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A RESEARCH REPORT
ON
Submitted By
THIMMARAYAPPA.S.M
(REGD.NO:04XQCM 6111)
Under the Guidance and Supervision
Of
PROF. B.V.RUDRA MURTHY
Declaration
I hereby declare that this report titled “Risk factors in Indian capital
market” is a record of independent work carried out by me, towards the partial
Institute of Management. This has not been submitted in part or full towards any
other degree.
PLACE: BANGALORE
DATE: THIMMARAYAPPA.S.M
Principal’s Certificate
This to certify that this report titled “Risk factors in Indian capital
market” have been prepared by THIMMARAYAPPA.S.M bearing the
registration no.04 XQCM 6111 under the guidance and supervision of PROF.
Date: (Dr.N.S.Malavalli)
GUIDE’S CERTIFICATE
This is to certify that the Research Report entitled “Risk factors in Indian
capital market”, done by THIMMARAYAPPA.S.M bearing Registration
No.04 XQCM 6111 is a bonafide work done carried under my guidance during
the academic year 2005-06 in a partial fulfillment of the requirement for the
award of MBA degree by Bangalore University. To the best of my knowledge this
report has not formed the basis for the award of any other degree.
ACKNOWLEDGEMENT
Finally, I express my sincere gratitude to all my friends and well wishers who
helped me to do this project.
THIMMARAYAPPA.S.M
TABLE OF CONTENTS
CHAPTER PARTICULARS
ABSTRACT
1. INTRODUCTION
CAPM (capital asset pricing model).
CAPM in Indian context.
CAPM and Indian stocks.
Criticisms of CAPM
Back ground of the study
2. REVIEW OF LITERATURE
Risk factors in developing capital markets: Lakshman alles & Louis
Murray
Structural change and asset pricing in emerging markets: Rene Garcia,
Eric Ghysels
Distributional characteristics of emerging markets returns and asset
allocation: Geert Bekaert, Claude B. Erb, Campbell R, Harvey and Tadas
E. Viskanta.
Skew ness preference and the valuation of the risk assets:
Alan Kraus & Robert H Litzenberger
Equilibrium in an imperfect market: A constraint on the number of
securities in the portfolio : Haim Levy
Common risk factors in the returns on stocks and bonds:
Eugene F. Fama & Kenneth R .French
Tests of the Fama and French model in India: Gregory Connor and Sanjay
Sehgal
Relationship between return and market value of common stocks: Rolf w
Banz
3. METHODOLOGY
Problem statement
Objectives of the study
Scope of the study
Limitations of the study
Data
Sources of data
Period of study
Sample
Sample size
Statistical procedure
Back ground of regression
Hypothesis
Scatter diagrams
4 DATA ANALYSIS
5 CONCLUSION
GLOSSARY & BIBLIOGRAPHY
LIST OF TABLES
1 Showing return, beta, variance and skew ness for the year 2002.
2 Showing return, beta, variance and skew ness for the year 2003.
3 Showing return, beta, variance and skew ness for the year 2004.
4 Showing return, beta, variance and skew ness for the year 2005.
Abstract
This project addresses the question as to whether the Capital Asset Pricing Model
(CAPM) offers an appropriate explanation of stock returns in the Indian capital markets.
The question is whether the CAPM is appropriate, given potential relevance of
unsystematic risk of market distortions, thin trading and its related effects on market
price. Arguments for considering additional factors like variance, skew ness in pricing
models to better deal with such situations are presented. Using BSE 100 stock returns
data for financial years 2002 to 2005, a series of empirical tests examine whether these
factors, in a cross sectional regression model, offer a statistically significant explanation
of company returns.
Introduction
Capital asset pricing model always referred to as CAPM, is one of the most
popular model used for in applications, such as estimating the cost of the capital for firms
and evaluating the performance of the managed portfolios. It is the center piece of MBA
investments courses. The attraction of the CAPM is that it offers predictions about how to
measure risk and the relation between expected return and risk.
The CAPM builds on the model of portfolio choice developed by Harry Markowitz
(1959). Sharpe (1964) and Lintner (1965) add two key assumptions to the Markowitz
model to identify a portfolio that must be mean-variance-efficient.
The first assumption is, given market clearing asset prices at t-1, investors agree
on the joint distribution of asset returns from t-1 to t. And this distribution is the true one,
that is, the distribution from which the returns we use to test the model are drawn.
The second assumption is that there is borrowing and lending at a risk free rate,
which is the same for all investors and does not depend on the amount borrowed or lent.
The set of assumptions employed in the development of the CAPM are follows:
1. Investors are risk-averse and they have a preference for expected return and a
dislike for risk.
3. Investors behave in a normative sense and desire to hold a portfolio that lies
along the efficient frontier.
4. There exists a risk less asset and investors can lend or invest at the risk less rate
and also borrow at this rate in any moment.
5. All investments are perfectly divisible. This means that every security and
portfolio is equivalent to a mutual fund and that fractional shares for any investment can
be purchased in any amount.
9. Capital markets are in equilibrium. That is, all investment decisions have been
made and there is no further trading without new information.
According to CAPM
1. The risk of the project is measured by beta of the cash flow with respect to the
return on the market portfolio of all assets in the economy.
