Content area
Full Text
Abstract
The arbitrage pricing theory (APT) has been proposed as an alternative to the capital asset pricing model (CAPM). This paper uses principal components analysis to estimate the factors that influence stock returns. Analysis of the Indian stock market using monthly and weekly returns for 1991-2002 shows that APT with multiple factors provides a better indication of asset risk and estimates of required rate of return than CAPM which uses beta as the single measure of risk.
Key Words : Asset Pricing; CAPM, APT, Principal Components Analysis
JEL Classification : G12
Introduction
The Capital Asset Pricing Model (CAPM) is widely accepted as an appropriate technique for evaluating financial assets. It is used to construct portfolios, measure the performance of investment managers, develop project screening rates for capital budgeting, and value companies. Betas are calculated and displayed by the National Stock Exchange, Bombay Stock Exchange, leading investment related web sites and journals. The Arbitrage Pricing Theory (APT) which offers an alternative explanation of the relationship between risk and return is yet to receive widespread acceptance in India.
The objective of this study was to compare the CAPM and APT using principal components analysis. This paper briefly reviews the relevant literature and presents evidence that APT may lead to better estimates of risk and expected rate of return than CAPM.
CAPM and APT
Prelude
CAPM has been tested extensively, for over three decades, in various forms primarily in developed capital markets and to some extent in developing markets. Early work in this area including Black, Jenson and Scholes', Fama and McBeth2 and Blume and Friend3 supported the standard and zero beta model of CAPM. However Banz4, Reinganum5, Gibbons6, Shanken7 and Fama and French8, highlighted the danger of focusing exclusively on meanbeta space. These studies found that the return generation process also depends on other variables like size, book to market ratio and earnings price ratio.
In the Indian context Dhankar9, used the CAPM to compute risk adjusted cost of capital for public sector undertakings and to measure their performance. There have also been a number of studies which investigated the linearity, slope and intercept of the security Market Line, with varying results. Some including Yalawar10, Obaidullah & Mohanty11, Dhankar12, Ghosh" and Vipul'4, concluded that evidence...