Analysis of Risk Return Relationship in

Project Report
Analysis of Risk-Return Relationship in

Indian Stock Market
Submitted in partial fulfillment of the requirements for degree of
B.A. (Hons.) Business Economics
By
Abhishek Gupta
(Roll No. - 11078208003)
Atul Panchal
(Roll No. - 11078208012)
Deepak Tiwari
(Roll No. - 11078208016)
Mayank Jain
(Roll No. - 11078208031)
Rahul Malhotra
(Roll No. - 11078208039)
Rohan Yadav
(Roll No. - 11078208041)
Supervisor:
Mr. Abhishek Kumar

Assistant Professor
(University of Delhi)
DECLARATION
This is to certify that the material embodied in the present study entitled Analysis of Risk-Return
Relationship in Indian Stock Market is based on my original learning work and has not been
submitted in part or full time for any other college or degree of the university. Any indebtedness to other
work has been duly acknowledged.
Group Members:
ABHISHEK GUPTA
Project Supervisor:
MR. ABHISHEK KUMAR
(Roll No. - 11078208003)
Assistant Professor
ATUL PANCHAL
(University of Delhi)
(Roll No. - 11078208012)

DEEPAK TIWARI
(Roll No. - 11078208016)
MAYANK JAIN
(Roll No. - 11078208031)
RAHUL MALHOTRA
(Roll No. - 11078208039)
ROHAN YADAV
(Roll No. - 11078208041)
ACKNOLEDGEMENT
It is great pleasure for us to acknowledge the kind of help and guidance received to us during our
research work. We were fortunate enough to get support from a large number of people to whom we
shall always remain grateful.
We sincerely thank Mr. Abhishek Kumar, Assistant Professor (University of Delhi), Person of
amiable personality, for assigning such a challenging project work which has enriched our work
experience and for his extended guidance, encouragement, support and reviews without whom this
project would not have been a success.
CONTENTS
INTRODUCTION..................................................................................................................................................... 1
Indian Stock Market .......................................................................................................................................... 1
Portfolio Theory .............................................................................................................................................. 10
Defining Risks .................................................................................................................................................. 10
Capital Asset Pricing Model ............................................................................................................................. 13
Equity Risk Premium........................................................................................................................................ 16
OBJECTIVE OF THE STUDY ................................................................................................................................... 18
LIMITATIONS OF THE STUDY................................................................................................................................ 18
VARIABLE SELECTION .......................................................................................................................................... 19
LITERATURE REVIEW ........................................................................................................................................... 20
EMPIRICAL ANALYSIS........................................................................................................................................... 25
Part 1 CAPM Validity (Time Series Analysis) ..................................................................................................... 25
Statement Of Hypothesis ............................................................................................................................. 26
Methodology............................................................................................................................................... 28
Results Obtained ......................................................................................................................................... 29
Part 2 CAPM Validity (Cross Sectional Analysis) ............................................................................................... 31
Methodology............................................................................................................................................... 31
Assumption test .......................................................................................................................................... 32
Results Obtained ......................................................................................................................................... 36
Part 3 Equity Risk Premium ............................................................................................................................. 37
Methodology............................................................................................................................................... 37
Part 4 Optimal Holding Period ......................................................................................................................... 46
Methodology............................................................................................................................................... 46
Results and Findings .................................................................................................................................... 49
CONCLUSION ...................................................................................................................................................... 53
DATA SOURCES & REFRENCES ............................................................................................................................. 55
INTRODUCTION
Indian Stock Market
CNX Nifty
The CNX Nifty, also called the Nifty 50 or simply the Nifty, is National Stock Exchange of India's
benchmark index for Indian equity market. Nifty is owned and managed by India Index Services and
Products Ltd. (IISL), which is a wholly owned subsidiary of the NSE Strategic Investment Corporation
Limited.CNX Nifty has shaped up as a largest single financial product in India, with an ecosystem
comprising: exchange traded funds (onshore and offshore), exchange-traded futures and options (at NSE
in India and at SGX and CME abroad), other index funds and OTC derivatives (mostly offshore).
The CNX Nifty covers 22 sectors of the Indian economy and offers investment managers exposure to the
Indian market in one portfolio. Our study has used nifty as representing the market portfolio comprising
of all assets. The CNX Nifty index is a free float market capitalisation weighted index. The index was
initially calculated on full market capitalisation methodology. From June 26, 2009, the computation was
changed to free float methodology.
CNX Bank Index

The CNX Bank Index is an index comprised of the most liquid and large capitalized Indian Banking
stocks. It provides investors and market intermediaries with a benchmark that captures the capital market
performance of the Indian banks. The Index has 12 stocks from the banking sector, which trade on the
National Stock Exchange (NSE).
CNX Bank Index is computed using free float market capitalization method, wherein the level of the
index reflects the total free float market value of all the stocks in the index relative to particular base
market capitalization value. CNX Bank Index can be used for a variety of purposes such as
benchmarking fund portfolios, launching of index funds, ETFs and structured products.
Top 10 Constituents by Weightage
Company' s Name
Weight (%)
HDFC Bank Ltd.
30.52
ICICI Bank Ltd.
28.42
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State Bank of India
11.6
Axis Bank Ltd.
8.71
Kotak Mahindra Bank Ltd.
7.16
IndusInd Bank Ltd.
4.36
Bank of Baroda
2.58
Yes Bank Ltd.
2.15
Punjab National Bank
1.91
Bank of India
0.94
Portfolio Characteristics
Methodology:
Free Float Market Capitalization
No. of Constituents:
12
Launch Date:
September 15, 2003
Base Date:
January 1, 2000
Base Value:
1000
Calculation Frequency:
Real-time Daily
Index Rebalancing:
Semi-Annually
Index PE:
10.99
CNX Energy Index

CNX Energy sector Index includes companies belonging to Petroleum, Gas and Power sectors. The Index
comprises of 10 companies listed on National Stock Exchange of India (NSE).
CNX Energy Index is computed using free float market capitalization method, wherein the level of the
index reflects the total free float market value of all the stocks in the index relative to particular base
market capitalization value. CNX Energy Index can be used for a variety of purposes such as
benchmarking fund portfolios, launching of index funds, ETFs and structured products.

Company' s Name
Weight (%)
Reliance Industries Ltd.
46.32
Oil & Natural Gas Corporation Ltd.
16.25
NTPC Ltd.
10.42
Cairn India Ltd.
6.47
Page | 2
GAIL (India) Ltd.
5.05
Power Grid Corporation of India Ltd.
4.76
Tata Power Co. Ltd.
4.46
Bharat Petroleum Corporation Ltd.
2.94
Indian Oil Corporation Ltd.
1.71
Reliance Power Ltd.
1.62
Methodology:
10
Launch Date:
1-Jul-05
Base Date:
1-Jan-01
Base Value:
1000
Real-time Daily
Index Rebalancing:
Semi-Annually
Index PE:
10.15
CNX Finance Index

The CNX Finance Index is designed to reflect the behavior and performance of the Indian financial
market which includes banks, financial institutions, housing finance and other financial services
companies. The CNX Finance Index comprises of 15 stocks that are listed on the National Stock
Exchange (NSE).
CNX Finance Index can be used for a variety of purposes such as benchmarking fund portfolios,
launching of index funds, ETFs and structured products.
Company' s Name
Weight (%)
Housing Development Finance Corporation Ltd.
24.43
HDFC Bank Ltd.
22.49
ICICI Bank Ltd.
20.94
State Bank of India
8.55
Axis Bank Ltd.
6.41
Kotak Mahindra Bank Ltd.
5.28
Page | 3
IDFC Ltd.
2.24
Shriram Transport Finance Co. Ltd.
1.98
Mahindra & Mahindra Financial Services Ltd.
1.44
1.41
Methodology:
15
Launch Date:
September 7, 2011
Base Date:
January 1, 2004
Base Value:
1000
Real-time Daily
Index Rebalancing:
Semi-Annually
Index PE:
13.02
CNX FMCG Index

The CNX FMCG Index is designed to reflect the behavior and performance of FMCGs (Fast Moving
Consumer Goods) which are non-durable, mass consumption products and available off the shelf. The
CNX FMCG Index comprises of 15 stocks from FMCG sector listed on the National Stock Exchange
(NSE).
Methodology:
10
Launch Date:
September 22, 1999
Base Date:
December 1, 1995
Base Value:
1000
Real-time Daily
Index Rebalancing:
Semi-Annually
Index PE:
37
Page | 4

Company' s Name
Weight (%)
I T C Ltd.
58.85
Hindustan Unilever Ltd.
13.96
United Spirits Ltd.
6.93
Godrej Consumer Products Ltd.
3.29
Dabur India Ltd.
2.91
Colgate Palmolive (India) Ltd.
Tata Global Beverages Ltd.
1.81
United Breweries Ltd.
1.8
Marico Ltd.
1.8
GlaxoSmithkline Consumer Healthcare Ltd.
1.58
CNX IT Index
The CNX IT index provides investors and market intermediaries with an appropriate benchmark that
captures the performance of the Indian IT companies. The CNX IT Index comprises of 20 companies
listed on the National Stock Exchange (NSE).
The CNX IT index is computed using free float market capitalization method with a base date of Jan 1,
1996 indexed to a base value of 1000 wherein the level of the index reflects total free float market value
of all the stocks in the index relative to a particular base market capitalization value. The base value of
the index was revised from 1000 to 100 with effect from May 28, 2004.
Methodology:
20
Launch Date:
Base Date:
January 1, 1996
Base Value:
100
Real-time Daily
Index Rebalancing:
Semi-Annually
Index PE:
21.66
Page | 5