2. The relation between the required expected return and the beta are linear
E (Ri) = Rf + [E (RM)-Rf] β IM
Where,
An asset exhibits both systematic and unsystematic risk. The portion of its
volatility which is considered systematic is measured by the degree to which its returns
vary relative to those of the overall market. To quantify this relative volatility, a
parameter called beta was conceived as a measure of the risk contribution of an
individual security to a well diversified portfolio:
Where,
RA is the return of the asset.
Rm is the return of the market.
In simple words beta is the ratio of the expected excess return of an asset relative
to the overall market’s excess return, where excess return is defined as the return on any
given asset less the return on a risk-free asset.
In practice, beta is calculated using historical returns for both the asset and the
market, with the market portfolio being represented by a broad market index like nifty
index, bse index, nifty junior etc.
One of the important outcomes of the CAPM assumptions is that all investors
hold a portfolio which is a combination between risk less portfolio and market portfolio.
This is because all investors will have identical efficient frontiers due to the assumption
of homogeneous expectations. They can however have different utility functions, which
will decide what combination of risk less portfolio and market portfolio the investor will
choose. This implies that all investors hold the same combination of risky securities
namely, the market portfolio. This is also known as the separation theorem.
The market portfolio in CAPM is the unanimously desirable risky portfolio which
contains all risky assets. Thus return on market portfolio is weighted average of return of
all risky assets in the market and in theory it should contain, besides ordinary shares, all
assets, like art objects, commodities, real estates and so on.
The total risk of a portfolio can be measured by the variance of its return. In a
more general situation of a portfolio p consists of n shares and any individual share i has
a weightage of Xi in the portfolio, then the total risk can be expressed as follows:
If CAPM holds, then investors should hold diversified portfolios and the
systematic risk or non-diversifiable risk will be the only risk which will be of importance
to the investors. The other part of the risk, known as the diversifiable risk or unsystematic
risk will be reduced to nil by holding a diversified portfolio. Thus beta, which is a
measure of the non-diversifiable risk in a portfolio, is most important for investors, from
the point of view CAPM theory.
In case the CAPM holds in the market, an investor will no longer require any
sophisticated portfolio selection technique to select his portfolio. He will choose a mix
between risk-free rate and the market portfolio based on his utility function.
In other words optimal investment decision will be simply to buy the market
portfolio. This investment decision is independent from the decision about how to finance
the investment i.e. whether to lend or borrow at the risk-free rate. Ideally, if CAPM holds,
there will not be any identifiable inefficiency in the market and all securities will lie on
the security market line.
The graphic relationship between expected return on asset i and beta is called the
security market line. If CAPM is valid, all securities will lie in a straight line called the
security market line in the E(R), βi frontier. The security market line implies that return is
a linearly increasing function of risk. Moreover, only the market risk affects the return
and the investor receive no extra return for bearing diversifiable (residual) risk.
Essentially, the CAPM states that an asset is expected to earn the risk-free rate
plus a reward forbearing risk as measured by that asset’s beta. The chart below
demonstrates this predicted relationship between beta and expected return – this line is
called the Security Market Line.
The security market line (SML) provides a bench mark for the evaluation of
investment performance. Given the risk of an investment, as measured by its beta, the
SML provides the required rate of return necessary to compensate investors for both risk
as well as the time value of money.
Suppose the SML relation is used as a bench mark to assess the fair expected
return on a risky asset. Then security analysis is performed to calculate the return actually
expected. If a stock is perceived to be under priced, it will provide an expected return in
excess of the fair return stipulated by the SML. Under priced stocks therefore plot above
security market line: given their betas, their expected returns are greater than dictated by
the CAPM. Over priced stocks plot below the security market line. The difference
between the fair and actually expected rates of return on a stock is called the stock’s
alpha, which is denoted by α.
Some of the other uses of the CAPM are it helps in the capital budgeting
decisions. For a firm considering a new project, the CAPM can provide the required rate
of return that the project needs to yield, based on its beta, to be acceptable to investors.
Managers can use the CAPM to obtain the cutoff internal rate of return (IRR) or the
hurdle rate for the project.
Extensions of CAPM
The assumptions that Sharpe is considered to be unrealistic, so many financial
economists have worked to extend the model to more realistic situations. The following is
the extended model THE CAPM WITH RESTRICTED BORROWING: THE ZERO
BETA MODEL and other models.
2. Liquidity
Liquidity is possibly the most serious problem faced by the Indian investors. A
consultative paper by SEBI indicated a poor liquidity situation at the stock exchanges in
India. Lack of liquidity can violate the assumptions of CAPM in two ways. Firstly it
results in a transaction cost for the investors. If the transaction cost is added to the CAPM
model, there will be a price band around the SML in which the scrips can lie. Within this
band, it will not be profitable for investors to buy or sell shares.
Secondly, CAPM assumes that all assets are infinitely divisible and readily
marketable. This assumption is also violated in India, due to the low liquidity observed in
majority of the shares, as discussed earlier. Low liquidity can also result in inefficient
pricing of scrips and price setting behavior by investors (non-price taker).
