Study of various Multi-Factor Asset Pricing models in Indian context
Dissertation Proposal Submitted to Prof. Deepak Danak October 10, 2011
Submitted By: Anshul Rathi (101109)
Factors are compared using the following formula
Ri = ai + βi(m) Rm + βi(1)F1 + βi(2)F2 +…+βi(N)FN + ei
Where: Ri is the returns of security i Rm is the market return F(1. The cost of equity capital is used as a discount factor when calculating the net present value (NPV) of investment projects.
Cost of Capital The cost of equity capital is crucial information that is needed in order to assess investment opportunities and the performance of managed portfolios.2. the capital asset pricing model (CAPM) is commonly used by financial managers to calculate the cost of equity capital. as well as to assess the performance of managed portfolios such as mutual funds What is Multi-factor Asset Pricing Model? A Financial model which employs more than one factors in its computation to explain the market phenomena and equilibrium asset prices.Research Problem
Study of various Multi-Factor Asset Pricing models in Indian context and propose a Model which will be able to estimate the average return from an Indian Stock.3…N) is each of the factors used e is the error term a is the intercept 2|Page
. In developed markets. It will do this by comparing two or more factors to analyze relationships between variables and the security’s resulting performance. The multi-factor model can be used to explain either an individual security or a portfolio of securities.
temporarily selling low because future earnings look doubtful. then stocks with a high book/price ratio must be more risky than average . They then added two factors to CAPM to reflect a portfolio's exposure to these two classes: r .Rf ) + bs x SMB + bv x HML + alpha One thing that's interesting is that Fama and French still see high returns as a reward for taking on high risk. Types of Factor Models 1) Macroeconomic factor models Macroeconomic factor models are the simplest and most intuitive type. Some of the 3|Page
. it could mean a stock is capital intensive. so he would say high book/price indicates a buying opportunity: the stock looks cheap.exactly the opposite of what a traditional business analyst would tell you. Fama and French aren't particular about why book/price measures risk. although they and others have suggested some possible reasons. in particular that means that if returns increase with book/price. The difference comes from whether you believe in the efficient market theory. their opposites are called "growth" stocks). Or. For example. namely that investors think they're risky. They use observable economic time series as measures of the pervasive factors in security returns. But if you do believe in EMT then you believe cheap stocks can only be cheap for a good reason.. but they seem to be describing completely different situations (and what happens when a company that isn't capital intensive becomes "distressed"?) It may be that the success of this model at explaining past performance isn't due to the significance of any of the three factors taken separately.Literature Review
Study of Fama French Multifactor Model Fama and French started with the observation that two classes of stocks have tended to do better than the market as a whole: (i) small caps and (ii) stocks with a high book-value-to-price ratio (customarily called "value" stocks. but in their being different enough that taken together they do an effective job of "spanning the dimensions" of the market. The business analyst doesn't believe it..Rf = beta3 x ( Km . making it generally more vulnerable to low earnings during slow economic times. Those both sound plausible. high book/price could mean a stock is "distressed".
the factor betas are exogenously determined. holding other attributes constant. and the realized return premium of low-grade corporate bonds relative to high-grade bonds. firm-specific attributes rather than estimated sensitivities to random factors. the dividend yield factor is the realized return per extra unit of dividend yield. A fundamental factor model uses observed company attributes as factor betas. A small number of pervasive sources of risk may exist. the percentage change in industrial production. book-to-market ratio. 2) Statistical factor models Statistical factor models use various maximum-likelihood and principal-components-based factor analysis procedures on the cross-sectional/time-series samples of security returns to identify the pervasive factors in returns. In the case of a fundamental factor model. Time-series regression requires a long and stable history of returns to estimate the factor betas accurately. The random return of each security is assumed to respond linearly to the macroeconomic shocks. A security’s linear sensitivities to the factors are called the factor betas of the security. 3) Fundamental factor models Fundamental factor models do not require time series regression. and industry classification explain a substantial proportion of common return. each security also has an asset-specific return unrelated to the factors. The factors in a fundamental factor model are the realized returns to a set of mimicking portfolios designed to capture the marginal returns associated with a unit exposure to each attribute. As in all factor models. they are of little use in explaining returns. A drawback to macroeconomic factor models is that they require identification and measurement of all the pervasive shocks affecting security returns. For example. Given the nature of security returns data.macroeconomic variables typically used as factors are inflation. the excess return to long-term government bonds. but without knowing exactly what they are. dividend yield. Macroeconomic and statistical factor models both estimate a firm’s factor beta by time-series regression. and the factor returns are empirically determined random returns associated with these various attributes 4|Page
. or lacking data to measure them. They rely on the empirical finding that company attributes such as firm size. this limitation is substantial.
