A DISSERTATION REPORT ON

A Study on Capital Asset Pricing Model and Feasibility of its

Anomalies in Indian Market

IN
PARTIAL FULFILLMENT OF
REQUIREMENT OF POST GRADUATE DIPLOMA IN
MANAGEMENT PROGRAMME 2009-11

Submitted To:- Submitted By:-

Vimal Babu Varun Narang
Faculty (HR) PGDM 2009
Roll No. 29118

Northern Integrated Institute Of Learning Management

Centre for Management Studies
Greater Noida,

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 ACKNOWLEDGEMENT

“When time, speed, skill, timing and diligence combine’s horizons

become the ultimate site.”

No task however small could be accomplished without guidance, help, and assistance. I am
indebted to all persons who have contributed there worth in completion of my study.

The financial Dissertation project was successfully completed with the help, encouragement,
advice, inspiration and stimulus received from my faculty Vimal Babu, Sukumar Dutta and Hima
Bindu Kota

I feel deep sense of gratitude in thanking them as they sincerely helped me heaps to carry on this
project to its eventual friction. My Dissertation project would have been mobilized had they not
have given their invaluable guidance and consistent support at all hours.

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EXECUTIVE SUMMARY

This study deals with the Effect Capital Asset Pricing Model and its anomalies in Indian Market.
The Capital Asset Pricing Model (CAPM) is the most popular model of the determination of
expected returns on securities and other financial assets. It is considered to be an “asset pricing”
model since, for a given exogenous expected payoff, the asset price can be backed out once the
expected return is determined. Additionally, the expected return derived within the CAPM or any
other asset pricing model may be used to discount future cash flows. These discounted cash
flows then are added to determine an asset’s price.
The first part of the study deals with the basic definition, advantages and application of CAPM.
CAPM is tool used for risk return analysis. It helps to know the Company’s Cost of capital. In
the first part of the study CAPM calculation, CML, SML etc has been explained. In the second
chapter the literary review about capital asset pricing model is stated. CAPM is based on
Markowitz Modern portfolio theory. Various other scholars gave their own analysis for CAPM
model. Like Fama modified CAPM and gave an alternative version called CCAPM which is
Conditional Capital Asset Pricing Model. 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—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. But they may also be caused by
difficulties in implementing valid tests of the model
In the third chapter Alternative model is described and a comparison between Arbitrage Pricing
Model and Captial Asset Pricing Model. . The Capital Asset Pricing Model (CAPM) and the
Arbitrage Pricing Theory (APT) have emerged as two models that have tried to scientifically
measure the potential for assets to generate a return or a loss. They are similar in that they
attempt to measure an asset's propensity to follow the overall market however APT attempts to
divide market risk into smaller component risk.
The fourth chapter deals with testing CAPM in Indian market .a sample of 50 companies listed
on BSE are taken. The average return of all the 50 companies for 10 years is calculated. Sensex
yearly Market rate is taken for 10 years. Beta of each company with respect to the market return
is calculated. The result showed that higher beta firms always earn higher returns. Hence through
this finding Capital asset pricing model is tested.

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In the fifth part of the study Efficient Market hypothesis is explained. All the types of Form:
Weak Form, Semi Strong form and Strong form is explained. In this part the CAPM Anomalies
like Small firm effect, P/E effect, D/e effect, and Seasonality effects are also explained.

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TABLE OF CONTENT

Submitted To:- Submitted By:-.......1

INTRODUCTION TO CAPITAL ASSET PRICING MODEL..........................................................6

RISK RETURN POSSIBILITIES WITH LEVERAGE........................................................11
THE DOMINANT PORTFOLIO ‘M’...................................................................................12
THE CAPITAL MARKET LINE..........................................................................................14
SECURITY MARKET LINE................................................................................................16
The Logic of the CAPM........................................................................................................19
Multifactor Models and Arbitrage Pricing Theory (APT).....................................................28
Testing Capital Asset Pricing Model in Indian Stock market........................................................32
INTRODUCTION.................................................................................................................33
Methodology..........................................................................................................................38
CONCLUSION......................................................................................................................41
THREE VERSIONS OF THE EFFICIENT MARKETS HYPOTHESIS............................44
COMMON MISCONCEPTIONS ABOUT THE EMH........................................................46
CONCLUSIONS...................................................................................................................54
BIBLIOGRAPHY AND ANNEXURE.............................................................................................55

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 Chapter - i

INTRODUCTION TO
CAPITAL ASSET PRICING
MODEL

EVOLUTION OF CAPM
The CAPM was developed in the mid 1960’s. The model has generally been attributed to
William Sharpe, but John Lintner and Jan Massin also made similar independent derivations.