3. Insider Trading
Insider trading is believed to be rampant in the Indian market. The lack of
transparency in the trading system facilitates insider trading. Earlier there was virtually
no law against insider trading. After SEBI was formed, it has taken several steps to
protect the small investors and prevent insider trading. However, the task of detecting
insider trading is a difficult one.
4. Lack of Transparency
Indian stock markets suffer from lack of transparency between members and
constituents. Members perceive that the prices of transactions are not properly reflected
in their gains. All intra-day quotations are not readily available. Since exact time of the
transaction is not known, disputes persist. Also it is felt that some transactions are not
reported. In such a context any analysis has to consider the limitations of available price
series.
5. Inadequate Infrastructure
The infrastructure in the stock markets in India is woefully inadequate. The stock
exchanges are faced with inadequate office space, lack of computerization and
communication system, etc. These inadequacies in turn have affected the quality of the
investor service provided by the members of the exchanges. Though the number of
investors as well as the volume of transaction has gone up many folds in recent years, the
basic infrastructure and system has almost remained unchanged.
The lack of infrastructure adds to the transaction cost of the investors. Moreover
inadequate infrastructure and delays in settlement can slow down the absorption of price
sensitive information in the market, affecting its overall efficiency. Both increased
transaction cost and low operational efficiency violates the assumptions of CAPM
The study aimed at measuring returns and risks of the representative sample of
Indian stocks. The study also explored different issues regarding application of CAPM in
calculating stock market risk measure, beta.
It was found that the time internal choice did not have any significance impact on
calculated values of beta, but the choice of market proxy could significantly change the
values of beta .It was found that the betas bear linear relationship with mean quarterly
returns . The study suggests that this factor can’t be treated as proof of validity of CAPM.
The plotting of security market line revealed the majority of stocks under analysis are not
rewarded investors appropriately.
Criticisms of CAPM
The various assumptions of the CAPM model are considered to be unrealistic:
4. The investors hold all the assets included in the market port folio, the
various studies has shown that it is impossible to determine a market
portfolio or market proxy which contains all assets.
5. There are no taxes, but most studies have shown that tax effects via the
dividend yield are important in the pricing process. In particular, there is
a positive relationship between dividend yields and average returns.
Apart from assumptions, according to CAPM beta is the measure of systematic risk, but
beta may not be the correct measure of systematic risk.
Other criticisms of Beta are, it can be easily rolled over. Richard Roll has
demonstrated that by changing the market index against which betas are measured, one
can obtain quite different measures of the risk level of individual stocks and portfolios.
As a result, one would make different predictions about the expected returns, and by
changing indexes, one could change the risk-adjusted performance ranking of a manager.
This is in consistent with the results which were found in the study CAPM and Indian
stocks. There also the study suggested that with changing of the market proxy the value
of betas also significantly changed.
Beta is a short-term performer. Some short-term studies have shown risk and
return to be negatively related. For example, Black, Jensen and Scholes found that from
April 1957 through December 1965, securities with higher risk produced lower returns
than less risky securities
Theory does not measure up to practice. In theory, a security with a zero beta
should give a return exactly equal to the risk-free rate. But actual results do not come out
that way, implying that the market values something besides a beta measure of risk.
However, what ever the flaws one can find in the CAPM model, it is one of the
model which is still popularly used in the academics, as mentioned in the introduction,
that the CAPM model is the center piece of the MBA investment courses. It is considered
that unrealistic assumptions can be relaxed, leading to different versions of the CAPM.
1. Inclusion of skew ness (third moment) in the pricing model has led to the
three moment CAPM.
2. Different borrowing and lending rates lead to different CAPM lines and no
general equilibrium pricing model.
3. No risk less asset exists, leading to the zero beta CAPM, which provides
for a theoretical explanation of the basic CAPM empirical results.
5. There is risk less lending but no risk less borrowing, leading to the zero
betas CAPM.
It is certain that there are a variety of risk factors facing companies today. Some
of these factors are market risk, bankruptcy risk, currency risk, supplier risk, etc, and it is
known that the CAPM uses a single factor to describe aggregate risk. Effectively,
additional factors allow more specific attribution of the risks to which a company is
exposed, but CAPM considers only one factor that is the beta.
The attraction of the CAPM is that it offers powerful and intuitively pleasing
predictions about how to measure risk and the relation between expected return and risk.
Unfortunately, the empirical record of the model is poor enough to invalidate the way it is
used in applications. The CAPM’s empirical problems may reflect theoretical failings,
the result of many simplifying assumptions.
Bhandari (1988) finds that high debt-equity ratios (book value of debt over the
market value of equity, a measure of leverage) are associated with returns that are too
high relative to their market betas. Statman (1980) and Rosenberg, Reid, and Lanstein
(1985) document that stocks with high book-to-market equity ratios have high average
returns that are not captured by their betas.
Fama and French (1992) update and synthesize the evidence on the empirical
failures of the CAPM. Using the cross-section regression approach, they confirm that
size, earnings-price, debt-equity, and book-to-market ratios add to the explanation of
expected stock returns provided by market beta.
