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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.

Introduction

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. The cost of equity capital is used as a discount factor when calculating the net present value (NPV) of investment projects. In developed markets, 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. The multi-factor model can be used to explain either an individual security or a portfolio of securities. It will do this by comparing two or more factors to analyze relationships between variables and the securitys resulting performance.

Where: Ri is the returns of security i Rm is the market return F(1,2,3N) is each of the factors used e is the error term a is the intercept 2|Page

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; their opposites are called "growth" stocks). They then added two factors to CAPM to reflect a portfolio's exposure to these two classes: r - Rf = beta3 x ( Km - 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; in particular that means that if returns increase with book/price, then stocks with a high book/price ratio must be more risky than average - exactly the opposite of what a traditional business analyst would tell you. The difference comes from whether you believe in the efficient market theory. The business analyst doesn't believe it, so he would say high book/price indicates a buying opportunity: the stock looks cheap. But if you do believe in EMT then you believe cheap stocks can only be cheap for a good reason, namely that investors think they're risky... Fama and French aren't particular about why book/price measures risk, although they and others have suggested some possible reasons. For example, high book/price could mean a stock is "distressed", temporarily selling low because future earnings look doubtful. Or, it could mean a stock is capital intensive, making it generally more vulnerable to low earnings during slow economic times. Those both sound plausible; 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, but in their being different enough that taken together they do an effective job of "spanning the dimensions" of the market. Types of Factor Models 1) Macroeconomic factor models Macroeconomic factor models are the simplest and most intuitive type. They use observable economic time series as measures of the pervasive factors in security returns. Some of the 3|Page

macroeconomic variables typically used as factors are inflation, the percentage change in industrial production, the excess return to long-term government bonds, and the realized return premium of low-grade corporate bonds relative to high-grade bonds. The random return of each security is assumed to respond linearly to the macroeconomic shocks. As in all factor models, each security also has an asset-specific return unrelated to the factors. A securitys linear sensitivities to the factors are called the factor betas of the security. A drawback to macroeconomic factor models is that they require identification and measurement of all the pervasive shocks affecting security returns. A small number of pervasive sources of risk may exist, but without knowing exactly what they are, or lacking data to measure them, they are of little use in explaining returns. 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. Macroeconomic and statistical factor models both estimate a firms factor beta by time-series regression. Given the nature of security returns data, this limitation is substantial. Time-series regression requires a long and stable history of returns to estimate the factor betas accurately. 3) Fundamental factor models Fundamental factor models do not require time series regression. They rely on the empirical finding that company attributes such as firm size; dividend yield, book-to-market ratio, and industry classification explain a substantial proportion of common return. A fundamental factor model uses observed company attributes as factor betas. 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. For example, the dividend yield factor is the realized return per extra unit of dividend yield, holding other attributes constant. In the case of a fundamental factor model, the factor betas are exogenously determined, firm-specific attributes rather than estimated sensitivities to random factors, and the factor returns are empirically determined random returns associated with these various attributes 4|Page

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). The method estimates the betas and risk premiafor any risk factors that are expected to determine asset prices. The method works with multiple assets across time. The parameters are estimated in two steps: 1. First regress each asset against the proposed risk factors to determine that asset's beta for that risk factor. 2. Then regress all asset returns for a fixed time period against the estimated betas to determine the risk premium for each factor. Eugene F. Fama and James D. 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".

Emerging markets have been studied quite extensively due to the large interest of investors, who view them as an attractive alternative to investing in more developed markets. Emerging markets are typically characterized by higher returns, but also by higher volatility of stock returns as compared to the developed ones. 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. In emerging markets the CAPM i.e. capital asset pricing model (which is mostly used in the developing countries) has poor empirical evidence. CAPM is also less likely to hold in the less developed markets and less liquid emerging markets. In order to overcome over-come these shortcomings various multifactor models have been proposed. 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.

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Factor models, including factors such as the excess market return, industrial production, inflation, money, the exchange rate, exports, the commodity index, and the term structure, can in fact explain part of the variance in the Indian stock returns. However, 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. The aim of this paper is to propose such a model for the stock markets in India. More specifically, 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.

Objectives

Study and analyze the empirical evidence of CAPM Model Study and test the empirical evidence of Fema French Multifactor Asset Pricing Model. Study the Fema MacBeth method to identify the factors and associated risk with the factors.

Research Methodology

In the literature one can find several ways of testing capital asset pricing models. They can be divided into the following three categories: tests involving time-series regression, tests involving cross-sectional regression, and tests involving a combination of the two. One of the most widely used methods is the Fama-MacBeth (FMB) procedure, which combines time-series and cross-section regressions. The FMB method has several advantages. It uses all the information available for a given data point, 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, it is a key to be able to use all the available data points to the maximum. More importantly, this method corrects for cross-sectional correlation in the panel.

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References

1) Eugene F. Fama and Kenneth R French ,Multifactor Explanations of Asset Pricing Anomalies, Journal of Finance, 1996 2) Derek Cheng(June 01, 2010), Factorial design of Multi-Factor Asset-Pricing Model with Randomization Approach by Derek Cheng, June 01, 2010 3) Bartholdy J, Peare P (2003): Unbiased Estimation of Expected Return Using CAPM. International Review of Financial Analysis. 4) Bekaert G, Harvey C (1995): Time-Varying World Market Integration. Journal of Finance. 5) G. Connor and R.A. Korajczyk, A Test for the Number of Factors in an Approximate Factor Model, The Journal of Finance, vol. 48, no. 4 (September 1993)

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