Company' s Name
Weight (%)
Infosys Ltd.
41.31
Tata Consultancy Services Ltd.
27.94
Wipro Ltd.
8.78
HCL Technologies Ltd.
8.22
Tech Mahindra Ltd.
5.61
Oracle Financial Services Software Ltd.
1.84
MindTree Ltd.
1.04
MphasiS Ltd.
0.92
Hexaware Technologies Ltd.
0.79
Vakrangee Software Ltd.
0.62
CNX Metal Index

The CNX Metal Index is designed to reflect the behavior and performance of the Metals sector (including
mining). The CNX Metal Index comprises of 15 stocks that are listed on the National Stock Exchange
(NSE).
Company' s Name
Weight (%)
Sesa Goa Ltd.
19.84
Coal India Ltd.
16.52
Tata Steel Ltd.
16.08
Hindalco Industries Ltd.
12.78
NMDC Ltd.
8.46
Jindal Steel & Power Ltd.
7.99
JSW Steel Ltd.
7.7
Steel Authority of India Ltd.
3.67
Bhushan Steel Ltd.
2.83
National Aluminium Co. Ltd.
1.33
Page | 6
Methodology:
15
Launch Date:
July 12, 2011
Base Date:
January 1, 2004
Base Value:
1000
Real-time Daily
Index Rebalancing:
Semi-Annually
Index PE:
12.75
CNX Pharma Index

CNX Pharma Index captures the performance of the pharmaceutical sector. The Index comprises of 10
companies listed on National Stock Exchange of India (NSE).
Methodology:
10
Launch Date:
July 1, 2005
Base Date:
January 1, 2001
Base Value:
1000
Real-time Daily
Index Rebalancing:
Semi-Annually
Index PE:
45.89

Company' s Name
Weight (%)
Sun Pharmaceutical Industries Ltd.
28.94
Dr. Reddy's Laboratories Ltd.
19.56
Cipla Ltd.
14.23
Lupin Ltd.
13.22
Glaxosmithkline Pharmaceuticals Ltd.
6.69
Glenmark Pharmaceuticals Ltd.
4.82
Divi's Laboratories Ltd.
Ranbaxy Laboratories Ltd.
3.31
Page | 7
Piramal Enterprises Ltd.
2.97
Cadila Healthcare Ltd.
2.27
CNX Auto Index

The CNX Auto Index is designed to reflect the behavior and performance of the Automobiles segment of
the financial market. The CNX Auto Index comprises 15 tradable, exchange listed companies. The index
represents auto related sectors like Automobiles 4 wheelers, Automobiles 2 & 3 wheelers, Auto
Ancillaries and Tyres.
Methodology:
15
Launch Date:
July 12, 2011
Base Date:
January 1, 2004
Base Value:
1000
Real-time Daily
Index Rebalancing:
Semi-Annually
Index PE:
22.72

Company' s Name
Weight (%)
Tata Motors Ltd.
30.24
Mahindra & Mahindra Ltd.
19.26
Bajaj Auto Ltd.
13.5
Hero MotoCorp Ltd.
9.71
Maruti Suzuki India Ltd.
9.1
Bosch Ltd.
4.15
Exide Industries Ltd.
3.01
Motherson Sumi Systems Ltd.
2.35
Eicher Motors Ltd.
1.77
MRF Ltd.
1.75
Page | 8
CNX PSU Bank Index

The CNX PSU Bank Index captures the performance of the PSU Banks. The Index comprises of 12
companies listed on National Stock Exchange (NSE).
Methodology:
12
Launch Date:
August 30, 2007
Base Date:
January 1, 2004
Base Value:
1000
Real-time Daily
Index Rebalancing:
Semi-Annually
Index PE:
5.15

Company' s Name
Weight (%)
State Bank of India
54.48
Bank of Baroda
12.13
8.99
Bank of India
4.42
Canara Bank
4.14
Union Bank of India
3.61
IDBI Bank Ltd.
2.88
Oriental Bank of Commerce
2.32
Allahabad Bank
2.23
Syndicate Bank
1.8
Page | 9
Portfolio Theory
The birth of modern theory of investment can be traced to 1950s when Markowitz developed the
portfolio theory. Before he came up with his theory, investors did not have a concrete measure of risk and
return, although they were not unaware of adages like "don't put all your eggs in one basket." It goes to
the credit of Markowitz that he developed mathematically the concept of diversification. Portfolio means
a mix of assets (both real and financial) invested in and held by an investor. Diversification is the act of
holding many securities to lessen risk. Markowitz proved that if investors balanced their investment
among several securities, it was possible to reduce risk. This possibility of risk reduction emerges if
securities do not move in lock-step fashion. The risk of a portfolio is diversified if stocks added to
portfolio do not co-vary (i.e. move together) too much in concordance with other stocks in the portfolio.
This helps investors constitute portfolios that attain the highest possible expected return for a given level
of risk or minimum risk for a given level of expected return.
The Markowitz's theory is based on the assumption that investors care only about the mean and variance
of return. That is why his theory is also known as mean-variance analysis. The investors are meanvariance optimizer, and therefore, they seek and prefer portfolio with lowest possible return variance for
a given level of mean (expected) return. Simply put, it implies that investors prefer portfolios that
produce greatest amount of wealth with lowest amount of risk. This also suggests that variancedispersion in possible return outcomes is an appropriate measure of risk.
Before moving on to the main topic let us first understand the concept of risk
Defining Risks
The chance that an investments actual return will be less than its expected return is known as risk.
This risk of loss is linked to the expected variability in the investments return. The more volatile an
investments return is, the greater the chance investors will experience a loss
In finance, total risk of investing can be classified in two main groups
Page | 10
1. Systematic Risk
Systematic risk is due to the influence of external factors on an organization. Such factors are
normally uncontrollable from an organization's point of view.
It is a macro in nature as it affects a large number of organizations operating under a similar stream
or same domain. It cannot be planned by the organization.
For example, the risk of higher oil prices is a systematic risk factor.
Higher oil prices affect
transportation costs, which in turn, affects the price of almost everything else in the economy. Higher oil
prices result in losses for car rental firms, trucking firms, shipping firms, and airlines. They cause higher
prices for food (all of which is transported from where it is grown to where it is sold to consumers), and
raw materials for manufacturers which leads to higher prices for finished goods. Since consumers must
pay higher prices for fuel, they have less money to spend on other consumer items which produces losses
for firms supplying these products.
Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the
market as a whole. In other words, beta gives a sense of a stock's market risk compared to the greater
market. Beta is also used to compare a stock's market risk to that of other stocks. Investment analysts use
the Greek letter '' to represent beta. Beta is used in the capital asset pricing model (CAPM), as we
described in the previous section.
Beta is calculated using regression analysis, and one can think of beta as the tendency of a security's
returns to respond to swings in the market. A beta of 1 indicates that the security's price will move with
the market. A beta of less than 1 indicates that the security will be less volatile than the market. A beta of
greater than 1 indicates that the security's price will be more volatile than the market. For example, if a
stock's beta is 1.2, it's theoretically 20% more volatile than the market.
Here is a basic guide to various betas:
Negative beta - A beta less than 0 - which would indicate an inverse relation to the market - is
possible but highly unlikely. Some investors used to believe that gold and gold stocks should have
negative betas because they tended to do better when the stock market declined, but this hasn't proved to
be true over the long term.
Beta of 0 - Basically, cash has a beta of 0. In other words, regardless of which way the market
moves, the value of cash remains unchanged.
Page | 11
Beta between 0 and 1 - Companies with volatilities lower than the market have a beta of less
than 1 (but more than 0).

Beta of 1 - A beta of 1 represents the volatility of the given index used to represent the overall
market against which other stocks and their betas are measured. Nifty is such an index. If a stock has a
beta of 1, it will move the same amount and direction as the index. So, an index fund that mirrors the
Nifty will have a beta close to 1.
Beta greater than 1 - This denotes a volatility that is greater than the broad-based index.
2. Unsystematic Risk
Unsystematic risk has two other names: firm-specific risk and diversifiable risk. Unsystematic risk is the
variability of returns (risk) caused by factors associated with a particular firm. Examples include the risk
of bad or fraudulent management, the risk of a plant fire, a labor strike, or a lawsuit. These risk factors
are not likely to be present in all the firms in a portfolio at the same time. Some firms will have them and
some wont. An investor holding a well-diversified portfolio (investments in firms in different industries
and locations) will not be concerned with unsystematic risk. For example, consider the quality of
management. Some of the firms in a portfolio will have good managers and some will have poor
managers. The net effect on the return of the portfolio will be nil. In effect, investors can diversify away
the risk posed by bad managers. The same is true for the other factors causing unsystematic risk.
Page | 12
Capital Asset Pricing Model

