Academic journal article Journal of Financial Management & Analysis

Arbitrage Pricing Theory and the Capital Asset Pricing Model-Evidence from the Indian Stock Market

Academic journal article Journal of Financial Management & Analysis

Arbitrage Pricing Theory and the Capital Asset Pricing Model-Evidence from the Indian Stock Market

Article excerpt


The Capital Asset Pricing Model (CAPM) is widely accepted as an appropriate technique for evaluating financial assets. It is used to construct portfolios, measure the performance of investment managers, develop project screening rates for capital budgeting, and value companies. Betas are calculated and displayed by the National Stock Exchange, Bombay Stock Exchange, leading investment related web sites and journals. The Arbitrage Pricing Theory (APT) which offers an alternative explanation of the relationship between risk and return is yet to receive widespread acceptance in India.

The objective of this study was to compare the CAPM and APT using principal components analysis. This paper briefly reviews the relevant literature and presents evidence that APT may lead to better estimates of risk and expected rate of return than CAPM.



CAPM has been tested extensively, for over three decades, in various forms primarily in developed capital markets and to some extent in developing markets. Early work in this area including Black, Jenson and Scholes', Fama and McBeth2 and Blume and Friend3 supported the standard and zero beta model of CAPM. However Banz4, Reinganum5, Gibbons6, Shanken7 and Fama and French8, highlighted the danger of focusing exclusively on meanbeta space. These studies found that the return generation process also depends on other variables like size, book to market ratio and earnings price ratio.

In the Indian context Dhankar9, used the CAPM to compute risk adjusted cost of capital for public sector undertakings and to measure their performance. There have also been a number of studies which investigated the linearity, slope and intercept of the security Market Line, with varying results. Some including Yalawar10, Obaidullah & Mohanty11, Dhankar12, Ghosh" and Vipul'4, concluded that evidence supports CAPM to some extent. Others, such as Maheshwari & Vanjara15, Madhusoodan16 and Sehgal17 found that CAPM was not an appropriate tool to be used in Indian markets.

A great deal of research work on APT has been undertaken in developed markets, particularly in the U.S. markets using two approaches. The first approach, i.e., factor analysis, was used by Roll and Ross18 in their classic study of APT, where four or five factors were found to have significant explanatory power. Dhrymes, Friend and Gultekin19 found that the number of significant factors increased with the number of securities included in factor analysis. This, Roll and Ross20 explained, could be due to new factors depending on the companies included in the sample. The decision as to how many factors are to be extracted depends on the researcher. In the second approach, factors are specified by the researcher in advance. Sharpe21 showed that company attributes such as size, dividend yield and sector membership increased the explanatory power of the model. Chen, Roll and Ross22 found that macro variables have a significant explanatory influence on prices. Studies comparing APT and CAPM have used both approaches. Bower et al23 used factor analysis to show that APT is a better choice than CAPM for evaluating utility stock returns. Conner & Korajczyk24 used Principal Components Analysis and found five factors that could explain the size and January effect better than CAPM. Lehmann and Modest25 show that a multi-index model can explain the extra returns associated with high dividend yields and partly explain the size and January effect. Burmiester and McElroy26 concluded that CAPM can be rejected in favour of the APT model which included factors like default premium and time premium. Vipul and Gianchandani27 found that the BSE National Index and dollar exchange rate was significant in the first stage, but not properly priced in the second stage. APT is yet to be critically researched in the Indian context, and this study is an effort in this direction.

Methodology Used

Study includes frequently traded stocks of large and medium size companies, listed on the BSE 200, Nifty and Junior Nifty during the twelve year period, i. …

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