Chan, Hamao, and Lakonishok (1991) find a strong relation between book-to-
market equity (B/M) and average return for Japanese stocks. Capaul, Rowley, and Sharpe
(1993) observe a similar B/M effect in four European stock markets and in Japan. Fama
and French (1998) find that the price ratios that produce problems for the CAPM in U.S.
data show up in the same way in the stock returns of twelve non-U.S. major markets, and
they are present in emerging market returns. This evidence suggests that the
contradictions of the CAPM associated with price ratios are not sample specific.
In the light of above, in this project we are testing whether the CAPM offers a
better explanation of the company returns in Indian capital markets or can we find
evidence of the other factors giving better explanation of the company returns in Indian
capital markets.
This paper address the question as to whether the CAPM offers an appropriate
explanation of the company returns in less developed capital markets .The question is
whether the CAPM is appropriate, given the potential relevance of unsystematic risk,
Market distortions and of thin trading and its related effects on the market price.
Arguments for considering additional factors in pricing models to better deal with such
situations are presented.
Garciaa, Rene, Ghyselsb, U Eric (1998) “Structural Change and Asset Pricing in
Emerging Markets” Journal of International Money and Finance, Vol. 17, pp. 455-
473.
This paper documents the importance of testing for structural change in contexts
of emerging markets. Typically asset pricing factor models for emerging markets are
conditioned on world financial markets factors such as world equity excess rut urns, risk
and maturity spreads as well as other variable.
They show that more may country one cannot reject the model according to one
usual chi square test for over identifying restrictions but they reject it on the basis of
structural change tests, especially when international factors are considered. In this paper
much better support and greater stability are found. When a local CAPM is tested it sized
ranked portfolios. Also some evidence of small size effect persists for some countries.
To conclude, for the conditional world CAPM and conditional local and US factor
model test for structural stability of the GMM parameter estimates show that for most
countries and portfolios according to the case, although we cannot reject the model on the
basis of the over identifying restrictions criterion, the rejection of the absence of
structural change is quite strong. This is quite reasonable if one considers both political
and economical factors that have disrupted these emerging markets in comparison with
world events. This rejection means that the model yields a systematic mispricing of risk
factors.
A much more stable relationship is found however in a simple local CAPM model
for size ranked portfolios, although the small size effect appears to be present in a number
of countries. They show the empirical evidence that the emerging stock markets is also
dependent on structural changes.
They undertake to test whether the 1990’s is different from 1980’s for that they
have used chow test and found that there was a little evidence that mean returns are
significantly different, there is substantial evidence that volatility changed in 1990’s,
there is also evidence that the skew ness in returns changed in 1990’s and kurtosis is
similar to skew ness.
They have explained the fundamental characteristics of emerging market returns.
Then they have mentioned about higher moments and asset allocation .Here they have
looked at the impact of skew ness and kurtosis on asset allocation. They have found that
the emerging markets allocation increases as the skew ness increases up to the level of
1.5.They see that as the level of kurtosis raises beyond 5 the portfolio weight for the
emerging markets increases .hence they conclude that skew ness and the kurtosis impact
the asset allocation.
To conclude, in their research they suggest that it could be a mistake to treat the
emerging markets on par with the developed markets. They report that emerging market
equity index return distributions are highly non normal, in comparison with the
developed market equity index return. They identify significant skew ness and kurtosis in
emerging market return and they obverse the persistence of skew ness over time. They
suggest that investors will have preference for positively skewed investments and they
wish to avoid the negatively skewed distributions .Here one can notice that skew ness
will play an important role in explaining the company returns.
Kraus and Litzenberger (1976) “Skew ness Preference and the Valuation of Risk
Assets” Journal of Finance, Vol. 31, pp. 1085-1099
This paper extends the capital asset pricing model to incorporate the effect of
skew ness on valuation .The empirical evidence presented is consistent with the
prediction of the three moment extension of the traditional CAPM that the intercept is
equal to the risk less rate of interest. The evidence suggest that prior empirical findings
that are interpreted as in consistent with the traditional theory can be attributed to the
misspecification of the CAPM by omission of systematic (non diversifiable) skew ness.
In this paper Levy has tried to narrow the gap between the theoretical model and
the empirical findings by deriving a new version of the CAPM in which investors are
assumed to hold in their portfolios some given no; of securities. He as denoted the
modified model as general capital asset pricing model (GCAPM).
He has relaxed the assumption of a perfect market and hence the k th investors
holds stocks of n companies in his portfolio, where n can be very small i.e. 1, 2 etc.He
has first derived an equilibrium relationship between the return and risk of each security.
He has found that the well known systematic risk of the traditional CAPM beta has little
to do with equilibrium price determination .on the other hand beta * which is a weighted
average of the k th investor systematic risk beta, is the correct measure of the i th security
risk .since variance is a major component of beta, it plays an important role in the risk
measure of each stock, which is contrary to the equilibrium results of the CAPM.
To Conclude, he has mentioned that the variance plays an important role in the
risk-return relationship, but suggests that it is not the only measure of the i th security
risk. The variance is the only one component in this risk. For securities which are widely
held, beta will provide a better explanation for price behavior, while for most securities,
which are not held by many investors then variance provides a better explanation of the
price behavior.
Fama, Eugene F and French, Kenneth R :( 1993) “Common Risk Factors in the
Returns on Stocks and Bonds” Journal of Financial Economics, Vol. 33, pp. 3-56.