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Consequently, the model is often referred to as Sharpe-Lintner-Mossin (SLM) Capital Asset
Pricing Model. The CAPM explains the Relationship that should exist between the securities
expected returns and their risk in terms of the means and standard deviation about security
returns. Because of this focus of the mean and standard deviation, the CAPM is a direct
extension of the portfolio models developed by Sharpe and Markowitch. Although the model has
been extensively examined, modified and extended in the literature, the original SLM version of
CAPM still remains the central theme in the Capital Market theory as well as the current
practices of Investment management.
Using Simplified assumptions, the CAPM is an equation that expresses the equilibrium
relationship between the security’s or portfolio’s expected return and its systematic risk. Because
the CAPM is relatively a simple model, it has been applied in wide variety of academic and
institutional applications such as measuring the portfolio performance, testing of marketing
efficiency, identifying undervalued and overvalued securities, determining price of risk implicit
in the current market prices and capital budgeting.

The Capital Asset Pricing Model (CAPM) is the most popular model of the determination of
expected returns on securities and other financial assets. It is considered to be an “asset pricing”
model since, for a given exogenous expected payoff, the asset price can be backed out once the
expected return is determined. Additionally, the expected return derived within the CAPM or any
other asset pricing model may be used to discount future cash flows. These discounted cash
flows then are added to determine an asset’s price. So, even though the focus is on expected
return, we will continue to refer to the CAPM as an asset pricing model.

Assumption of CAPM
The capital market theory is based on the basis of Markowitz’s portfolio model. This theory is
based on certain assumptions as:
a) All the investors are considered to be efficient investors who like to position themselves
on the efficient frontier. Their exact location on the efficient frontier, however, depends
on their risk return utility function.
b) Investors are free to borrow or lend any amount of money at the Risk- Free Rate of
Return (RFR).

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c) All investors are expected to have homogeneous expectations, i.e., their future rates of
return have identical probability distributions.
d) All investors have same investment time horizon.
e) All investors are assumed to be infinitely divisible making it possible to even buy or sell
fractional shares of any portfolio.
f) The process of buying or selling of assets does not involve any transaction costs. For
example, holders of pension funds and even religious groups do not have to pay taxes and
further it has been found out that the transaction cost of many financial instruments that
are traded by most of the financial institutions are less than one percent.
g) It is assumed that the inflation rates are fully anticipated or in other situations it may be
totally be absent thus resulting in no changes in the tax rate.
h) Another assumption of the theory is the equilibrium in the capital markets, that is, all
investments are correctly priced on par with their risk levels.
It might sound unrealistic; for instance, it may be possible to lend money at risk free rate by
buying the risk-free securities, say, treasury bills but it may not be possible to be possible to
borrow money at risk free rate while stating some of the assumptions and it should be borne
in mind that even by relaxing some of these assumptions, the model does not change much.
CAPM is the extension of the Markowitz portfolio theory. The assumptions, on which
Markowitz portfolio theory is based, are applicable to CAPM also.

CAPM is a model about the relationship between risk and required return of return on asset,
and embodies the two fundamental relationships: capital market line and security market line.
The risk that CAPM discussed consists of two components: systematic risk and fundamental
risk. The most important thought of CAPM is that beta; the systematic risk is a complete
measure of security risk. Therefore there is a need to distinguish the difference of systematic
and unsystematic risk in order to understand CAPM through security market line and capital
market line.

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 Figure 1: Systematic and Unsystematic Risk

The CAPM assumes that investors hold fully diversified portfolios. This means that investors are
assumed by the CAPM to want a return on an investment based on its systematic risk alone,
rather than on its total risk. The measure of risk used in the CAPM, which is called ‘beta’, is
therefore a measure of systematic risk. The minimum level of return required by investors occurs
when the actual return is the same as the expected return, so that there is no risk at all of the
return on the investment being different from the expected return. This minimum level of return
is called the ‘risk-free rate of return’.

Beta and Standard Deviation

Investments are risky because returns cannot be comprehended. The return that an investment is
expected to fetch probably will not be the same as that actually obtained. Therefore, variation
exists around the expected returns.
In investment analysis, it is necessary to quantify the risk usually employing the following two
measures:
 The Standard deviation
 The Beta

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Now, a rational, risk-averse investor view variance as the appropriate risk measure if he holds
only one security. In that case, the only security he holds becomes his portfolio. So, the return on
his security becomes the return on his portfolio. Variance around the expected return statistically
can be measured by standard deviation or variance. On the other hand, for holding multiple
assets, the contribution of any one of the asset \s to the riskiness of the portfolio is its systematic
or non-diversifiable risk. Thus for a well diversified portfolio, the appropriate measure of risk
would be beta, for, in that case the return on assets move relative to the returns on the market
portfolio. Beta in fact absorbs the risk which cannot be diversified. By effective diversification,
asset specific risks are eliminated, and measure of risk in such a case is beta. It is an indication as
to how the individual asset is contributing to the total risk of the portfolio.