The core idea of CAPM is that only non-diversifiable risk is relevant in the determination of expected
return on any asset. Since the diversifiable risk can be eliminated, there is no reward for bearing it. The
corollary is, no matter how much total risk an asset has, only the non-diversifiable (systematic) portion is
pertinent in determining expected return. For instance, if there are two assets A and B, A has a total risk
(variance) of 40% and a systematic risk of 0.5, B has a total risk of 20% and a systematic risk of 1.5. It is
evident that A has more total risk, while on the contrary, B has more systematic risk. In the world of
CAPM, B rather than A will have higher expected return because A has more unsystematic portion of
risk that can be diversified away. Thus, the total risk (variance) of an asset itself is not an important
determinant of the asset's expected return.
As mentioned earlier the systematic risk is measured by . The coefficient tells us how much
systematic risk a particular asset has relative to a portfolio that contains all assets in the economy.
The portfolio that contains all assets in the economy is called market portfolio. This portfolio plays a
central role in CAPM. The market portfolio is unobservable, and therefore, it has to be proxied by
some index like stock market. Technically speaking, is the covariance of a stock's return with the
return on a market index scaled by variance of that index. It is also measured as slope in the
regression of a stock's return on market.
To derive the risk-return relation depicted by CAPM, let us consider two investments, one in the
Treasury bill and the other in the market portfolio. The investment in Treasury bill has a guaranteed
return, (risk-free return), and contains no systematic risk or has a of 0. The market portfolio
(proxied by index) has a of 1. By definition, is the ratio of covariance to variance. The covariance
of a variable [market portfolio] with itself is the variable's variance
Therefore, of the market portfolio has to be 1. Those who make investment in market portfolio take
average systematic risk, and therefore, require higher return than the Treasury bill. The difference
between the return on market and interest rate is termed as market risk premium. The Treasury bill has a
of 0 and its risk premium is zero. The market portfolio has a of 1 and risk premium RM RF . This
gives two benchmarks for calculating expected returns on any asset in the economy. CAPM predicts that
risk premium varies in direct proportion to . The return between expected return and posited by
CAPM can be stated in the following equation.
Page | 13
Ri=RF + (RM RF)i

Where
Ri= Expected Return on security i

RF= Risk-free interest rate
i = Systematic risk for security i
RM= Expected Return on market portfolio
RM RF= Market risk premium
Above Equation can be interpreted as
Expected return =Price of time + Price of Risk XAmount of Risk

The first expression is the reward for waiting, i.e. delaying consumption without taking risk. It amounts
to investing in Treasury bill, the least risky investment that provides guaranteed return and has a of
zero. The second expression is the reward per unit of risk borne. This component is return required due to
risk.
RM RF is the reward market offers for bearing average systematic risk in addition to waiting. The
amount of systematic risk present in a security is presented by i. Thus, the return on any asset is risk-free
rate plus the multiplied by the market risk premium.
CAPM assumes existence of risk-free asset. Black (1972) derived a more general version of CAPM
in which it is not necessary to assume existence of risk-free asset.
This does not alter the risk-return equation depicted earlier. The only difference is that risk-free return is
replaced with another value Rz expected return of a portfolio with a of zero. This portfolio has no
correlation with the market portfolio. This model is also known as zero- model. CAPM has a variety of
applications. The tools of CAPM are helpful not only for allocation of capital for real investment
(machineries and factories) but also for allocation of funds for financial investment (bonds, stocks, etc).
CAPM can be used for decisions concerning capital expenditure, corporate restructuring, financing,
Page | 14
investment, and evaluation of portfolio performance.
The capital expenditure decisions require estimation of cost of capital (required rate of return) for
discounting of future cash flows. CAPM helps in determination of cost of capital. To calculate the
cost of capital, the model requires three inputs: the stock's , the market risk premium, and risk-free
return.
Basic Assumptions of CAPM

All investors:
1.
Aim to maximize economic utilities.
2.
Are rational and risk-averse.
3.
Are broadly diversified across a range of investments.
4.
Are price takers, i.e., they cannot influence prices.
5.
Can lend and borrow unlimited amounts under the risk free rate of interest.
6.
Trade without transaction or taxation costs.
7.
Deal with securities that are all highly divisible into small parcels.
8.
Assume all information is available at the same time to all investors.
Page | 15
Equity Risk Premium
Equity risk premium is the price or premium which an investor gets for taking risk. It is a key component
into the expected return that we demand for a risky investment. This expected return, is a determinant
of both the cost of equity and the cost of capital. The size of the premium varies with the risk
inclusive in stocks.
The risk in return is usually measured by variance in actual returns around an expected return. So we can
say an investment is risk free when return is equal to expected.
What are the determinants of equity risk premiums? (Source- A. Damodaran)
Risk Aversion
The first and most critical factor, obviously, is the risk aversion of investors in the markets. As investors
become more risk averse, equity risk premiums will climb, and as risk aversion declines, equity risk
premiums will fall. While risk aversion will vary across investors, it is the collective risk aversion of
investors that determines equity risk premium, and changes in that collective risk aversion will
manifest themselves as changes in the equity risk premium. While there are numerous variables that
influence risk aversion, we will focus on the variables most likely to change over time.
a. Investor Age: There is substantial evidence that individuals become more risk averse as they get
older. The logical follow up to this is that markets with older investors, in the aggregate, should have
higher risk premiums than markets with younger investors, for any given level of risk. Bakshi and Chen
(1994), for instance, examine risk premiums in the United States and noted an increase in risk premiums
as investors aged.
b. Preference for current consumption: We would expect the equity risk premium to increase as
investor preferences for current over future consumption increase. Put another way, equity risk premiums
should be lower, other things remaining equal, in markets where individuals are net savers than in
markets where individuals are net consumers. Consequently, equity risk premiums should increase as
savings rates decrease in an economy. Relating risk aversion to expected equity risk premiums is not as
easy as it looks. While the direction of the relationship is fairly simple to establish higher risk aversion
should translate into higher equity risk premiums- getting beyond that requires us to be more
precise in our judgments about investor utility functions, specifying how investor utility relates to wealth
(and variance in that wealth).
Page | 16
Economic Risk
The risk in equities as a class comes from more general concerns about the health and predictability of
the overall economy. Put in more intuitive terms, the equity risk premium should be lower in an economy
with predictable inflation, interest rates and economic growth than in one where these variables are
volatile.
Information
When you invest in equities, the risk in the underlying economy is manifested in volatility in the earnings
and cash flows reported by individual firms in that economy. Information about these changes is
transmitted to markets in multiple ways, and it is clear that there have been significant changes in both
the quantity and quality of information available to investors over the last two decades. During the
market boom in the late 1990s, there were some who argued that the lower equity risk premiums that
we observed in that period were reflective of the fact that investors had access to more information about
their investments, leading to higher confidence and lower risk premiums in 2000. After the accounting
scandals that followed the market collapse, there were others who attributed the increase in the equity
risk premium to deterioration in the quality of information as well as information overload. In effect,
they were arguing that easy access to large amounts of information of varying reliability was making
investors less certain about the future.
Catastrophic Risk
When investing in equities, there is always the potential for catastrophic risk, i.e. events that occur
infrequently but can cause dramatic drops in wealth. Examples in equity markets would include the great
depression from 1929-30 in the United States and the collapse of Japanese equities in the last 1980s. In
cases like these, many investors exposed to the market declines saw the values of their investments
drop so much that it was unlikely that they would be made whole again in their lifetimes. While
the possibility of catastrophic events occurring may below, they cannot be ruled out and the equity risk
premium has to reflect that risk
Page | 17
OBJECTIVE OF THE STUDY

To develop an understanding of the Capital Asset Pricing Model.
To test whether CAPM is valid in Indian Market.
To develop an understanding of Equity Risk Premium.
To test whether the theories for ERP hold same for Indian Market as for U.S.A. Market.
To find out risk & return for 9dominant industries & 2 market Indices of Indian Market.
To calculate ERP for 9 dominant industries of Indian Stock Market individually.
To test the effect of various variables on ERP.
To develop an understanding of the behavior of Risk with duration of Investment.
To find out the best holding (lock in) period for different industries &for Indian Stock Market.
To find out the industry that has given highest return.
To find out the industry that maximizes return in shortest time (holding period).
LIMITATIONS OF THE STUDY

Dividends distributed is totally ignored, therefore the return calculated by us is not perfect.
For CAPM analysis we did a short period analysis i.e. from 2004 to 2009.
For ERP also, data used for India is not for that much longer period as we used for U.S.A.
We took just 7 indices for cross sectional analysis of CAPM
Failure to amount adequately for riskless rate of interest, possible non-linearity in the risk return
relation, and distortion due to heteroscedasticity & other CNLRM assumptions as we did not
provided proof for them.
We jumped to results in case of optimum holding period just by considering simple average
return, which does not provide any kind of surety for receiving the same return and holding period
in future.
Page | 18
VARIABLE SELECTION
This empirical analysis has used particular software like Excel and SPSS and depends on both
availability of data and established statistical criteria that are frequently used in the selection of variables.
The National Stock Exchange Index (Nifty) has been considered as a proxy of the Indian Stock Market
and used to obtain a measure of market price movement of Indian securities since this index is
comprehensive.
To address the objective of this research government Treasury bill and 9 sectors namely auto, bank,
energy, finance, FMCG, IT, metal, Pharma & PSU Banks have been considered. CNX Auto Index has
been used as a proxy to Automobile Sector, CNX bank Index as a proxy to banking sector, CNX Energy
Index as a proxy to Energy Sector, CNX Finance Index as a proxy to financial Sector, CNX FMCG Index
as a proxy to FMCG Sector, CNX IT Index as a proxy to IT Sector, CNX Metal Index as a proxy to metal
sector, CNX PSU Banks Index as a proxy to public sector banks and CNX Pharma Index as a proxy to
Pharma Sector.
The empirical investigation is carried out using monthly data from January, 2004 to October, 2013 which
covers 118 monthly observations of all the sectors mentioned above and of 2 dominant Market Indices
i.e. SENSEX & Nifty. We also used monthly Consumer Price Index for India data from January, 2004 to
October, 2013 to calculate required inflation rate for different periods.
We also used yearly saving rate, ERP, Real interest rate & Inflation data of United States of America
(U.S.A.) from 1961 to 2012 from World Bank site.
Yearly saving rate, Sensex return, Treasury bill rate (365 days), Real interest rate, Gross Domestic
Product & Inflation data of India from 2004 to 2013 from World Bank & Reserve Bank of India site.
Page | 19
LITERATURE REVIEW
Capital Asset Pricing Model
A study by Sharpe and Cooper (1972) generally provided support for a positive relationship between
return and risk, although it was not completely linear. They formed equally weighted portfolio of all
stocks on NYSE dividing them into deciles on the basis of their beta calculated at a point if time using 60
months previous data. Sharpe and Cooper examined the average rate of returns for each of these
portfolios.
Results: they found that generally returns increased with high risk class except for the very high risk
classes where there was a tendency to level off and decline slightly. They also showed that the betas
for the portfolios were stable. Therefore it was possible to derive the average betas and the return
during a subsequent period was generally consistent with the risk.
Jacob (1971) studied the validity of CAPM using 593 stocks of NYSE for which historical data were
used for the entire period of 1946-65. For the purpose of study Jacob divided this period into two subperiods of 1946-55 and 1956-65. Regression analysis was performed using both monthly as well as
yearly return on the securities.
Result: the result shows a significant positive relationship between realized return and risk during
each of the sub-periods. Although the relationship established by the study is all positive they are
weaker than predicted by CAPM.
Lintner (1969) used 301 stocks yearly return as his sample for testing CAPM. He regressed the
yearly return of each stock against the average return of all the stocks included in the sample (using it
as a market proxy), to estimate betas for each security. The first pass regression was of the form:
Rit=it +it RMtit + eit

