Ample work has been done on pricing asset due to its vital importance in finance literature. Several researches have been conducted in the area of pricing stock prices Harry Markowitz (1952) gave portfolio theory in his research “portfolio selection”, Sharpe (1964) and Lintner (1965) introduced capital asset pricing model, Sharpe was awarded with noble prize for his work on capital asset pricing model, Stephen A. Ross (1976) came up with arbitrage pricing theory which is much flexible in comparison to portfolio theory and capital asset pricing model because it can incorporate many factors for the purpose of asset pricing . In this chapter of study some theories related to asset pricing and researches conducted based on those theories have been discussed.

PORTFOLIO THEORY

Harry Markowitz (1952, 1959 portfolio selection) introduced the model for portfolio. Markowitz stated two stages of portfolio selection he said that first stage initiates from examination and practice and finishes with views about the potential performance of available securities. The second stage initiates from the relevant views about the potential performance of securities and finishes at the selection of portfolio. Focus of markowitz study was the second stage of portfolio selection. Model developed by markowitz works on the mechanism of expected rate of return and expected risk of portfolio. Markowitz

Proved that variance of the rate of return is sensible measure of risk. Markowitz also proposed the formula for the purpose of calculating risk. Markowitz demonstrated that how to diversify efficiently to minimize the total risk of portfolio in order to maximize returns.

Ray ball and Philip brown (1969) conducted study on “portfolio theory and accounting”. The purpose of this study was to prove that portfolio theory can be implemented on several areas of accounting such as capital budgeting, divisional planning and reporting and external reporting. According to author, the application of portfolio theory on capital budgeting has vital role because the rate of return is dependant on the risk associated with the project so the same rate of return on every projects can not be applied. Author beliefs that portfolio theory has several applications on divisional planning and reporting because different rates of return are required for the different divisions so the portfolio theory applies that rate of return in analyzing divisional performance should be according to the extent of volatility against the different economic effects. As far as question of external reporting is concerned it is also connected to portfolio theory because the prediction about the risk and future performance of firm is conducted through the current and past information.

Lindon J. Robinson and John R. Brake (1979) investigated the implementation of portfolio theory on farmer and lender behavior. This study evaluate the formation of portfolio theory and its later application as a farm-planning model under uncertainty. As a monetary model, the assumptions and limitations seem satisfactory: production is linear, asset selections are commonly dividable, and the inconsistency is on the price side. But as a farm-planning instrument, portfolio models appear to be less applicable because production is not linear, asset selections are rarely totally dividable, and inconsistency on the output side is at least as significant as inconsistency on the price side. Yet, as an experimental instrument, it seems better compared to earlier well-liked linear programming models.

This study also evaluated concisely more than a few uses of portfolio theory in agricultural economics. They attended to explain portfolio selections along expected value frontiers and permitted costless changeover from one portfolio to another and from one asset to another. Author disputed on this generalization which pays no attention to a necessary consideration of the investment (chq). The two ideas are same and when their effects are included in a portfolio model, they considerably decrease the economic inducement for portfolio review. Other addition to portfolio theory which author suggested was:

1. Incorporating the value of non deterministic returns in meeting non deterministic cash needs (liquidity risk considerations)
2. Value of firm wealth in generating credit should be accounted and incorporating as a cost.

Finally, authors noticed that unused credit was valuable to a firm, but they found no simple approach to find out its value or best favorable use.

Paul L. McEntire (1984) the theory of independent asset. The notion of the generalized harmonic mean was brought in and was revealed to be the analogue to the risk free rate of return for issues without a risk-free asset. After that, a new ordering theorem was confirmed for portfolio issues with independent assets showing that the mean value of any asset incorporated in an most favorable portfolio is more than or equal to the mean value of any asset which is not incorporated. This theorem is an expansion of Samuelson’s findings, which shows that the asset with the highest mean value is always incorporated.

The other major findings involve the no dependency from unrelated alternatives property.