This paper identifies five common factors in the returns on stocks and bonds.
There are three stocks –market factors: an overall market factor and factors related to
firm size and book to market equity.
There are two bond market factors, related to maturity and default risks. Stock
returns have shared variation due to the stock market factors, and they are linked to bond
returns through shared variation in the bond market factors .Except for low grade
corporates, the bond market factors capture the common variation in bond returns. Most
important, the five factors seem to explain average returns on stocks and bonds.
To conclude, in a nutshell, their results suggest that there are at least three stock
market factors and two term structure factors in returns. Stock returns have shared
variation due to the three stock market factors, and they are linked to bond returns
through shared variations in the two term structure factors. Except for low grade
corporate bonds only the two term structure factors seem to produce common variation in
the returns on government and corporate bonds. There argue that if other variables ,such
as book to market equity, market value, or price earning ratios are considered ,the beta
has no significant influence on the observed returns.
Gregory Connor and Sanjay Sehgal: Tests of the Fama and French model in India:
This paper empirically examines the Fama-French three- factor model for the
Indian stock market. Objectives of the paper are: To test the one- factor linear pricing
relationship implied by the CAPM and the three- factor linear pricing model of Fama and
French, To analyze whether the market, size and value factors are pervasive in the cross-
section of random stock returns, To investigate whether there are market, size and value
factors in corporate earnings similar to those in returns, and whether the common risk
factors in earnings translate into common risk factors in returns.
Fama and French offer three central findings in support of their three- factor Asset-
pricing model that are pervasive market, size and value factors. This paper examines
these three central findings on the Indian equity market. They confirm the first two of
them, but cannot draw a reliable conclusion on the third. They view their findings as
generally supportive of the Fama-French model applied to Indian equities.
To conclude, the evidence for pervasive market, size, and book-to-market factors in
Indian stock returns is found. They find that cross-sectional mean returns are explained
by exposures to these three factors, and not by the market factor alone. They find mixed
evidence for parallel market, size and book-to- market factors in earnings they do not
find any reliable link between the common risk factors in earnings and those in stock
returns. The empirical results, as a whole, are reasonably consistent with the Fama-
French three- factor model.
This paper examines the empirical relationship between the return and the market value
of the NYSE common stocks .It is found that smaller firms have had higher risk adjusted
returns on average than large firms and evidence that CAPM is mis specified.
The data used in this paper, Sample includes all common stocks quoted on the NYSE
between 1926 and 1975, monthly price and return data & no of shares outstanding at the
end of each month. Three different market indices are used CRSP-equally and value
weighted indices, combination of value weighted index & return data on corporate &
government bonds.
The Methodology used is, they have selected 25 portfolios first one to five on the basis of
market value. Then securities in each of those five are in assigned to one of five
portfolios on the basis of their beta. Next five years data are used for the re estimation of
the security beta .stock prices and number of shares outstanding at the end of five year
periods is used for the calculation of the market proportion. The cross-sectional
regression is performed in each month.
To conclude, evidence presented in this paper suggests that the CAPM is mis specified
.Small NYSE firms have had significantly larger risk adjusted returns than large NYSE
firms over a forty year period. The size effect exists but it is not at all clear why it exists
.so it should be interpreted with caution. it might be tempting to use the size effect e g: as
the basis for the theory of mergers larger firms are able to pay a premium for the smaller
stocks since they will be able to discount the same cash flows at a smaller discount rate
.Naturally, this might turn out to be complete nonsense if size were to be shown to be just
a proxy.
Problem statement
CAPM one of the most popular methods used for estimating the required returns,
which states that only beta, the systematic risk has the power to explain the returns. But
recent empirical studies have suggested apart from beta others factors like skew ness,
variance, co skew ness etc also have a significant power to explain the returns and not
alone the beta as suggested by traditional CAPM. In light of this, here in this project we
address the question whether the CAPM offers a better explanation of stock returns in the
Indian capital markets, or can we find the existence of any other factors apart from
systematic risk which offers better explanation of the stock returns in Indian stock
market.
Objectives
2) To find the evidence of other risk factors namely variance and skew ness in addition to
beta (systematic risk) those are present in the Indian capital markets.
Since several researchers have found that the beta is not only the factor which
explains the company returns, but there are also other factors to be considered, so in this
project there is an attempt to find out the additional factors namely variance and skew
ness which are not considered by the capital asset pricing model, that are found in the
Indian capital markets and have considerable influence on the stock returns.
3) To find whether the additional risk factors namely variance and skew ness present in
Indian capital market, offer a better explanation of the stock returns when compared to
beta.
After finding the evidence of the additional factors namely variance and skew
ness that are present in the Indian capital markets, the next objective would be to identify
whether these factors explains the stock returns better than the beta as predicted by the
capital asset pricing model. So that the importance of considering the additional factors is
highlighted.
3) Only 4years data have been taken for the purpose of the study.
Only 4 years data is considered for the purpose of the analysis. However since the
daily data is considered the 4 years data is considered to be relevant and the conclusions
arrived at are accurate.
4) Consideration of limited additional factors.