Where it was the estimate of true of security i.
Lintner then performed the second pass cross-sectional regression of the following form:
Page | 20
Ri = a1 +a2it +a3S2eit + n
2
eitis
Where S
the residual variance (the variance of e) from the first pass regression.
His results seem to violate the CAPM. The term representing the residual risk was statistically significant
and positive. The intercept term was larger than expected while a2 although significant had value slightly
lower than reasonably expected.
Dougles (1969) employed similar methodology as used in Lintner (1969) and found similar results.
Dougles specifically examined the relationship between return and several measures of risk for individual
stocks. In the study he examined both total risk measure as well as systematic component of total risk
relative to return. The results were not consistent with CAPM, intercept was little larger than expected.
More importantly the coefficient of total risk variable was generally significant. Further the coefficient of
systematic risk variable was typically not significant.
Friend and Blume (1971) applied the test of CAPM on 10 portfolios out of NYSE common stocks
formed on the basis of estimated betas of each security. They tested them for three different periods in the
range of 1929-69 (1929-69, 1948-69 and 1956-69). Their results showed strong positive association
between return and beta for the period 1929-69. For the period 1948-69, while higher beta portfolio had
higher return than portfolios with low betas, there was little difference in return among portfolios with
>1. Moreover, the results showed no clear relationship between return and beta for the period 1956-69.
On this basis, they concluded that NYSE stocks with above average risk have higher returns than those
with below average risk but the premium for bearing additional risk on the portfolio composed of stocks
with above average betas was little.
Black, Jensen and Scholes (1972) were the first to conduct an in depth time series test of CAPM. They
took astheir basic time series model. Fitting the above equation on the time series data of the 10
portfolio, formed on the basis of the securities betas, to estimate the beta, intercept and correlation
coefficients for each portfolio, Black, Jensen and Scholes found that it explains the excess return quite
well, thereby lending support to the structure of the linear equation as a good explanation of security
returns. However, there was quite a variation in the intercept from zero. The intercept tend to be negative
when >1 and it tend to be positive when <1. The cross-sectional tests of Black, Jensen and Scholes
provided support for the zero-beta model of CAPM developed by Black, Fisher (1972). In brief, Black,
Page | 21
Jensen and Scholes study provides substantial support for the hypothesis that the realized returns are a
linear function of the systematic return defined by the beta of the security or portfolio. Also, their study
shows that the relationship is significantly positive over long periods of time.
Indian Studies
Gupta and Sehgal (1993) tested CAPM over the period April 1979-March 1989. They employed 30
stocks forming BSE sensitive index and used portfolio method constructing three equally-weighted and
three value-weighted portfolios. They also explicitly addressed questions of non-linearity and the role of
residual risk in explaining returns. They concluded that CAPM did not seem to be a suitable descriptor of
asset pricing in the Indian capital market during the \study period. The risk-return relation over the period
is positive but weak. Madhusoodanan (1997) carried out his testing on a sample of 120 securities traded
on the BSE pertaining to the period January 1987 to March 1995. He used the portfolio technique testing
over several holding periods. In order to check the sensitivity of the result to the choice of index, he
employed both BSE index and NSE index. He did not find any positive relationship between and
return. The maximum risky portfolio gave the minimum return while the minimum risky portfolio
yielded comparably higher return. He suggested that high risk and high return strategy will not be
rewarding in the Indian context and it is better to opt for low stocks. He conjectures that as more
investors tilt their portfolio in favor of low stocks, a much tighter relationship between and return will
emerge. Madhusoodnan's study is not only disturbing for CAPM but also for the efficiency of the Indian
Capital Market. Sehgal (1997) reports that CAPM is not a suitable descriptor of asset pricing on the
Indian capital market for the period April 1994 to March, 1993. He finds the slope negative but
insignificant for the total period, implying absence of any significant relationship between and average
return.
Study by Yalwar, Y B (1988) attempts to test the following hypotheses of the CAPM:
1. Market portfolio explains significantly the variations in the returns on securities and portfolio.
2. Positive relationship between return and risk of securities or portfolio exists.
3. In a cross-sectional regression of expected return against beta, the intercept term is equal to the risk
free rate and the slope coefficient is equal to the market risk premium per unit of systematic risk i.e. RM RF.
Rit - RFt = 1 +b1(RM RF) + eit
Page | 22
If CAPM is valid, a1 is expected to be zero and b1should be statistically significant. The author used a
sample of 122 stocks for which monthly return data for 5 continuous years were available. The study
revealed that, the beta estimate is positive and statistically significant at a significance level of 0.05, a1 was not statistically different from zero for 73 out of the 122 stocks included in the sample. These results
suggested that the market-index was an important explanatory variable to explain the variations in the
returns on securities traded on Bombay Stock Exchange and that CAPM is a good descriptor of active
security returns. To test the hypothesis concerning the return-risk relationships, cross-sectional regression
of the following form was carried out after eliminating the extreme observations observed.
Ri = 0 + 1b1i + e
Where, 0 and 1 are regression parameters.
Positive slope coefficient supported the hypothesis that there exists a positive relationship between return
and risk in Bombay Stock Exchange. Also t-statistics revealed that the estimates of 0 and 1were
statistically were not different from their expected value i.e. average bank return and average excess
return on the market index over average bank rate. Thus, the result indicated that the CAPM was a good
descriptor of security returns in the Indian equities market.
Page | 23
Equity Risk Premium

The main work done in the field of ERP is A. Damodarans work in ERP. His model is also the guideline
for us and helped us lot in making this project. The other works done in this field are as follows:
Bakshi and Chen (1994), for instance, examine risk premiums in the United States and noted an increase
in risk premiums as investors aged.
Lettau, Ludwig son and Wachter (2007) link the changing equity risk premiums in the United States to
shifting volatility in the real economy. In particular, they attribute that that the lower equity risk
premiums of the 1990s (and higher equity values) to reduced volatility in real economic variables
including employment, consumption and GDP growth. One of the graphs that they use to illustrate the
correlation looks at the relationship between the volatility in GDP growth and the dividend/ price
ratio (which is the loose estimate that they use for equity risk premiums).
Brandt and Wang (2003) argue that news about inflation dominates news about real economic
growth and consumption in determining risk aversion and risk premiums. They present evidence
that equity risk premiums tend to increase if inflation is higher than anticipated and decrease when
it is lower than expected. Reconciling the findings, it seems reasonable to conclude that it is not so much
the level of inflation that determines equity risk premiums but uncertainty about that level.
While much of the empirical work on liquidity has been done on cross sectional variation across stocks
(and the implications for expected returns), there have been attempts to extend the research to
look at overall market risk premiums. Gibson and Mougeot (2002) look at U.S. stock returns from
1973 to 1997 and conclude that liquidity accounts for a significant component of the overall equity
risk premium, and that its effect varies over time. Baekart, Harvey and Lundblad (2006) present
evidence that the differences in equity returns (and risk premiums) across emerging markets can be
partially explained by differences in liquidity across the markets.
The Equity Risk Premium Puzzle
While many researchers have focused on individual determinants of equity risk premiums, there is
a related question that has drawn almost as much attention. Are the equity risk premiums that we have
observed in practice compatible with the theory? Mehra and Prescott (1985) fired the opening
shot in this debate by arguing that the observed historical risk premiums (which they estimated at
about 6% at the time of their analysis) were too high, and that investors would need implausibly
high risk-aversion coefficients to demand these premiums.
Page | 24
EMPIRICAL ANALYSIS
This Portion is divided into four parts:-
1. In first, time series data is used to verify CAPM, calculate mean excess return of sectors & nifty & to
calculate betas for different sectors for further analysis.
2. In second, the output from the first part is used to verify CAPM from cross sectional data.
3. In third, relationship between various Variables & ERP is obtained for United States of America (U.S.A.)
& India.
4. In forth, Optimum holding (lock in) period for Indian Stock Market & different sectors is obtained.
Part 1 CAPM Validity (Time Series Analysis)
Time Series Analysis