Then regress all asset returns for a fixed time period against the estimated betas to determine the risk premium for each factor.The Fama-Macbeth Method The Fama-Macbeth regression is a method used to estimate parameters for asset pricing models such as the Capital asset pricing model (CAPM). Eugene F. The method estimates the betas and risk premiafor any risk factors that are expected to determine asset prices. First regress each asset against the proposed risk factors to determine that asset's beta for that risk factor.
. but also by higher volatility of stock returns as compared to the developed ones. who view them as an attractive alternative to investing in more developed markets. capital asset pricing model (which is mostly used in the developing countries) has poor empirical evidence. Fama and James D. CAPM is also less likely to hold in the less developed markets and less liquid emerging markets.
Need for Research
Emerging markets have been studied quite extensively due to the large interest of investors. The research will examine different models including the CAPM and multifactor asset pricing models to examine their ability to explain average stock returns in the Indian Markets. The method works with multiple assets across time. The parameters are estimated in two steps: 1. In emerging markets the CAPM i. 2.e. There is no consensus on which asset pricing model to use in order estimate the returns and the cost of capital in the emerging markets. Emerging markets are typically characterized by higher returns. MacBeth (1973) demonstrated that the residuals of risk-return regressions and the observed "fair game" properties of the coefficients are consistent with an "efficient capital market". In order to overcome over-come these shortcomings various multifactor models have been proposed.
accounting for the variation coming from both sources: time-series and cross-section. Given the relatively short time spans of the data available for the stock markets in the emerging countries. can in fact explain part of the variance in the Indian stock returns. The aim of this paper is to propose such a model for the stock markets in India. exports. the commodity index. The FMB method has several advantages. tests involving cross-sectional regression.
In the literature one can find several ways of testing capital asset pricing models.Factor models. inflation. More specifically. industrial production. However. More importantly. this method corrects for cross-sectional correlation in the panel.
. It uses all the information available for a given data point.
Study and analyze the empirical evidence of CAPM Model Study and test the empirical evidence of Fema French Multifactor Asset Pricing Model. and tests involving a combination of the two. Study the Fema MacBeth method to identify the factors and associated risk with the factors. money. One of the most widely used methods is the Fama-MacBeth (FMB) procedure. the exchange rate. there is no consensus in the literature as to which model should be used to explain the returns in these markets and estimate the cost of equity capital. we will analyze how different models perform in explaining the variations in stock returns on the stock markets and which one of these models should be used to estimate the cost of equity capital in these markets. which combines time-series and cross-section regressions. including factors such as the excess market return. it is a key to be able to use all the available data points to the maximum. They can be divided into the following three categories: tests involving time-series regression. and the term structure.
Korajczyk. 5) G.References
1) Eugene F. “A Test for the Number of Factors in an Approximate Factor Model.A. 48. Connor and R.” The Journal of Finance. 2010). 1996 2) Derek Cheng(June 01. vol.Multifactor Explanations of Asset Pricing Anomalies. Harvey C (1995): Time-Varying World Market Integration. 4) Bekaert G. Fama and Kenneth R French . Journal of Finance. Peare P (2003): Unbiased Estimation of Expected Return Using CAPM. Journal of Finance. International Review of Financial Analysis. Factorial design of Multi-Factor Asset-Pricing Model with Randomization Approach by Derek Cheng. 2010 3) Bartholdy J. no. 4 (September 1993)
. June 01.