ACOMPARATIVE EMPIRICAL INVESTIGATION OF THE VALIDITY OF THE TRADITIONAL CAPM, THE HIGHER-MOMENT CAPM AND THE DOWNSIDE RISK BASED CAPM IN THE EMERGING EQUITY MARKET OF PAKISTAN

Abstract

Though there is plethora of asset pricing models proposed to explain the cross-section of asset returns, however, these models require ideal perfect conditions which are grossly present in developed markets of the world. The present study aims to investigate the empirical validity and comparative performance of the traditional capital asset pricing model (CAPM), the higher- moment CAPM and the downside risk based CAPM in explaining the cross section of stock returns in the emerging equity market of Pakistan. Given the acclaimed theoretical supremacy of the downside risk based CAPM it is expected to perform better at explaining the cross-section of stock returns in the Pakistani equity market, i.e. KSE. For empirical analysis, this study uses the Fama-MacBeth methodology (Fama & MacBeth, 1973). Accordingly a sample of 313 stocks from 30 different sectors listed on the Karachi stock exchange is used to form portfolios and the KSE100 index is used as a proxy for the market portfolio. Monthly data on all the variables was obtained over sample period July 2000 to June 2011. The six month’s Treasury bills rate is used as a proxy for the risk free rate. Time series regression and cross sectional regression techniques are used for empirical analysis in line with the Fama-MacBeth methodology. To overcome the problem of heteroskedasticity in the cross sectional regression, the models are estimated using two alternative techniques; white heteroskedasticity-consistent standard errors and covariance matrix and generalized least squares (GLS). Further the traditional CAPM and the higher- moment CAPM are also estimated in the conditional form using generalized autoregressive conditional heteroskedasticity (GARCH) model. The findings of the present study on the empirical validity of the traditional CAPM, the higher- moment CAPM and the downside risk based CAPM are mostly mixed and inconclusive. This implies that though the downside risk based CAPM may have a stronger theoretical background; however, empirically it performs no differently than the traditional CAPM and higher-moment CAPM in explaining the cross section of stock returns in the KSE. In the empirical estimation of all the models, the intercept terms has been mostly found to be statistically insignificant which evidences the absence of consistent mispricing at the KSE over the sample period. This finding is consistent with the underlying theories of the traditional CAPM, the higher-moment CAPM and the downside risk based CAPM which state the hypothesis that the intercept term should be xvistatistically insignificant. The findings of the study suggest that there is no statistically significant risk premium for systematic risk as defined in traditional CAPM, higher-moment CAPM and the downside risk based CAPM over the full and sub-sample periods. However, the unconditional systematic risk in the traditional CAPM has been found to positive and statistically significant over the sub-sample period of July 2007 to June 2009 using GLS as estimation technique. The findings of the present study show that co-skwness and co-kurtosis risks are mostly insignificantly priced in conditional and unconditional form over the full and sub-sample periods. However, over the sub-sample period of June 2007 to July 2009, the unconditional co- skewness risk is negatively and statistically significantly priced, using white heteroskedasticity- consistent standard errors and covariance matrix in the cross-sectional regression, which is consistent with the theory of higher-moment CAPM. The co-skewness risk has also been shown to be marginally statistically significantly (at 10 percent) and correctly priced over the full sample period using the three moment specification using white heteroskedasticity-consistent standard errors and covariance matrix. The findings also revealed that co-kurtosis risk is positively and statistically significantly priced over the sub-sample periods of July 2003 to February 2006 and July 2003 to June 2005 using GLS as estimation technique in the cross sectional regression. Based on the major findings of the present study, it is concluded that there is lack of substantive evidence to validate any of the competing asset pricing theories i.e. the traditional CAPM, the higher-moment CAPM and the downside risk based CAPM in the KSE. Hence it may be implied that the KSE is an inefficient equity market and does not provide a fair risk-return trade-off. It implies that any diversification based on the underlying theory of any of the asset pricing models investigated in the present study may result in poor investment performance and losses. Investors should give more attention to obtain and analyze information that is adequate, accurate and timely. The stock markets in Pakistan should be demutualized to reduce the role of insider trading, private information as well as speculation and manipulation of the market by few influential market players. For future research the market micro-structure may be considered and investigate to explain the cross-section of stock returns in the KSE.