A utility function satisfies this property if, for any three independent assets A, B and C:

Harry markowitz (1991) discussed the foundation of portfolio theory. He wrote that he got the concept of portfolio theory while he was studying the theory of investment value by Williams. According to Williams theory price of stocks can be calculated by getting the present value of future inflows of dividends. Since the dividends are not certain so markowitz considered the value of stock calculated by future inflows of dividends as an expected value. He added that if investors are looking for the expected value of stocks so they must be also looking for the expected value of portfolio as well in order to maximize their return and minimize risk. Markowitz said that it was clear that investors were interested in risk and return. He selected variance of the portfolio as a measure of risk.

Being an economic student he thought that investor would select the portfolio where he could earn maximum/optimal return at a particular variance from different portfolios.

With the passage of time he kept on adding some details into this idea of portfolio selection. He acknowledges the efforts of sharpe, blume, kings and Rosenberg in clarifying the problem of covariance calculation.

Then markowitz raised the question that if mean and variances were the sufficient criteria for the purpose of portfolio selection?

In order to answer this question he took the support from the theory of rational choice under uncertainty and concluded that investor should be concerned about maximizing returns. In addition in order to answer the raised question he quoted the results of various

researches conducted and concluded that the theory of rational choice under uncertainty can be still helpful to give more approaches. It can give additional satisfactoriness of mean and variance or any other useful measures as criteria.

On the basis of Harry Markovitz (1959) portfolio theory the well known asset pricing model called CAPM was built. The portfolio model gives a numerical state, if asset’s mean-variance are given then the portfolio having minimum risk and maximum return is called efficient portfolio. The CAPM makes this numerical statement a testable calculation about the association between risk and expected return by recognizing a portfolio that must be efficient if asset prices are to clear the market of all assets.

CAPITAL ASSET PRICING MODEL

William sharpe (1964) and john lintner (1965) gave very first theory of asset pricing known as CAPM (Capital Asset Pricing Theory).CAPM is the expansion of portfolio theory which allows the pricing of all risky assets. Sharpe (1964) and Lintner (1965) put two more assumptions in portfolio theory in order to recognize mean-variance efficient portfolio First assumption is “Investor agrees on joint distribution of asset returns from t-1 to t. and The second assumption is that there is borrowing and lending at a riskfree rate, which is the same for all investors and does not depend on the amount borrowed or lent.

According to this theory, beta employed to calculate stock market volatility should indicate the investors’ calculation of stock’s future in relation to market risk. For the purpose of estimating betas historical data is used. If there is a consistency in historical betas then investor can use historical betas for estimating future volatility.

Long time has not been passed that two problems were noticed.

1. Estimates of beta individual securities/asset are not consistent which result in measurement error problem when used to describe average returns.
2. The regression residuals have common sources of variation, such as industry effects in average returns. Positive correlation in the residuals produces downward bias in the usual ordinary least squares estimates of the standard errors of the cross-section regression slopes.( to be discussed with sir AND REVIEWED)

As far as the question of beta steadiness is concerned. Robert levy, Marshall blume(1970), Black, Jensen, and Scholes (1972), and many others have conducted studies on this question. Robert levy estimated betas for both individual securities and portfolios and found no consistency in betas of individual stock on the other hand betas of portfolios were found consistent. The study of blume and others also supports these findings.

Fama and MacBeth (1973) came up with the solution for the problem of correlation of the residuals in cross-section regression. They suggested that rather than estimating a single cross section regression of average monthly returns of betas, month by month cross-section regressions of monthly returns should be estimated.

Basu (1977) in his study “Investment Performance of Common Stocks in Relation to Their Price Earnings Ratios: A Test of the Efficient Market Hypothesis.” Confirmed that when common stocks are arranged in the basis of price earning ratios. Returns on stocks having high price earning ratios are greater then the returns estimated by CAPM.

Banz (1981) investigated “The Relationship between Return and Market Value of Common Stocks.” Banz (1981) incorporated firm size effect in his study and confirmed that when stocks are arranged on the basis of market capitalization. Average returns on stocks having little market capitalization is greater than the returns estimated by the CAPM.

Bhandari (1988) conducted study on “Debt/Equity Ratio and Expected Common Stock Returns: Empirical Evidence.” Purpose of study was to incorporate debt/equity ratio for the calculation of common stock returns and confirmed that there is the relation between debt to equity ratio and expected common stock returns. Study verified that common stocks having high debt to equity ratios have very high returns in comparison to market betas.

Statsman (1980) worked on “Book Values and Stock Ret