Only measures like variance, skewness is considered, apart from beta. However
there also other measures like co-skew ness, kurtosis which are not considered in this
study. This can be considered for further research.
Data
Secondary data
Daily adjusted closing price, of the companies included in the BSE 100 and also
for the BSE 100 index is collected for 4 years, which is essential for the purpose of
calculation and analysis.
Sources of Data.
The required data was taken from the prowess 2.5 database and capital line plus
,center for monitoring Indian economy private limited (CMIE).
Sample
The sample consists of companies included in the BSE 100. The sampling
technique used here is convenience sampling, which is by selecting the companies in
the BSE 100.
Sample size
The size of the sample is 87 companies, included in the BSE 100. The
other thirteen companies is not included in the study, because in early years of the
study they were not listed in the BSE 100 and hence the data for the company in that
years as a listed company in the BSE 100 is not available, if these companies are
selected there would be lot of deviations, which would affect the out come of the
results and there by affecting our analysis to an larger extent. Also at the end, our
conclusions would not be accurate.
Vijaya Bank
Allahabad Bank
Biocon Ltd.
Canara Bank
N T P C Ltd.
Petronet L N G Ltd.
Statistical procedure.
To test whether measures of variance, skew ness might offer an improved
explanation of company returns, individual estimates were prepared for the BSE 100
companies.
Estimates were prepared on an annual basis, for financial years 2002, 2003, 2004,
and 2005 using individual daily market returns for each company.
For each of the sample companies, annual estimates of beta, variance and skewness are
initially estimated. Second pass regressions then offer an indication of whether any of
these estimates offer a significant explanation of company returns. To do this, measures
of average annual daily returns for each company are regressed on the different measures
of risk.
Model 1:
A test of the cross sectional explanatory power of market model betas in
competition with the variance of returns:
Ri=α+βi (b1) +Variance (b2) +ei
Model 2:
A test of the cross sectional explanatory power of market model betas in
competition with skew ness of returns:
Model 3:
A test of the cross sectional explanatory power of market model betas in
competition with both the variance of returns and the skew ness of returns:
Regression shows us how to determine both the nature and the strength of a
relationship between two variables. We will learn to predict, with some accuracy, the
value of an unknown variable based on past variable based on past observations of that
variable and others.
Multiple regressions
When we use more than one independent variable to estimate the dependent
variable, it is called as multiple regressions. Here we can increase the accuracy of the
estimate.
The principal advantage of multiple regressions is that it allows us to use more of
the information available to us to estimate the dependent variable. In addition, in multiple
regressions, we can look at each individual independent variable and test whether it
contributes significantly to the way the regression describes the data. In this project this is
What we are going do using regression that is testing whether the independent variables
like beta, variance, skew ness individually contribute significantly to the returns and also
in combination whether these independent variables contribute significantly to the
returns.
Multiple regressions will also enable us to fit curves as well as lines. Using the
technique of dummy variables, we can even include qualitative factors such as gender in
our multiple regressions. This technique will enable us to analyze the discrimination
problem.
Dummy variables and fitting curves are only two of the many modeling technique
that can be used in the multiple regression to increase the accuracy of our estimating
equations.
Hypothesis testing
Null hypothesis (H0): There is no significant relationship between the risk factors
namely beta, variance, skewness and returns.
Alternative hypothesis (H1): There is significant relationship between the risk factors
namely beta, variance, skewness and returns.
For the purpose of running the single factor and multiple regressions and also for testing
hypothesis the SPSS (statistical package for social science) software is used.
We use scatter diagram to find the relationship between return and beta, return and
skewness, return and variance .a brief background of scatter diagram is given below.
SCATTER DIAGRAMS
The first step in determining whether there is relationship between two variables
is to examine the graph of the observed (known) data. This graph or chart is known as
scatter diagram.
A scatter diagram can give us two types of information. Visually, we can look for
patterns that indicate that the variables are related. Then if variables are related we can
see what kind of line, or estimation equation, describes this relationship.
In scatter diagrams the pattern of points results because each pair of data will be
recorded as a single point. When all these points are visualized together, we can visualize
the relationship that exists between the two variables.
Ex:
80
70
60
50
40
30
20
10
0
0 20 40 60 80
Ex:
70
60
50
40
30
20
10
0
0 20 40 60 80
The relationship between two variables can take the form of a curve.
Ex:
250
200
150
100
50
0
0 20 40 60 80 100
Ex:
250
200
150
100
50
0
0 20 40 60 80
5. Inverse linear relationship with a widely scattered pattern of points. The wider
scattering indicates that there is a lower degree of association between the independent
and dependent variables.
Ex:
100
90
80
70
60
50
40
30
20
10
0
0 5 10 15 20 25 30
Ex:
90
80
70
60
50
40
30
20
10
0
0 10 20 30 40
Based on the scatter diagrams interpretation we find the relationships between the
return and beta, return and variance, return and skew ness in the project and draw
necessary conclusions.
Table 1 showing return, beta, variance and skew ness for the year 2002.
Table 2 showing return, beta, variance and skew ness for the year 2003.
Table 3 showing return, beta, variance and skew ness for the year 2004.
Table 4 showing return, beta, variance and skew ness for the year 2005.