A time series is a sequence of data points, measured typically at successive points in time spaced at
uniform time intervals. Examples of time series are the daily closing value of the Dow Jones Industrial
Average and the annual flow volume of the Nile River at Aswan. Time series are very frequently plotted
via line charts. Time series are used in statistics, signal processing, pattern recognition, econometrics,
mathematical finance, weather forecasting, earthquake prediction, electroencephalography, control
engineering, astronomy, and communications engineering.
Time series analysis comprises methods for analyzing time series data in order to extract meaningful
statistics and other characteristics of the data.
Descriptive Statistics
Descriptive statistics provides simple summaries about the sample and about the observations that have
been made. Such summaries may be either quantitative, i.e. summary statistics, or visual, i.e. simple-tounderstand graphs. These summaries may either form the basis of the initial description of the data as
part of a more extensive statistical analysis, or they may be sufficient in and of themselves for a particular
investigation.
Page | 25
Descriptive Statistics
Return
Mean
Std. Deviation
Variance
Covariance
Excess_auto
64
0.296694
9.311588225
86.705675
48.83594541
Excess_bank
64
1.073299
12.6614555
160.31246
79.91402061
Excess_Energy
64
0.617695
9.624748707
92.635788
59.57133867
Excess_finance
64
1.170846
12.31653647
151.69707
80.20788658
Excess_FMCG
64
0.403208
7.504852227
56.322807
24.64266302
Excess_IT
64
-1.54762
14.26039793
203.35895
59.74401173
Excess_Metal
64
1.455102
14.88836932
221.66354
92.6659727
Excess_Pharma
64
-0.14573
8.139090261
66.24479
30.01475517
Excess_PSU
64
0.981596
13.15009769
172.92507
76.02589683
Excess_Nifty
64
0.571192
8.904230241
79.285316
79.28531618
CAPM Model:
RP = RF + (RM RF)
RP - RF= (RM RF)
Excess RP= (Excess RM)
Statement Of Hypothesis
Null Hypothesis
All sectors (FMCG, Pharma, Auto, Energy, IT, PSU banks, banking, financial and metal) have no
independent returns and their excess returns are totally dependent on market excess returns. Here
measures the independent return and which is a measure of systematic risk shows the movement of
industry returns with market returns
This means
Page | 26
Ho : FMCG= 0
Ho : PHARMA = 0
&
Ho : PHARMA = 0
&
Ho : AUTO = 0 &
Ho : ENERGY = 0
Ho : FMCG = 0
Ho : AUTO = 0
Ho : ENERGY = 0
&
Ho : IT = 0
&
Ho : PSU_BANKS = 0
&Ho : PSU_BANKS = 0
Ho : BANK = 0 &
Ho : IT = 0
Ho : BANK= 0
Ho : FINANCE = 0
&
Ho : FINANCE = 0
Ho : METAL = 0
&
Ho : METAL = 0
Alternate Hypothesis
HA : FMCG 0
HA : PHARMA 0
HA : AUTO 0
HA : ENERGY 0
&
&
Ho : FINANCE 0
HA : METAL 0
HA : AUTO 0
HA : ENERGY 0
&
HA : PSU_BANKS 0
HA : BANK 0
HA : PHARMA 0
&
HA : IT 0
HA : FMCG 0
&
HA : IT 0
&
HA : PSU_BANKS 0
&
&
&
HA : BANK 0
HA : FINANCE 0
HA : METAL 0
Page | 27
Methodology
As per the CAPM, risk free securitys return has no sensitivity to market rate of return. It means of risk
free security is 0.
So, before moving ahead with our analysis we have checked the correlation of TB return (proxy of risk
free return) with Nifty return (proxy of market portfolio) and the result is 0.11. We know from our
statistical understanding that correlation below 0.3 is considered very weak, which allow us to use TB
return as risk free return.
Now we have calculated the excess return of our 9 industry indices and our market portfolio Nifty. For
calculating the excess return we have subtracted Treasury bill monthly return from our respective index
monthly return.
In this part, monthly data of excess return of an index lets say CNX Auto index is regressed with the
monthly data of excess return on Nifty and then this process is repeated by regressing other indices with
monthly data of excess return on Nifty.
For CAPM to hold, should not be statistically significant and (which measures the sensitivity of
portfolio with market portfolio) should be statistically significant.
Conditions to satisfy CAPM

1.
First and foremost the value of should not be statistically different from 0.
2.
The value of should be positive and should be statistically different from 0.
We obtain the following results after regressing the excess industry return with excess market return
Return
Beta
P-Value ()
Alpha
P-Value ()
R2
Excess_FMCG
0.311
0.00
0.226
0.80
0.136
Excess_Pharma
0.379
0.00
-0.362
0.70
0.172
Excess_Auto
0.616
0.00
-0.055
0.95
0.347
Excess_Energy
0.751
0.00
0.189
0.83
0.483
Excess_IT
0.754
0.00
-1.978
0.22
0.221
Excess_PSU
0.959
0.00
0.434
0.73
0.422
Excess_bank
1.008
0.00
0.498
0.66
0.502
Excess_finance
1.012
0.00
0.593
0.58
0.535
Excess_Metal
1.169
0.00
0.788
0.56
0.489
Page | 28
As we can observe from the above table that the p-value of s (slope coefficient) are close to 0 and pvalue of s are very high. These findings are consistent with our model.
Also we have calculated R2 (Coefficient of Determination)after running the regression.
In statistics, the Coefficient of Determination denoted R2 and pronounced R squared, indicates how well
data points fit a line or curve. It is a statistic used in the context of statistical models whose main purpose
is either the prediction of future outcomes or the testing of hypotheses, on the basis of other related
information. It provides a measure of how well observed outcomes are replicated by the model, as the
proportion of total variation of outcomes explained by the model.
In short, R2measures how much variation in excess return of our industries (dependent variable) is
explained by excess return on market portfolio(dependent variable).
Summarizing the above results
(At 5% Level Of Significance)

Return
Beta
Alpha
Excess_FMCG
Significant
Insignificant
Excess_Pharma
Significant
Insignificant
Excess_Auto
Significant
Insignificant
Excess_Energy
Significant
Insignificant
Excess_IT
Significant
Insignificant
Excess_PSU
Significant
Insignificant
Excess_bank
Significant
Insignificant
Excess_finance
Significant
Insignificant
Excess_Metal
Significant
Insignificant
Results Obtained
1. The in all regression has p-value greater than 0.20 and this implies that the value of is not
statistically different from zero, and
2. All the values of are positive and has p-value equals to 0. This implies that for every sector the value
of is significant
Page | 29
Inference
Thus, in above analysis both the conditions of CAPM are satisfied and we can say that the CAPM can be
used in Indian stock market to evaluate the return on security/portfolios.
In this model Excess return of market (Reward for bearing risk of 1) and the portfolios or risk are the
most significant determinants of the return on any portfolio.
Page | 30
Part 2 CAPM Validity (Cross Sectional Analysis)
Cross Sectional Data

Cross-sectional studies (also known as cross-sectional analyses, transversal studies, prevalence study)
form a class of research methods that involve observation of all of a population, or a representative
subset, at one specific point in time. They differ from case-control studies in that they aim to provide data
on the entire population under study, whereas case-control studies typically include only individuals with
a specific characteristic, with a sample, often a tiny minority, of the rest of the population.
In this we make use of the results of the above analysis and data for different sectors.
Similar CAPM equation is tested in this part, as used in above part, which is,
CAPM Model:
RP = RF + (RM RF)
RP - RF= (RM RF)
Excess RP= (Excess RM)
But with little changes,
Mean(Excess RP) = (Mean(Excess RM))
Methodology
In Part 1, we calculated the Excess Monthly Return of all 9 industries and market representative index
Nifty.
For cross sectional analysis, we have calculated average of excess return of all 9 industries and Nifty
index.
For this analysis mean of expected return , total variance in returns of different sectors and (obtained in
Part 1) of different sectors is used as data , but the data for CNX FMCG and CNX IT sectors are not used
because of their extreme characteristics.
By following the above process we obtained 7 observations showing average of excess return of different
industries along with of different industries.
Page | 31
Then mean returns of 7 sectors is regressed with their respective s , to get a equation like,
Mean(Excess Rp)i = 1 + 2i
Here,
1 represents independent return of industry portfolio
2 represents the excess market return
Now for CAPM to hold (in Cross Sectional Data), 1should be 0 and 2which shows the excess return on
market portfolio should be statistically different from 0.
So stating the above conditions again, CAPM will hold if
1.
1 should not be statistically different from 0, so that all the returns should be explained by
only. Or in other words 1 should be insignificant.

2.
2 should be statistically significant and should be equal to mean of excess RM .
Now after regressing average of excess monthly return of 7 industries (Pharma, auto, energy, PSU banks,
banks, finance and metal) with their respective s, we got the following results.
P-Value(1)
P-Value(2)
R2
Adjusted R2
-0.925
0.00
2.023
0.996
0.996
The p-value of 1and 2 is very low and close to 0.

