Comparing Capital Asset Pricing And Arbitrage Pricing Theory

Investment and portfolio selection decisions are made on a regular basis in the daily routines of investment managers, financial managers of companies, mutual fund managers as well as by individual investors themselves. Selecting an investment or a portfolio of investments is a very important and tough decision because it not only involves estimating the expected value of the securities in the form of return but also requires the decision maker to make a reasonable assessment of risk entailed in the process. This gives rise to the great importance that is attributed to asset pricing theories in the literature of Finance, Financial Management, Investment and Portfolio Management and other related disciplines.

Asset pricing theories have long been a source of intrigue for academicians, researchers and practitioners alike. Although the history of these theories dates back to a few hundred years ago, the very first notable theory was proposed by Harry Markowitz. Markowitz theory is sometimes also called the “mean – variance model” because he represented return as mean while risk was represented as the variance. He proposed that investors acting rationally make a diversified portfolio of securities in order to minimize their risk and maximize their returns for a certain period. (Markowitz, 1952)

This theory by Markowitz marked the beginning of a long string of asset pricing theories proposed by a number of researchers. Most of these theories discussed the mechanics of risk and return and examined various ways in which risk could be minimized for a certain level of return or return could be maximized for a certain level of risk. In simplest words, we can say that these theories deal with the concept of risk-return trade-off in investment decisions.

First such theory based on Markowitz portfolio theory was Capital Asset Pricing Model (CAPM), which was proposed almost simultaneously by three researchers, Sharpe, Lintner and Mossin (Sharpe, 1964) (Lintner, 1965) (Mossin, 1966). This is a relatively simple model which suggests that there is a linear relationship between return and risk of an asset or a portfolio of assets. It is a one factor model which posits that return of an asset or a portfolio of assets can be assessed or measured by one factor, i.e. the beta (β) of that asset which is a measure of non diversifiable risk of the asset. Immediately after it was proposed CAPM became a target of intensive scrutiny and debate among researchers. Since almost three decades, this model has been subjected to rigorous testing and retesting where it has been approved and validated by some while rejected by others. Some researchers have even used its altered and more improved forms to try to decrease the problems encountered due to its oversimplifying assumptions.

A major alternative to the capital asset pricing model (CAPM) is arbitrage pricing theory (APT) proposed by Ross in 1976. Arbitrage pricing theory as opposed to CAPM is a multifactor model suggesting that expected return of an asset cannot be measured accurately by taking into account only one factor, i.e. the asset beta. Instead APT suggests that there are a number of factors at work that can help explain variance in return of assets thus giving us a measure of the assets’ risk. These factors include various macroeconomic variables like inflation, growth in GDP (gross domestic product), political stability or instability etc (Ross, 1976).

Reasons or objectives for choice of industry and topic of research

The industry that I have chosen to work in is the stock market because:

Personal:

Firstly, investment is an important field of study in my area of specialization i.e., Finance and to study investment one must have sound knowledge of the workings of stock markets. Working in this area will help me apply the theoretical knowledge, that I gain in classroom as well as through reading, in a practical manner and also enrich my knowledge of the field.

Professional:

Secondly, stock market can be rightly called the index of economic activity in a country. It is the place where companies can get listed to trade their stocks and raise money to finance and expand their business operations. At the same time it gives a platform to institutional as well as individual investors to invest their excess money and gain from their investment. Karachi stock exchange being the largest of the three stock markets in Pakistan is the hub of its investment activities, and therefore proves very good choice to study the behavior of stock returns in Pakistan as has already been done by many researchers.

Through this study I intend not just to enrich my knowledge but also to help future investors and decision makers make better informed decisions while making investment choices.

Research Objectives

Can capital asset pricing model (CAPM) be applied to Pakistani stock market (i.e. Karachi Stock Exchange, KSE)?

Does CAPM succeed in explaining the behavior of stock returns in KSE? Does CAPM hold true in KSE

Can arbitrage pricing theory (APT) be applied to Pakistani stock market (i.e. Karachi Stock Exchange, KSE)?

Does APT succeed in explaining the behavior of stock returns in KSE? Does APT hold true in KSE?

Are the results of the two theories comparable, if yes what does this comparison reveal?

Is one theory proved to be better than the other in explaining stock return behavior?

Literature Review

While making investment decisions, financial managers, mutual fund managers as well as individual investors tend to go for the asset or a portfolio of assets that gives high return for a certain level of risk, or poses low risk for a certain level of expected return. Therefore, a constant trade-off between risk and return has to be made during the selection process of any investment or investment portfolio.

Asset pricing theories help us determine risks of assets and provide us a framework to associate risks of assets with their expected returns. A multitude of theories and models have been presented to relate the risk and return of various assets to help practitioners in selecting investment portfolios. Since all of these models exhibit some limitations therefore these are still under constant scrutiny of researchers so that the existing shortcomings can be identified and overcome.

Although the history of study of risk-return trade-off in investments and asset pricing theories goes back a long time, the first notable theory was proposed by Harry Markowitz (Markowitz, 1952). Markowitz model was based on a number of assumptions and it gave a formula for calculating the variance of an investment portfolio assuming that variance in the return of a portfolio is a measure of its risk. Among other assumptions, this theory of asset pricing considered the investor’s behavior for only one investment period. Markowitz model is often also known as “mean – variance model” because it assumes that risk averse investors try to select a portfolio of investments in such a manner that will minimize their portfolio’s risk and maximize its return for a certain period of time. (Fama & French, 2004) This theory not only highlighted the importance of diversification to reduce risk but also suggested how to effectively diversify.

Markowitz theory is important in this discussion because it is the forerunner of those asset pricing models that we intend to study in this research. Another theory namely capital market theory was developed based on Markowitz portfolio theory which led to the development of Capital Asset Pricing Model (CAPM). This is one of the most widely used and extensively studied models of modern portfolio theory to date.

CAPM was proposed almost simultaneously by William Sharpe (Sharpe, 1964), John Lintner (Lintner, 1965) and Jan Mossin (Mossin, 1966). The capital asset pricing model proposed by Sharpe and Lintner is called Sharpe-Lintner CAPM and is depicted as follows:

“(Sharpe – Lintner CAPM)

E (Ri) = Rf + [E (Rm) – (Rf)] βim ……