SCATTER DIAGRAMS
X axis= Return
Y axis=Beta
2.0000
1.5000
1.0000
Return
0.5000
0.0000
-0.5000
-1.0000
0.0000 0.5000 1.0000 1.5000 2.0000 2.5000 3.0000
Beta
2.5000
2.0000
1.5000
Returns
1.0000
0.5000
0.0000
0.0000 0.2000 0.4000 0.6000 0.8000 1.0000 1.2000 1.4000 1.6000 1.8000 2.0000
Beta
1.4000
1.2000
1.0000
0.8000
0.6000
Return
0.4000
0.2000
0.0000
-0.2000
-0.4000
-0.6000
0.0000 0.2000 0.4000 0.6000 0.8000 1.0000 1.2000 1.4000 1.6000 1.8000 2.0000
Beta
1.40000
1.20000
1.00000
0.80000
0.60000
0.40000
Returns
0.20000
0.00000
-0.20000
-0.40000
-0.60000
-0.80000
0.00000 0.50000 1.00000 1.50000 2.00000 2.50000
Beta
Interpretation:
Excepting in the years 2002 and 2003, where we can find a direct linear
relationship with wide scattering, in other two years there is no evidence of linear
relationship between beta and return as propounded by the CAPM model. However one
cannot rule out the CAPM completely in the Indian context, because there is evidence of
beta being the significant explanatory variable.
2002
2.0000
1.5000
1.0000
Return
0.5000
0.0000
-0.5000
-1.0000
0.0000 0.1000 0.2000 0.3000 0.4000 0.5000 0.6000 0.7000 0.8000
Variance
2003
2.5000
2.0000
1.5000
Returns
1.0000
0.5000
0.0000
0.0000 0.1000 0.2000 0.3000 0.4000 0.5000 0.6000
Variance
1.4000
1.2000
1.0000
0.8000
0.6000
Returns
0.4000
0.2000
0.0000
-0.2000
-0.4000
-0.6000
0.0000 0.1000 0.2000 0.3000 0.4000 0.5000 0.6000
Variance
2005
1.40000
1.20000
1.00000
0.80000
0.60000
0.40000
Returns
0.20000
0.00000
-0.20000
-0.40000
-0.60000
-0.80000
0.00000 0.05000 0.10000 0.15000 0.20000 0.25000 0.30000 0.35000
Variance
Interpretation:
In the above scatter diagrams we can find that, the variance and the return as a
direct linear relationship with wide scattering in three years that is 2002, 2003 & 2004
indicating that the variance is better proxy than the beta. The variance can be considered
as a better explanatory variable of the returns than the beta when both are considered
individually. However the variance and the return relationship in the year 2005 cannot be
found as indicated by the scatter diagram, where we can find that the points are widely
scattered indicating no relationship what so ever between return and variance in the year
2005. It can also be noted that the variance is considered to be the alternative proxy,
which came to be true in this analysis.
2.0000
1.5000
1.0000
Returns
0.5000
0.0000
-0.5000
-1.0000
-0.1000 -0.0800 -0.0600 -0.0400 -0.0200 0.0000 0.0200 0.0400
Skewness
2003
2.5000
2.0000
1.5000
Returns
1.0000
0.5000
0.0000
-0.0400 -0.0300 -0.0200 -0.0100 0.0000 0.0100 0.0200 0.0300
Skewness
1.4000
1.2000
1.0000
0.8000
0.6000
Returns
0.4000
0.2000
0.0000
-0.2000
-0.4000
-0.6000
-0.0200 -0.0150 -0.0100 -0.0050 0.0000 0.0050 0.0100
Skewness
2005
1.40000
1.20000
1.00000
0.80000
0.60000
0.40000
Returns
0.20000
0.00000
-0.20000
-0.40000
-0.60000
-0.80000
-0.00002000 -0.00001000 0.00000000 0.00001000 0.00002000 0.00003000 0.00004000 0.00005000
Skewness
Interpretation:
In the above scatter diagrams we can find that, the skew ness and the return has a
direct linear relationship with scattering in three years that is 2002, 2003 & 2005
indicating that the skew ness is better proxy than the beta. The skew ness can be
considered as a better explanatory variable of the returns than the beta when both are
considered individually. However the skew ness and the return relationship in the year
2004 cannot be found as indicated by the scatter diagram, where we can find that the
points are widely scattered indicating no relationship what so ever between return and
skew ness in the year 2004.
Conclusion:
When the scatter diagram is used to find the linear relationship between the beta
and return as indicated by the CAPM model, we can conclude that the beta cannot be
completely ruled out, since it is being an significant explanatory variable in as many as
two years i.e. 2002 and 2003. But we can also find the evidence of other risk factor’s
presence in the Indian capital markets that is the variance and skew ness. However we
cannot find complete linear relationship between the beta and the return as indicated by
the traditional CAPM model. Also the beta in combination with other risk factors is a
better explanatory variable of the returns, giving an indication of not rejecting the CAPM
model completely.
*
and ** statistically significant coefficients, at the 5% and 10% respectively.
*
& ** statistically significant coefficients, at the 5% and 10% respectively.
*
& ** statistically significant coefficients, at the 5% and 10% respectively.