Now from the above regression we obtain the following results
1.
1 is statistically significant and different from 0.
2.
2 is also statistically significant. Also it is different from mean of excess RM (0.57).
Thus CAPM model does not hold in cross sectional analysis with any significant effect. But in this
analysis also our model is significant with R2 of 0.996, and the i significantly explain the return in any
portfolio although not exactly in the manner explained by the CAPM.
Assumption test
According to CAPM model (Systematic Risk) is the main determinant of excess return on any portfolio.
Although total risk in investing any security, is the sum total of systematic and unsystematic risk. But
Page | 32
CAPM says that unsystematic risk can be reduced by diversifying our portfolio. So it is the systematic
risk which explains excess return on any security.
To test the above assumption we have regressed average of excess monthly return of 7 industries
(Pharma, auto, energy, PSU banks, banks, finance and metal) by taking different independent variables:
The results of the above regressions are summarized in the table below:
Regression
1
Dependent
Independent
Variable
Variable(s)
Mean Of Excess
Return
Of Time Series
Mean Of Excess
Of Time Series,
Return
Total Risk(2)
Mean Of Excess
Return
Mean Of Excess
Return
Total Risk(2)
P-Value
( 1 )
-0.093
0.00
-0.094
0.00
P-Value
2 ,3
(2, 3)
2.023
0.00
2.101,0.
0.00,0.
000
661
Adjusted R2
0.996
0.995
-0.49
0.089
0.009
0.002
0.848
-0.51
0.361
0.017
0.046
0.50
-0.913
0.00
2.078,-
0.00,
0.001
-0.484
Residual
Variance/
Unsystematic Risk
Mean Of Excess
Of Time Series,
Return
Residual Variance
0.995
Note:-1 Constant Term (Measures Independent Return of a portfolio)

2 Coefficient of Independent Variable 1
3 Coefficient of Independent Variable 2
Page | 33
Regression 1:
Mean Of excess return of each industry was regressed with s of these industries (obtained in part 1).It
should be kept in mind that measures the systematic risk of investing in a particular security/portfolio.
1and 2 were statistically significant. Although the above findings are inconsistent with the model. But
taking into account adjusted R2, explains 99.6% of variation in our dependent variable.
Regression 2:
Mean Of excess return of each industry was regressed with s of these industries (obtained in part 1) and
variance of excess monthly return of the industries. It should be noteworthy that 2 (variance) is the
measure of total risk.
1and 2 were statistically significant but 3 was statistically insignificant.
By increasing on more independent variable (Total Risk) adjusted R2has fallen.
Page | 34
Regression 3:
Mean Of excess return of each industry was regressed with variance of excess monthly return of the
industries. This is done to check whether the total risk, independently, explains the total return better than
or not.
1was statistically insignificant but 2 was statistically significant.
Thus, looking at adjusted R2we can say that total risk only explains 84.8% variation in our dependent
variable. By comparing this with 99.6 % (adjusted R2 for regression 1), we can say that is more relevant
than 2(variance).
Page | 35
Regression 4:
Mean Of excess return of each industry was regressed with residual variance of excess monthly return of
the industries. It should be kept in mind that residual variance is a measure of unsystematic risk i.e risk
which can be reduced with diversification.
1was statistically significant but 2 was statistically insignificant.
Thus, looking at adjusted R2we can say that residual variance only explains 50% variation in our
dependent variable.
Regression 5:
Mean Of excess return of each industry was regressed with s of these industries (obtained in part 1) and
residual variance of excess monthly return of the industries.
1and 2 were statistically significant, and 3 was insignificant.
Adjusted R2 was 99.5% .and thus only because of introducing in this regression, our model was
significant. And residual variance has insignificant presence in our model.
Results Obtained
1.
Thus, CAPM does not seem to work when we use cross-sectional data. One of the possible
reasons for this vague outcome could be the small sample size of 7 that we have used.
2.
Looking at our regression results we can conclude that is the best measure of risk which
explains the risk-return relationship. In nutshell, we can say that cross sectional analysis does not verify
Capital Asset Pricing model equation but it explains CAPM general theory very well i.e. explains the
excess return but with a different framework/equation.
Page | 36
Part 3 Equity Risk Premium
Methodology
To see the relationship between ERP and various factors we have taken data of US of last 50 years. For
saving rate and ERP we have simply collected data of US for 50 years from World Bank site and showed
correlation between them. For ERP and volatility in real interest rate of US, we made group of 6 years of
total time period. Then we have checked volatility in real interest rate for that period by taking standard
deviation, and we have taken average of ERP by taking geometric mean. The rationale behind taking
geometric mean instead of arithmetic mean is that ERP of different years are correlated and we are need
compounded return while arithmetic mean gives simple return. Also arithmetic mean may tend to
overstate the mean.
To see relationship between volatility in inflation and ERP of US similar procedure is done as done with
real interest rate.
In case of India we have no data available of ERP so we have to calculate ERP by-.
ERP= return in economy- risk free return
For calculating return in economy we have checked percentage change in price of stock market (for this
we have took Sensex price). After this we have subtracted risk free return i.e. return on Treasury bill from
this return to get ERP.
After calculating ERP we have simply shown the relationship between saving and ERP.
To see relation between volatility in inflation and ERP in India we have divide the period in group of 3
years. Then we have calculated the standard deviation of each of the group as a measure of volatility, and
then showed the correlation with ERP.
A similar kind of method is done for relation between volatility in interest rate and ERP in India. But
here we have divided the time period in 4 year group. And then found the standard deviation in real
interest rate. We also tried to find any relation between inflation and ERP.
Page | 37
ERP OF DIFFERENT INDUSTRIES IN INDIA

We have calculated the ERP paid by different industries in India to compare their performance. For this
we have taken group of 5 years to calculate ERP of these industries per year. The reason behind taking
group of 5 years is that ERP gives good result in long run.
For calculating ERP we need return of these industries over the period which we are considering that is
2004-2013. Then we made group of 5 years in this time period like: 2004-09, 2005-10, 2006-11, 200712, and 2008-13. After grouping we calculated return in these industries based on the change in prices of
its stock (we have taken Sensex price).
For example Return (2004-09) = (closing price of 2009 closing price of 2004)/ closing price of 2004
After calculating the return its the time to find risk free return. For this we have taken government
Treasury bill rate.
ERP= Return in these industry government T-bill rate
Selecting risk free return

A major job in calculating ERP is selecting risk free return. For this we selected T-bill yield. And check
its correlation with overall return of economy. If there is very little correlation between return in
economy and government yield then we can select this yield as risk free return.
For calculating return in economy we have taken change in price of Sensex as our measure. And after
regressing the risk free return and Sensex return we have R2= 0.015, which means little or no correlation
so we can select our government yield as risk free return.
T-Bill Return & Economic Return

T-Bill Rate (365 days)
9
8
7
6
5
4
3
2
1
0
-60
-40
-20
y = 0.004x + 6.296
R = 0.011
20
40
60
80
Sensex Return
Note: Since we have given the annual yield on these T-bill we have adjusted these T-bill yields according
to inflation taking year 2004 as base.
Page | 38
Results
1. Relationship between Volatility in interest rate & ERP
Volatility in Intrest Rate & ERP(US)
y = 0.999x + 1.413
R = 0.292
ERP
4
3.5
3
2.5
2
1.5
1
0.5
0
0
0.2
0.4
0.6
0.8
1.2
1.4
1.6
1.8
Standard deviation of interest rate
We have shown earlier that there is positive relationship between volatility in interest rate and ERP,
because higher volatility means higher risk. Thus the above graph is showing the positive relation
between ERP and volatility. So we can infer the relationship between ERP and volatility in interest rate
for U.S.A. but intercept and slope, both are not statistically significant.
Volatility in Intrest Rate & ERP(India)

100
y = -17.33x + 64.17
R = 0.055
80
ERP
60
40
20
0
-20
0.5
1.5
2.5
Standard deviation of interest rate
But this relationship does not hold in case of India. Also intercept & slope, both are not statistically
significant.
Page | 39
2. Relationship between Saving Rate & ERP

y = -0.086x + 4.241
R = 0.077
Saving Rate (US)

6
5
ERP
4
3
2
1
0
0
10
15
20
25
Saving Rate
Since we have earlier shown that the relation between saving rate and ERP is negative. And same is
reflected through our graph of U.S.A. Here intercept is statistically significant and slope is not
statistically significant.
But this relationship does not hold for India. Here in this case we find that both intercept term and slope
are not statistically significant.
Saving Rate (India)

80
y = 4.116x - 115.2
R = 0.204
60
40
ERP
20
0
-20 0
10
15
20
25
30
35
40
-40
-60
-80
Saving Rate
Page | 40
3. Relationship between Volatility in Inflation & ERP
The relation between ERP and volatility of inflation is positive. Higher the fluctuation, higher will be the
ERP. And same result is shown by our graph for U.S.A. also in this case the intercept term is statistically
significant and the slope term is not statistically significant.
Volatility in Inflation & ERP (US)

ERP & Volatility in Inflation
4
3.5
3
2.5
2
standard deviation of inflation
1.5
average ERP
1
0.5
0
1961
1967
1973
1979
1985
1991
1997
2003
2009
The relation between ERP and volatility of inflation in US is not that clear by X-Y coordinate because
points are quite scattered. But graph line shows the correct relationship between ERP and average.
Page | 41
Volatility in Inflation & ERP(India)

200
y = -7.776x + 56.72
R = 0.006
150
ERP
100
50
0
0
0.5
-50
1.5
2.5
This relation does not hold with India and both the terms, intercept and slope are not statistically
significant.
ERP & Volatility in Inflation
Volatility in Inflation & ERP(India)

