Risk, Return, and Equilibrium in the Emerging Capital Market: The Case for Jordan

Article excerpt

ABSTRACT

This paper reports the results of tests of the major implication of the two-parametric assets pricing model in the Emerging Jordanian stock market. The findings indicate that the CAPM paradigm is not adequate in the Jordanian stock market. First, the critical condition of the CAPM, a positive trade-off between market risk and return is rejected Second, we find that residual risk played an important role in pricing risk assets. The inadequacy of the CAPM in the Jordanian stock market may be attributed to market inefficiency and the highly undiversified portfolios held by the Jordanian investors.

INTRODUCTION

Emerging markets are playing an increasingly important role in international portfolios. The motivation for investor interest in emerging capital markets can be explained by a discussion of risk and diversification. Foreign interest in the Jordanian stock market has greatly increased, with the Jordanian government's disclosure of its plan to liberalize the Jordanian stock market in early 1990s. In fact, 42% of all investors in Amman financial market are considered to be foreign investors. The process of internationalization holds many implications for both Jordanian and international investors. Hence, this paper attempts to empirically investigate the risk-return relationship for assets in the Jordanian stock market.

For the past 3 decades the two-parameter capital asset pricing model (CAPM) of Sharpe (1964), Fama (1965), Lintner (1965), and Black (1972) has constituted one of the cornerstones of modern financial theory. Indeed, in many people's minds CAPM is the modern theory of finance.

In modern portfolio theory, the mean variance capital asset pricing model has become the major analytic tool for explaining the relationship between the expected return and risk. The main implication of the CAPM is that expected return should be linearly related to an asset's covariance with the return on the market portfolio (i.e., beta risk). The principle of risk compensation that higher beta risk is associated with higher return has been established empirically. [For more details, see Black, Jensen, and Scholes (1972), and Fama and MacBeth (1973).] The empirical results obtained by Fama and MacBeth (1973) represent the most widely cited and respected evidence supporting the CAPM.

The Objective of this study is to test empirically how well the market equilibrium model of the CAPM, which was developed in the United States and other developed nations, can explain the pricing of assets in the emerging Jordanian stock markets. The risk-return structure of Jordanian stocks is analyzed by testing the CAPM with Fama and MacBeth's two-stage approach, a combination of both time series and cross-section estimation. Hence, this study attempts to determine whether the CAPM is applicable to the Jordanian stock markets, to asses the extent of diversification of Jordanian investors' portfolios, and to suggest portfolio management strategies that utilize controlled risk exposure and efficient diversification.

The remainder of this paper is organized as follows. Section 2 describes the data and section 3 discuses the methodology. Section 4 presents the empirical results. Finally, Section 5 offers a summary and concluding remarks.

DATA

The data used in this study are the monthly returns for all stocks traded on the Jordanian stock market. The data are obtained from two sources. The first source is based on the Amman Financial publications. The AFM publishes monthly statistical bulletin and annual report for companies trading in the market. The second source is the Statistical Bulletin Published by the Central Bank of Jordan (CBJ). This monthly bulletin includes comprehensive statistical information about the Jordanian economy. The monthly returns include dividends and capital gains, with appropriate adjustments for capital changes such as stock splits and dividends. …