032** -0.002 0.001
2007-08
(-0.644) (-1.576) (0.547) (-2.142) (-0.537) (0.282)
-0.031*** 0.009 -0.003 -0.027** 0.001 0.001
2009-10
(-1.886) (1.292) (-1.486) (-2.072) (0.188) (-0.347)
RPt = λ0 + βP λ1 + βP2 λ2 + εPt RPt = λ0 + DβP λ1 + DβP2 λ2 + εPt
Panel C
λ0 λ1 λ2 λ3 λ0 λ1 λ2 λ3
-0.014 -0.003 1.724 -0.020 0.000 1.009
2005-10
(-1.456) (-0.651) (0.797) (-2.657)* (-0.050) (0.788)
0.004 -0.001 0.291 0.001 0.001 1.183
2005-06
(0.374) (-0.411) (0.113) (0.055) (0.674) (0.403)
-0.024 -0.007 4.583 -0.035 -0.001 3.375
2007-08
(-1.267) (-0.598) (1.207) (-2.423)** (-0.390) (1.744)***
-0.021 -0.001 0.300 -0.026 0.000 -1.531
2009-10
(-1.259) (-0.129) (0.064) (-1.958)*** (-0.054) (-1.015)
RPt = λ0 + βP λ1 + βP2 λ2 + εPt RPt = λ0 + DβP λ1 + DβP2 λ2 + εPt
Panel D
λ0 λ1 λ2 λ3 λ0 λ1 λ2 λ3
-0.016 0.001 -0.001 3.839 -0.020** 0.001 0.001 1.291
2005-10
(-1.588) (-0.077) (-0.267) (0.467) (-2.497) (-0.051) (0.053) (0.134)
0.001 0.000 0.001 1.752 0.001 0.001 -0.001 1.471
2005-06
(0.117) (0.153) (0.515) (0.524) (0.118) (0.775) (-1.204) (0.485)
-0.011 -0.015 0.007 -11.386 -0.035** -0.001 -0.001 7.115
2007-08
(-0.517) (-1.199) (0.663) (-0.607) (-2.333) (-0.206) (-0.231) (0.367)
-0.038** 0.013 -0.012*** 21.151 -0.025*** 0.001 0.002 -4.714
2009-10
(-2.201) (1.618) (-1.714) (1.366) (-1.791) (-0.330) (0.417) (-0.218)
Results for cross-sectional analysis are given for intercept, risk-return relationship, nonlinearities and effect of residuals for
column 2 and 3 and 6 and 7 respectively for beta/DB sorted portfolios. Results for full sample are given in bold
from 2005 to 2010. Results for three subsamples are also given for breakup purpose. t-stat are given in brackets.
*shows significance at 1 percent, ** shows significance at 5 percent and *** shows significance at 10 percent.

Electronic copy available at: https://ssrn.com/abstract=2241416

An Investigation of Beta and Downside Beta Based CAPM-Case
Study of Karachi Stock Exchange 135

Table 2: Results for Fama-MacBeth Regression based on DB/Beta Sorting

RPt = λ0 + DββP λ1 + εPt RPt = λ0 + DβDβP λ1 + εPt

Panel A
λ0 λ1 λ2 λ3 λ0 λ1 λ2 λ3
2005-10 -0.024** -0.004*** -0.020** -0.001
(-2.695) (-1.495) (-2.634) (-1.020)
-0.013 -0.007 -0.002 -0.003
2005-06 (-0.669) (-1.199) (-0.157) (-1.251)
2007-08 -0.039* -0.0002 -0.034** 0.0005
(-3.076) (-0.032) (-2.521) (0.310)
2009-10 -0.019 -0.005** -0.023*** -0.0005
(-1.438) (-2.164) (-1.733) (-0.608)
RPt = λ0 + DββP λ1 + εPt RPt = λ0 + DβDβP λ1 + εPt
Panel B
λ0 λ1 λ2 λ3 λ0 λ1 λ2 λ3
2005-10 -0.025** -0.007*** 0.0003 -0.017** -0.002 0.00001
(-2.643) (-1.544) (0.257) (-2.228) (-1.286) (0.023)
-0.021 -0.012 0.0004 0.003 -0.005 -0.001
2005-06 (-0.955) (-1.164) (0.232) (0.238) (-1.215) (-0.612)
2007-08 -0.035* -0.002 -0.00004 -0.035** 0.001 0.0004
(-2.797) (-0.393) (-0.021) (-2.421) (0.451) (0.790)
2009-10 -0.020 -0.006 0.0004 -0.021 -0.004*** 0.0002
(-1.398) (-0.953) (0.290) (-1.574) (-1.427) (0.663)
RPt = λ0 + DββP λ1 + RVDβBλ3 + εPt RPt = λ0 + DβDβP λ1 + RVDβDB λ3 + εPt
Panel C
λ0 λ1 λ2 λ3 λ0 λ1 λ2 λ3
2005-10 -0.021** -0.005 -2.541 -0.017** -0.002*** -0.150
(-2.539) (-1.202) (-0.990) (-1.949) (-1.367) (-0.064)
-0.007 -0.012 -5.186 0.003 -0.002 0.925
2005-06 (-0.510) (-1.084) (-0.989) (0.185) (-0.779) (0.139)
2007-08 -0.037** 0.003 -3.711 -0.031** -0.001 -2.577
(-2.402) (0.571) (-0.822) (-2.108) (-0.266) (-1.628)
2009-10 -0.020 -0.007*** 1.273 -0.022*** -0.003 1.203
(-1.451) (-1.334) (0.365) (-1.655) (-1.253) (0.610)
RPt = λ0 + DββP λ1 + DββP2 λ2 + RVDβBλ3 + εPt RPt = λ0 + DβDβP λ1 + DβDβP2 λ2 + RVDβDBλ3 + εPt
Panel D
λ0 λ1 λ2 λ3 λ0 λ1 λ2 λ3
2005-10 -0.019** -0.003 0.003 -7.020 -0.018** -0.001 0.001 -5.981
(-2.172) (-0.860) (0.667) (-0.670) (-2.215) (-0.703) (0.625) (-0.661)
-0.008 -0.002 0.001 0.511 -0.004 -0.004 -0.001 2.417
2005-06 (-0.788) (-0.422) (0.204) (0.059) (-0.369) (-0.977) (-0.970) (0.229)
2007-08 -0.036** 0.002 0.001 -5.024 -0.031** 0.002 0.001 -2.750
(-2.430) (0.467) (0.182) (-0.419) (-2.118) (0.706) (0.324) (-0.380)
2009-10 -0.011 -0.008 0.008 -16.547 -0.017 -0.002 0.005 -17.610
(-0.635) (-1.277) (0.610) (-0.588) (-1.192) (-0.711) (0.776) (-0.728)
Results for cross-sectional analysis are given for intercept, risk-return relationship, nonlinearities and effect of residuals for
column 2 and 3 and 6 and 7 respectively for DB/Beta sorted portfolios. Results for full sample are given in bold from 2005 to
2010. Results for three subsamples are also given for breakup purpose. t-stat are given in brackets. *shows significance at 1
percent, ** shows significance at 5 percent and *** shows significance at 10 percent.

Electronic copy available at: https://ssrn.com/abstract=2241416