200
150
100
50
ERP
0
-50
1997.2
2003
2006
2009
2012
time period
Page | 42
4. Relation between Inflation & ERP

y = 6E-05x + 2.533
R = 2E-08
Inflation & ERP (US)

6
5
ERP
4
3
2
1
0
0
10
Inflation
From the above graph it is clear that there is no relation between inflation and ERP. The intercept and
slope both are statistically not significant for both of the countries.
Inflation & ERP (India)
y = -4.413x + 35.84
R = 0.080
80
60
40
ERP
20
0
-20
-40
-60
-80
Inflation
Page | 43
5. ERP of different industries in India
200
150
banking
auto
energy
100
finance
fmcg
50
it
metal
0
2004-06
2006-08
2008-10
2010-12
2012-13
pharma
psu
-50
-100
Source: World Bank & CNX Index
Year
2004
2005
2006
2007
2008
2009
2010
2011
2012
GDP
7.8
9.2
9.2
9.8
3.8
8.4
10.5
6.3
3.2
Source: World Bank
Here from the above graph it can be infer that in 2004-06, which was period of high economic growth,
when GDP was about 9.2 in both year 2005 and 2006. There was also huge capital formation in the
economy especially in private capital formation.
While during 2006-08 GDP was equal to 9.8 in 2007 but there was drastic fall in GDP in 2008 i.e. 3.8
when global economies were suffering from crisis, thus ERP of these industries also fell down.
Again in 2008-10 when Indian economy was coming back again at the path of restructuring, ERP of
these industries again started rising. But again in the period of 2010-13 ERP of these industries start
falling and become quite volatile.
Page | 44
The other important point that can be infer from the graph above is that almost all industries in India have
paid volatile return in this period. Only pharmaceuticals are the only industry which has paid always
positive and constant return. The possible reason could be that demand of pharmaceuticals products is
least elastic.
Inference
Analysis of our Indian economy gave inverse relationship between ERP and its variables that what it
gave for U.S.A. & what we expected. Major reason behind such inverse relationship in case of India is
that Indian stock market is not that much organized as the U.S.A. Market i.e. Indian stock market is not a
proper indicator of economys health, thats why the earlier Analysis of our Indian economy gave inverse
relationship for India.
Page | 45
Part 4 Optimal Holding Period
In this section we will try to find out best holding (lock in) period for investing in Equity Market. Our
focus will be to check whether it is good to invest for shorter period or one should invest for longer
period to maximize returns.
We will also find out the industry which gives the maximum return and the optimum holding periods
within different industries.
Methodology
We have calculated return for different holding periods for Sensex & other 9 dominant industries indices
that we used in earlier two parts ( CNX Parma , CNX auto , CNX energy , CNX PSU banks, CNX banks
, CNX finance, CNX FMCG , CNX metal and CNX IT) from 2004 onwards.
We have calculated the annual return of all 10 indices for 1 month holding period by subtracting
M1(month1) closing price from M2(month2) closing price & dividing the result by M1. Then we
multiplied the result by 1200 to get the annual return. Following the same process we calculated the
return till October, 2013.
i.e. Annual Return(1 month holding period) =
( ) ( )
1200
( )
Similarly for calculating annual return for investing for 2 months we used the following formula
Annual Return (2 months holding period)=
( ) ( )
( )
Following the above logic

Annual Return (3 months holding period) =
( ) ( )
( )
( ) ( )
( )
( ) ( )
( )
Page | 46
( ) ( )
( )
( ) ( )
( )
( ) ( )
( )
( ) ( )
( )
( ) ( )
( )
( ) ( )
( )
( ) ( )
( )
( ) ( )
( )
( ) ( )
( )
( ) ( )
( )
Page | 47
Annual Return(108 months holding period) =
( ) ( )
( )
( ) ( )
( )
( ) ( )
( )
( ) ( )
( )
( ) ( )
( )
( ) ( )
( )
( ) ( )
( )
( ) ( )
( )
Then we calculated average return & standard deviation for different holding periods for each of the 10
indices.
Page | 48
We also calculated inflation rate for each of these holding periods by using monthly CPI data from 2004
onwards till October 2013. We use the same methodology to compute inflation rate for different holding
periods which we used to find return. i.e. To calculate the annual inflation rate for 1month holding
period we subtracted CPI1 (Consumer price index of 1st month taken in consideration of 2004) value
from CPI2 (Consumer price index of 2nd month taken in consideration of 2004) value & divided the
result by CPI1. Then we multiplied the result by 1200 to get the annual inflation rate for 1 month holding
period. Similarly we calculated the inflation rate p.a. till October, 2013 for each 1 month holding period.
Similarly to calculate the annual inflation rate for 108months holding period we subtracted CPI1
(Consumer price index of 1st month taken in consideration of 2004) value from CPI109 (Consumer price
index of 109 month taken in consideration from 2004) value & divided the result by CPI1. Then we
multiplied the result by 100/9 to get the annual inflation rate for 108 month holding period. Similarly we
calculated the inflation rate p.a. 2013 for every holding period till October 2013.
Now for calculating inflation adjusted returns for each holding period for each of the indices we
subtracted the corresponding inflation rate calculated for each of the holding period from annual returns
calculated above.
We also took a reinvestment assumption at 7% so we discounted each of the average holding period
return for each of the indices to get the inflation adjusted discounted rate of return.
Results and Findings
1) Risk Analysis
We observed that together with the increase in the holding period the standard deviation of returns have
decreased. Which suggest that, in holding period of shorter span there is more risk as compared to the
risk in holding periods of larger span. In other words with the increase in holding period risk (s.d.)
decreases.
Page | 49
Standard Deviation
Holding
Sensex
period
Auto
Banking
sector
sector
Energy
Finance
FMCG
IT
Metal
Pharma
PSU
bank
1 month
89
106.42
133.74
98.96
127.73
76.88
140.96
161.33
84.88
145.31
2 months
67.3
77.78
99.7
71.04
96.92
55.02
104.74
122.96
61.68
106.78
3 months
56.88
69.34
83.71
58.05
82.46
45.2
88.62
110.51
51.36
88.44
4 month
51.2
64.56
71.57
50.3
71.6
39.44
80.18
100.85
46.39
74.59
5 months
47.2
62.16
62.94
45.59
63.83
36.17
75.23
93.11
41.99
65.1
6 months
43.85
60.54
57.77
42
58.96
33.05
68.72
87.77
39.07
59.55
7 months
40.79
57.43
53.13
38.61
54.25
29.89
63.61
81.58
36.69
54.73
8 months
38.26
56.15
48.76
35.87
50.22
28.59
59.22
77.98
34.02
50.41
9 months
35.97
53.89
45.19
33.53
46.72
27.45
56.06
75.51
32.34
46.92
10 months
34.24
52.22
42.43
31.54
43.75
26.62
53.19
72.79
30.92
43.8
11 months
32.76
49.85
39.75
29.66
40.78
26.12
50.39
69
29.21
41.34
12 months
31.55
48.31
37.9
28.3
38.91
25.58
48.05
67.5
27.83
39.35
5 quarters
29.26
43.47
33.95
25.35
35.7
23.36
41.88
60.71
23.01
35.92
6 quarters
28.81
41.75
33.63
23.53
35.56
23.09
38.63
53.45
20.4
36.47
7 quarters
28.17
40.16
29.83
21.71
31.78
21.45
36.47
51.51
17.3
30.75
8 quarters
27.39
36.13
26.11
21.06
28.26
18.76
33.25
51.29
15.6
27.22
3 years
24.44
22.34
20.27
20.19
24.77
13.37
20.33
41.37
14.59
18.51
4 years
16.3
18.66
15.49
15.6
18.39
12.44
15.53
36.99
13.13
15.41
5 years
14.44
10.84
13.17
13.96
15.71
8.62
11.22
30.09
12.34
14.47
6 years
14.97
12.5
15.64
11.37
17.77
9.12
11.77
30.84
7.96
18.29
7 years
10.63
10.37
11.77
6.63
12.2
7.93
10.48
22.67
8.9
13
8 years
5.02
5.35
8.9
2.89
9.19
9.82
11.82
11.61
7.27
9.46
9 years
4.27
6.14
3.06
6.22
12.46
17.53
4.9
5.31
5.39
2) Optimal Holding Period

By calculating the inflation adjusted returns we observed that: On an average the maximum return for a holding period of up to 5 years for most of the industries was
obtained between 9-12 months of holding period which means there is no additional advantage of locking
the money in stock market for more than 1 year till 5 years.
FMCG industry which has provided 52.11% return annually for holding period of 9 years, followed by
finance industry providing 32.59% annual return for 9 years of holding period.
Page | 50
Inflation Adjusted Annual Returns

