REVISITING THE ASSET PRICING MODELS

Transcription

1 REVISITING THE ASSET PRICING MODELS Mehak Jain 1, Dr. Ravi Singla 2 1 Dept. of Commerce, Punjabi University, Patiala, (India) 2 University School of Applied Management, Punjabi University, Patiala, (India) ABSTRACT The fundamental feature of security analysis is its valuation by measuring the association between the security s return and the related risk factors. Markowitz s Modern Portfolio Theory pioneered the asset pricing theories by analysing the return on portfolio of investments based on the expected return and risk of individual securities and their interrelationships as measured by correlation. Capital Asset Pricing Model (CAPM) as developed by Sharpe and Lintner related the return on all individual securities and their portfolios to the single risk factor, that is, market risk. However it was found later that the CAPM based on single factor does not help in explaining the cross-section of returns. Since then a lot has been done and various multifactor models attempted to further the understanding of the risk-return relationship, making it more expansive and advanced to the earlier attempts, by identifying various risk factors affecting security returns as against a single risk factor used by CAPM. However every asset pricing theory is bundled with some inherent limitations. The present paper aims to revisit the plethora of asset pricing models to determine some conclusive insights into this important research area. Keywords: Asset pricing, Capital Asset Pricing Model, multi-factor model, risk and return. I. INTRODUCTION The most important issue that economists face is the quantification of relationship between risk and expected return. Markowitz was the first to propose a general solution for portfolio selection problem. The development of Capital Asset Pricing Model (CAPM) was the first step towards the quantification of the relationship of risk and return. The empirical evidence in favour of CAPM is very weak as the beta of CAPM is not able to explain the returns of portfolios formed on certain company characteristics known as CAPM anomalies. This led to the development of alternative asset pricing models in multi-factor framework. II. ASSET PRICING: AN OVERVIEW Foundations of modern finance were laid by Harry Markowitz who developed the modern portfolio theory. Markowitz (1952, 1959) was the first to lay the groundwork of CAPM and proposed a general solution for portfolio selection problem. He argued that investors would optimally hold a mean-variance efficient portfolio, that is, a portfolio with the highest return for a given level of risk. Sharpe (1964) and Lintner (1965) extended the Markowitz's portfolio theory to an equilibrium theory of asset pricing under uncertainty. 297 P a g e

2 III. ORIGIN OF CAPITAL ASSET PRICING MODEL (CAPM) Capital Asset Pricing model (CAPM) was developed by Sharpe (1964) and Lintner (1965) to quantify the relationship between risk and return. The Sharpe-Lintner CAPM builds the assumption that all investors plan investment and consumption decisions as well as portfolio revisions at the beginning of a single time period, which is identical for them. It assumes that all investors are risk-averters and seek to maximize the expected utility of terminal wealth. Under the premises of perfect capital market, there are zero taxes, no transaction costs, and possibility of infinite borrowing and lending at the risk-free rate. CAPM established that there exists linear relationship between returns on a financial asset and its sensitivity to returns on a broad based market portfolio. The two most important implications of the CAPM equation are that the risk-return relationship is linear and secondly only a fraction of total risk is priced by the market. The relevant risk is systematic in nature and is measured by beta. However, there is lack of empirical evidence in support of CAPM. IV. ANOMALIES IN CAPITAL ASSET PRICING MODEL Since the late 1970 s, researchers have observed that there are patterns in average stock returns which cannot be explained by the standard Capital Asset Pricing model of Sharpe (1964) and Lintner (1965), that is, the beta of Capital Asset Pricing Model is unable to capture the returns for portfolios formed on basis of certain company characteristics known as CAPM anomalies. The literature on anomalies shows that some of the portfolios formed on basis of company characteristics are not explained by the beta of CAPM, and hence the cross-section of average returns can be better explained by other risk factors. This is because there seem to be risk factors that affect security returns beyond beta s one dimensional measurement of market sensitivity. The emergence of prominent CAPM anomalies has led to the development of asset pricing models in the multi-factor domain. Price-earnings ratio (P/E) effect was first reported by Basu (1977). He found that the market portfolio does not seem to be efficient relative to the portfolios formed on the basis of price-earnings (P/E) ratios, that is, low P/E stocks exhibit higher returns and high P/E stocks provide lower returns. Size effect was first documented by Banz (1981) and found that company size explains the portfolio returns better than CAPM beta. Starting with Banz (1981), many papers have explored the reasons for its existence in both developed and emerging markets. Efforts to explain the size effect include Roll (1981), Reiganum (1981), Stoll and Whaley (1983) and Chan and Chen (1991). Stattman (1980) showed that the ratio of book equity to market equity (BE/ME) is positively correlated with the mean returns of stock. Chan, Hamao and Lakonishok (1991) reported similar results and showed that stocks with high ratios of book value to market value have high average returns. Explanations for the value premium by Fama and French (1992, 1996) showed that value strategies are fundamentally riskier, so the higher average return on value stocks reflects compensation for bearing this risk. Bhandari (1988) reported a positive relationship between leverage and asset return. Employing leverage as a third factor, along with beta and size, residual return s variability was explained. DeBondt and Thaler (1987) and Jones (1993) attributed contrarian profits to the price reversals which are provoked by market overreaction. On the other hand, momentum was documented by Jegadeesh and Titman (1993). They reported strong momentum profits for the U.S. market. Amihud and Mendelson (1986) were the first to study the role of liquidity and reported that returns increase in case of illiquidity. Hwang and Lu (2007) investigated factors formed on company characteristics and 298 P a g e

