Academic journal article International Journal of Management

Analysis of the Capital Asset Pricing Model in the Saudi Stock Market

Academic journal article International Journal of Management

Analysis of the Capital Asset Pricing Model in the Saudi Stock Market

Article excerpt

The Capital Asset Pricing Model (CAPM) is one of the most widely-used attempts to explain the variation in the prices of publicly-listed companies. According to the model, non-diversifiable risk (β) is the only substantial risk in the pricing of assets and expected return on assets is a positive linear function of β. Despite the logic in its argument, the ability of CAPM to predict and explain stock price variation has been relatively poor. This paper examines the validity of applying CAPM to an emerging stock market; in this case that of Saudi Arabia. The main data for the study comprised the daily stock returns of 70 companies quoted on the Saudi exchange, over the period 2003 to 2009. The results indicate that the unconditional relationship posited by CAPM between beta and return was positive, but weak. However, a significant relationship was obtained between beta and stock returns conditional on the performance of the total market.

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The Saudi market is the largest market in the Middle East and is one of the fastest growing markets in the world. The capitalization of the Saudi Stock Market (SSM) was 246,809.85 million USD in2008 and increased to 339,499. 12 million USD in September 2010. The SSM differs from other developed and emerging markets. When compared to other markets in the region, the SSM is relatively large in size and has a relatively large trading volume, although it has only 144 firms listed. The lack of academic studies on its behaviour has made the SSM an important and interesting topic of study.

The Capital Asset Pricing Model (CAPM) developed by Sharpe (1964) and Lintner (1965) is widely viewed as one of the most important contributions to our understanding of finance over the last 50 years. The CAPM describes the relationship between risk and expected return that it uses in the pricing of risky securities. The CAPM states that the expected return on a security or a portfolio equals the rate on a risk-free security plus a risk premium. The model implies a positive linear relationship between expected return and non-diversifiable risk of the security (beta): stocks with larger beta will demand higher expected return than stocks with smaller beta.

Pettengill et al. (1995) pointed out that for beta to be a useful measure of risk a systematic relationship must exist between beta and return. The CAPM shows an unconditional systematic and positive trade-off between beta and expected return. However, according to the authors' conditional version, the trade-off should reflect a segmented relationship between realized return and beta (i.e. a positive relationship during periods of positive market excess returns and a negative relationship during periods of negative market excess returns). If the realized market returns were barely less than the risk-free rate, this conditional relationship would have no significant impact on tests of the relationship between beta and returns.

The validity of the CAPM has been extensively tested in developed markets. Recently, there have been researches on the validity of the CAPM in Asian markets (e.g. Lam (2001)), and few studies in other emerging markets (Omran (2007)). This present study examines the validity of the CAPM and the model proposed by Pettengill et al. (1995) in the SSM.

This paper is organized as follows: Section 2 provides a detailed literature review. Section 3 discusses the data used in this paper, followed by a presentation of methodologies and empirical results in Section 4. Section 5 concludes and summarizes the paper's findings.

Literature Review

The Capital Asset Pricing Model (CAPM) developed by Sharpe (1964) and Lintner (1965) is still widely used by academics and practitioners to estimate the cost of capital for firms and evaluate the performance of investment managers. Several studies have focused on emerging markets (Beakaert and Harvey (2003); Harvey et al. …

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