Holding
Sense
Auto
Banking
period
sector
sector
1 month
8.28
12.37
2 months
8.4
3 months
PSU
Energy
Finance
FMCG
IT
Metal
Pharma
12.43
2.89
13.21
12.65
-0.98
9.71
10.16
8.5
12.6
12.99
3.64
13.93
12.99
0.15
12.03
10.06
9.09
8.48
12.97
13.07
3.42
14.26
13.42
0.48
12.96
10.21
8.35
4 month
8.83
13.58
13.23
3.36
14.66
13.91
0.54
14.58
10.93
8.04
5 months
9.65
14.43
13.44
3.5
15.13
14.61
0.91
16
11.37
7.98
6 months
10.28
15.53
14.39
4.2
16.17
15.32
2.31
17.42
11.66
9.03
7 months
10.58
15.94
14.65
4.46
16.52
15.68
3.41
17.94
12
9.4
8 months
10.81
16.59
14.82
4.59
16.77
16.07
4.15
18.45
12.06
9.66
9 months
10.88
17.13
15.21
4.82
17.19
16.54
4.78
19.18
12.12
10.03
10 months
11.07
17.69
15.57
4.91
17.55
16.94
5.07
19.58
12.31
10.43
11 months
11.15
18.04
15.85
4.97
17.85
17.38
5.26
19.72
12.25
10.84
12 months
11.13
18.27
15.82
4.98
17.88
17.58
5.55
19.82
12.1
10.83
5 quarters
11.03
18.26
15.14
4.77
17.54
17.84
5.89
18.92
11.29
10.26
6 quarters
11.09
18.88
15.12
4.68
17.71
18.19
6.25
18.25
10.54
10.56
7 quarters
11
19.16
14.24
4.7
17
17.94
6.34
19.02
9.69
9.59
8 quarters
10.76
18.51
13.32
4.74
16.24
17.55
5.75
19.82
9.8
8.89
3 years
9.27
15.27
14.07
5.49
17.41
16.01
2.27
20.31
11.94
10.11
4 years
6.42
14.79
13.79
4.67
16.64
16.63
0.81
20.08
12.84
11.06
5 years
5.34
13.43
12.47
3.22
14.94
16.65
-0.51
16.29
14.67
10.55
6 years
8.21
17.43
17.84
4.51
21.52
21.16
-0.29
22.11
15.21
14.53
7 years
9.77
19.5
19.25
3.35
23.82
26.17
-0.23
17.67
18.43
11.72
8 years
13.01
25.63
20.4
2.83
26.35
39.38
-0.02
11.21
17.25
9.25
9 years
16.92
29.48
26.41
2.88
32.59
52.11
-3.36
8.52
26.01
8.93
Banks
By calculating the discounted annual return at assumption of reinvestment at 7%, we observed that: On an average the optimization holding period is 11 months for most of the indices.
Metal sector is the one which has provided the highest optimized return followed by Auto sector.
Page | 51
7% Discounted Annual Returns

Holding
Sens
Auto
Banking
period
ex
sector
sector
1 month
8.23
12.3
2 months
8.3
3 months
Energy
Finance
12.36
2.88
13.14
12.45
12.84
3.6
8.33
12.75
12.85
4 month
8.63
13.26
5 months
9.37
6 months
9.93
7 months
FMC
PSU
IT
Metal
Pharma
12.58
-0.97
9.65
10.1
8.46
13.76
12.84
0.15
11.89
9.94
8.98
3.36
14.01
13.18
0.47
12.74
10.03
8.21
12.93
3.28
14.33
13.59
0.53
14.24
10.68
7.86
14.02
13.05
3.4
14.7
14.19
0.88
15.54
11.04
7.75
15
13.9
4.05
15.62
14.79
2.23
16.82
11.26
8.72
10.15 15.31
14.06
4.28
15.86
15.06
3.27
17.22
11.52
9.02
8 months
10.31 15.84
14.14
4.38
16.01
15.34
3.97
17.62
11.51
9.22
9 months
10.33 16.26
14.43
4.57
16.31
15.7
4.53
18.21
11.5
9.52
10 months
10.45 16.69
14.69
4.63
16.56
15.99
4.78
18.47
11.61
9.84
11 months
10.46 16.92
14.86
4.66
16.74
16.31
4.94
18.5
11.49
10.17
12 months
10.38 17.04
14.75
4.64
16.68
16.4
5.18
18.49
11.28
10.1
5 quarters
10.11 16.74
13.88
4.37
16.08
16.35
5.4
17.34
10.35
9.4
6 quarters
9.98
17.01
13.62
4.21
15.95
16.38
5.63
16.44
9.49
9.51
7 quarters
9.73
16.96
12.61
4.16
15.05
15.88
5.61
16.83
8.58
8.48
8 quarters
9.4
16.17
11.63
4.14
14.18
15.33
5.02
17.31
8.56
7.76
3 years
7.57
12.47
11.48
4.48
14.21
13.07
1.85
16.58
9.75
8.26
4 years
4.9
11.28
10.52
3.57
12.69
12.68
0.62
15.32
9.8
8.43
5 years
3.81
9.58
8.89
2.3
10.65
11.87
-0.36
11.62
10.46
7.52
6 years
5.47
11.61
11.89
3.01
14.34
14.1
-0.19
14.73
10.13
9.68
7 years
6.09
12.15
11.99
2.09
14.83
16.3
-0.14
11.01
11.48
7.3
8 years
7.57
14.92
11.87
1.65
15.34
22.92
-0.01
6.52
10.04
5.38
9 years
9.2
16.04
14.37
1.56
17.73
28.34
-1.83
4.63
14.15
4.86
Banks
Page | 52
CONCLUSION
Analysis of Risk-return relationship on Indian Stock Market showed that CAPM is satisfied in time series
analysis. So, we can say that the CAPM can be used in Indian stock market to evaluate the return on
security/portfolios. Which also suggest that Excess return of market (Reward for bearing risk of 1) and
the portfolios or risk are the most significant determinants of the return on any portfolio. CAPM does
not seem to work when we use cross-sectional data. One of the possible reasons for this vague outcome
could be the small sample size of 7 that we have used. Looking at our regression results we can conclude
that is the best measure of risk which explains the risk-return relationship. In nutshell, we can say that
cross sectional analysis does not verify Capital Asset Pricing model equation but it explains CAPM
general theory very well i.e. explains the excess return but with a different framework/equation.
Lets talk about the consistency of our CAMP analysis results with past studies:Indian Studies: - Our time series analysis results seem to be inconsistence with the studies performed by
Gupta and Sehgal, Madhusoodanan, and Sehgal. They come out with the results that the CAPM
model is not a good descriptor of asset pricing in the Indian capital market and the risk return relationship
was significantly weak in India. And similarly, our result of cross sectional analysis was inconsistence
with Y B Yalwar, whose results support the CAPM in cross sectional analysis.
But our time series analysis is consistent with Y B Yalwar time series analysis, with both showing
positive and strong relationship of risk and return.
International studies: -Black, Jensen and Scholes found that beta explains the excess return quite well
with a linear relationship, thereby lending support to the structure of the linear equation as a good
explanation of security returns and thus, were consistence with our result. Although Sharpe and Cooper,
and Jacob also show positive relationship but their results shows a weak relationship than ours.
Our regression 5 in cross sectional analysis is similar to Linter, but our results are not the same. He
found that residual variance has significant impact on return which was inconsistent with the CAPM
model but our result shows that residual variance is insignificant thereby is consistence with the CAPM.
Our results explicitly shows that the systematic risk is a sole determinant of return and including any
other form of risk only decreases the adjusted R2 instead of increasing it.
Analysis of our Indian economy gave inverse relationship between ERP and its variables that what it
gave for U.S.A. & what we expected. Major reason behind such inverse relationship in case of India is
Page | 53
that Indian stock market is not that much organized as the U.S.A. Market i.e. Indian Stock Market is not
a proper indicator of economys health, thats why the earlier Analysis of our Indian economy gave
inverse relationship for India. Also data available for India was for shorter period and relation of ERP
holds good in long run.
Lettau, Ludwigson and Wachter attribute that that the lower equity risk premiums of the 1990s (and
higher equity values) to reduced volatility in real economic variables including employment,
consumption and GDP growth. Similar results we have got for our data of US. High volatility in
economy gives higher high ERP.
One other major conclusion that can be drawn here is that the ERP of industries is dependent upon GDP
of country when GDP raises ERP of these industries also rises.
Studies that look at the relationship between the level of inflation and equity risk premiums find little or
no correlation. In contrast, Brandt and Wang (2003) argue that news about inflation dominates
news about real economic growth and consumption in determining risk aversion and risk
premiums. While when we tried to show relation between inflation and ERP we have not found any
relation among them.
We observed that together with the increase in the holding period the standard deviation of returns have
decreased. Which suggest that, in holding period of shorter span there is more risk as compared to the
risk in holding periods of larger span. In other words with the increase in holding period risk (s.d.)
decreases. By calculating the inflation adjusted returns we observed that, on an average the maximum
return for a holding period of up to 5 years for most of the industries was obtained between 9-12 months
of holding period which means there is no additional advantage of locking the money in stock market for
more than 1 year till 5 years of holding period. By calculating the discounted annual return at assumption
of reinvestment at 7%, we observed that, on an average the optimization holding period is 11 months for
most of the indices, so, 11 months of holding period is the optimum holding period for Indian Stock
Market. Metal sector is the one which has provided the highest optimized return in the shortest time
followed by Auto sector.
Page | 54
DATA SOURCES & REFERENCES

Yahoo finance: -
http://finance.yahoo.com/
BSE India: -
http://www.bseindia.com/
NSE India: -
http://www.nseindia.com/
World Bank: -
http://data.worldbank.org/
IMF:-
http://www.imf.org/external/index.htm
RBI: -
http://www.rbi.org.in/
For Consumer price Index: -
http://labourbureau.nic.in/indtab.html
The Capital Asset Pricing Model: Empirical Test of BSE Sensex Companies, by Manish Kumar,
Department of Commerce, University of Delhi, 2010.
The Capital Asset Pricing Model: Theory and Evidence, by Eugene F. Fama and Kenneth R. French,
Journal of Economic PerspectivesVolume 18, Number 3Summer 2004Pages 2546.
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