3 showed that the market portfolio, Fama French factors, momentum, liquidity and co-skewness explain the stock returns. Sloan (1996) was the first to document accrual anomaly. He investigated whether stock prices reflect information about future earnings contained in accruals and cash flow component and found that investors fail to account for these two components. Fama and French (2008) showed that higher profitability is associated with abnormally higher returns, but there is little evidence that unprofitable firms have unusually low returns. The CAPM anomalies literature has not been fully welcomed by the academicians as they lack a strong theoretical foundation. Also, these results are undermined by problems such as data snooping and sample selection bias. V. ARBITRAGE PRICING THEORY Stephen Ross (1976) developed an alternative theory of asset pricing with no arbitrage argument known as the Arbitrage Pricing Theory (APT). It states that the stochastic process generating security returns is a K-factor linear model. The model seeks to calculate the appropriate price of an asset, taking account of system risks across all class of assets. The APT is based on simpler assumptions and recognizes multiple risk factors thus making it closer to reality. However, APT fails to specify the nature of factors. These risk factors can be macroeconomic in nature, such as, political upheavals, level of interest rates, inflation, and real growth in GDP etc. Alternatively, these can be fundamental factors based on company characteristics like size, BE/ME, leverage etc. The APT is based on less restrictive set of assumptions as compared to CAPM. VI. CHARACTERISTICS BASED MUTIFACTOR MODELS Enormous amount of research in finance has tried to connect company characteristics to asset prices and returns. The aim is to find out the company characteristics that correlate with equity returns and then constructing factor-mimicking portfolios based on these firm characteristics. This empirical approach to develop assetpricing models was introduced by Fama and French. To explain the asset pricing anomalies which are not captured by CAPM, Fama French (1993) developed an empirical model with three factors namely market, size and value. They argued that their multifactor model is consistent with Merton s ICAPM framework (1973) and Ross s APT framework (1976). The Fama French model states that the expected return on a portfolio in excess of the risk free rate is explained by the sensitivity of its return to three factors, firstly the excess return on a broad market portfolio, secondly the difference between the return on a portfolio of small stocks and the return on a portfolio of big stocks (SMB) and third is the difference between the return on a portfolio of high-book-tomarket stocks and the return on a portfolio of low book-to- market stocks (HML), where the last two are mimicking size and value factors respectively. Fama and French showed that their three-factor model captures the cross-sectional variation in stock market returns that are missed by CAPM. The empirical model has evoked overwhelming response amongst investment researchers, posing a challenge to CAPM, as it is a more appropriate tool for corporate finance and investment management decisions. However, the Fama-French model needs to be supported by strong economic foundation. The three-factor model has been able to explain most of the CAPM anomalies. Recent studies have shown that there are patterns in average returns that even the Fama French three-factor model cannot explain. Successive research in this area extended the set of characteristics to 299 P a g e

4 add profitability (Fama and French, 2008), liquidity (Hwang and Lu, 2007), momentum (Jegadeesh and Titman, 1993), leverage (Bhandari, 1988). These models pose a challenge to CAPM and are being extensively used by analysts and researchers for applications in finance. VII. MACRO-ECONOMIC FACTORS BASED ASSET PRICING MODELS Risk factors can be viewed as macroeconomic in nature as it affects the firm s cash flows. Economic conditions such as changes in inflation or real GDP growth may also impact the investment decisions. One particularly influential model was developed by Chen, Roll and Ross (1986), who hypothesized that security returns are governed by a set of broad economic influences. Burmeister, Roll, and Ross (1994) analysed the predictive ability of a model based on different set of macroeconomic factors. Specifically, they define the five risk exposures namely confidence risk, based on unexpected changes in the willingness of investors to take on investment risk. The time horizon risk, which is the unanticipated changes in investors desired time to receive payouts. The inflation risk is based on amalgamation of the unanticipated components of long and short term inflation rates. The next exposure is the business cycle risk which depicts the unexpected changes in the overall level of business activity and last is the market-timing risk which is represented as the part of Standard & Poor s 500 total return that is not explained by the other four macroeconomic variables. Naik (2013) explored the relation between the Indian stock market and five macroeconomic factors, namely, money supply, industrial production index, treasury bills rates, wholesale price index and exchange rates and observed that in the long run, the stock prices are significantly associated to money supply. Sharpe (2002) investigated inflation and stock valuation and found negative relationship between equity valuations and expected inflation. The relationship between stock prices and macroeconomic variables has experienced significant attention in the literature, but with mixed results. Though, various studies has been done to know the impact of the macro-economic variables on the expected stock returns but no conclusive results are obtained as the list of macro-economic factors affecting stock prices kept on varying. VIII. CONCLUSION Although the CAPM is an appealing explanation for the way in which investment risk and expected return are related, empirical anomalies have caused financial economists to seek answers. It is probably safe to assume that both the CAPM and APT will continue to be used to value capital assets. Coincident with their use will be further empirical tests of both theories, the ultimate goal being to determine which theory does the best job of explaining current returns and predicting future ones. Multifactor models of risk and return attempt to bridge this gap by selecting a set of variables that are thought to capture the essence of the systematic risk exposures that exist in the capital market. Subsequent work in this area will seek to identify the set of factors that best captures the relevant dimensions of investment risk as well as explore the intertemporal dynamics of the models. 300 P a g e

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