Model 1:
Dependent variable: Return
Independent variables: Beta, Variance
Table 8 showing co efficient of beta and variance.
*
& ** statistically significant coefficients, at the 5% and 10% respectively.
In combination the variance explains the returns significantly better than beta in
the years 2002 and 2003 at 5% level of significance. However in the year 2004 both beta
and variance offer a significant explanation of the returns at 5% level of significance .in
the year 2005 none of the measures explain the returns significantly either at 5% or 10%
level of significance .The constant explains the returns significantly in the years 2003,
2004 and 2005 at 5% level of significance when the beta and variance is assumed zero.
Only exception is in the year 2002, it either offers significant explanation of returns at 5%
or10% level significance.
Model 2:
Dependent variable: Return
Independent variable: Beta, skew ness
Table 9 showing co efficient of beta and skew ness
*
& ** statistically significant coefficients, at the 5% and 10% respectively.
When beta and skew ness is considered both in combination explain the return
significantly in the years 2002, 2003, and 2005 at 5 % level of significance in the year
2004 both in combination explain the return significantly at 10% level of significance.
The constant explains the returns significantly in the years 2003 and 2005 at 5% level of
significance. The exception being in the years 2002 and 2004 where it does not explain
the returns either at 5% and 10% level of significance, when beta and skew ness is
assumed to be zero.
Model 3:
Year Constant T value Beta co- T value Variance T value Skew ness T value
efficient Co efficient coefficient
** *
2002 0.0786 1.0795 -0.1565 -1.6698 1.7596 5.1738 10.9219 4.1764*
2003 0.5806 5.2195* 0.0369 0.2335 1.1224 1.9116** 26.7290 3.8973*
2004 0.1279 1.5004 -0.2985 -1.9678* 1.9543 1.3669 9.5706 3.8475*
2005 0.4946 4.8228* 0.0060 0.0445 -2.9895 -2.7527* 107.7892 4.7457*
*
& ** statistically significant coefficients, at the 5% and 10% respectively.
When all the measures are considered, it remains inconclusive whether all the
measures explain the returns , in combination at a particular level of significance however
in the year 2002 and 2005 the variance and skew ness offer an significant explanation of
the returns at 5% level of significance , in the year 2004 the skew ness and beta offer
explanation to returns at 5% level of significance .considering individual measures the
skew ness offers an better explanation of returns in the year 2004 at 5% level of
significance ,the variance explains the returns in the year 2003 at 10% level of
significance ,the beta explains returns in the year 2004 and 2002 at 5% and 10% level of
significance respectively.
The constant explains the returns significantly in the years 2002 and 2005 at 5%
level of significance , the years 2002 and 2004 both being an exception either at 5% and
10% level of significance when all the measures are assumed to be zero.
Conclusion:
BETA
VARIANCE
SKEWNESS
This study provides some evidence that apart from beta, other measures of risk
may also be important in estimating company returns or cost of equity. Variance and
skew ness offer a more significant explanation of returns in the Indian capital markets.
There is evidence to show in the project that beta is not only the risk factor which
explains the company returns, there are evidence of other risk factors such as variance
and skew ness significantly explaining the company returns. It can also be seen that the
variance and skew ness is significantly explaining the returns in most of the years either
in either at 5% or 10% level of significance, when compared to the beta.
In combination it seems that the variance is a better proxy than the beta when
model 1 is considered signifying that the variance is better proxy than the beta. Even
skew ness is considered to be a significant explanatory variable of the returns. In multiple
regression results we can see that the skew ness dominating the other risk factors that is
the beta and variance in all most all the years.
However we cannot completely rule out the CAPM in the Indian context, because
in the results it can also be seen that the beta can also be a significant explanatory
variable of the returns in the years 2002 & 2004. Also in combination it seems that beta is
the dominating variable in model 2, in all the years. There fore we cannot completely rule
out the CAPM model.
It can be concluded that beta is not only the factor which explains the returns
significantly as predicted by the CAPM, but also other risk factors are present in Indian
capital markets which explains the return significantly, indicating consideration of the
other factors.
When we consider scatter diagram we can see that the beta has direct linear
relationship with wide scattering with returns in two years that is 2002 &2003 as
predicted by the CAPM. However there is strong evidence that variance and the skewness
are present in the Indian capital markets. In most of the years the skewness and the
variance have direct linear relationship with returns with wide scattering.
The scatter diagram is giving the indication of CAPM being appropriate in the
Indian capital market in the years 2002 and 2003, indicating that the model cannot be
completely ruled out. Even the regression results are indicating that beta is a significant
explanatory variable of the return either individually or in combination. However the
other risk factors namely the variance and skewness are found to be present in Indian
capital markets. These factors also significantly explain the returns in the Indian capital
markets. Both variance and skewness explain return better than beta in most of the years.
GLOSSARY:
Return: Return is a financial term that refers to the benefit derived from an investment.
Risk: Risk is the potential impact (positive or negative) to an asset or some characteristic
of value that may arise from some present process or from some future event
Scatter diagram: The graphical relationship between two variables is called scatter
diagram.
Security market line: The graphic relationship between expected return on asset i and
beta is called the security market line.
Bibliography:
Websites:
1. www.bse.com
2. www.google.com
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