Risk Free Assets

Before going into detail of risk free assets one need to know about risky assets. In essence, a
risky asset is one which gives uncertain future returns. The uncertainty can be measured by the
variance or the standard deviation of the expected future returns. And the risk free assets are
those whose expected risk is fully certain and thus standard deviation of such expected returns
comes to zero i.e. σf = 0. Further it is to remember that the rate of return earned on such asset
should be the risk free rate of return (rf).

Covariance of Risk free Assets with Risky Assets

Let us consider the covariance of two sets of returns, A &B
CovAB = ∑[rA – E(rA)][rB – E(rB)] /n
The uncertainty for the risk free asset is known, so σ f = 0, which implies that r A = E(rA) for all the
periods. Thus, rA – E(rA) = 0, which further leads to the fact that the product of any other
expression with this expression will be zero. This will result in the covariance of the risk free
asset with any risky asset or portfolio to be also zero. Similarly, the covariance between any risk
free asset and risky asset will be zero as rf,a = Covf,a/ σf σa.

Combining a Risk free Asset with the Risky Portfolio

When risky assets are combined with risk free assets then the expected return of the portfolio is
written as :

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E(ri) = Wf(rf) + (1-Wf) E(ra)
Where,
Wf = the proportion of the portfolio invested in the risk free assets
E(ra) = expected return on risky portfolio A
Further it is known that the expected variance for the two asset portfolio can be wriiten as:
E(σi2) = Wi2σi2 + 2W1W2 r1,2σ1σ2
Now on substituting the risk free asset for security 1 and risky asset for security 2, the equation
would be:
E(σi2) = Wf2σf2 + (1-Wf)2σA2 + 2Wf(1-Wf)rf,A σfσa
It is further known that σf2 = 0 and rf,a is also zero, because of the correlation between the risk
free asset and any risky asset A is zero. So the above equation becomes:
E(σi2) = (1-Wf)2σA2
Or E(σi) = (1-Wf) σA
So it can be said that for any portfolio that combines a risk free asset with any risky asset, the
standard deviation is the linear proportion of the standard deviation of the risky asset portfolio.

RISK RETURN POSSIBILITIES WITH LEVERAGE

As investor always want to increase his expected returns. Say, he is situated at a point ‘k’, on the
efficient frontier, he will want to go beyond that point i.e., increase his expected returns by
accepting higher degree of risk. One way of doing so may be by investing in risky portfolios on
the efficient frontier beyond the point ‘k’. Another way is to add leverage to the portfolio by
resorting to borrowing money at the risk free rate and use the proceeds to invest in risky asset
portfolio at point ‘k’.

LENDING AND BORROWING AT THE RISKLESS RATE

The consideration of riskless asset alters the efficient frontier considerably.

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Figure 2: Borrowing and Lending at Riskless rate Rf and investing in risky portfolio M

The above figure displays the efficient frontier, in terms of expected return E(r ) and standard
deviation (σ), along with the riskless asset f and three risky portfolios M, A, B. Since the riskless
asset f has no risk (i.e., σf = 0), it’s E(r) and σ plot on the zero risk, vertical axis at the point r f,
represents the expected rate of return on the riskless asset f.
With the riskless asset f and the ability to borrow or lend (invest) at risk free rate r f, it is now
possible to form portfolio that have risky assets as well as the risk free assets within them.
Furthermore, all combinations of any portfolio and the riskless asset will lie along a straight line
connecting their E(r), σ plots. For example, portfolios containing f and the risky portfolio A will
lie along the line segment rfA as shown in above figure. Similarly, combination of f with either
portfolio B or portfolio M will lie along segment rfB and rfM respectively. Therefore, combining
any risky portfolio with riskless asset produces a linear relationship between their respective
E(r), σ points.
An important implication of introducing riskless rate of lending and borrowing is the
transformation of the efficient frontier. With the introduction of rf, the efficient frontier is
transformed into a linear form. Furthermore, as long as E(rM) > rf investor can continually
increase expected return and risk by borrowing increasing amount at rf, and investing the
borrowed amount in portfolio M. the below figure shows the efficient frontier with borrowing
and lending portfolio:

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Figure 3: Borrowing and Lending at Riskless rate and Investing at Risky Portfolio M

THE DOMINANT PORTFOLIO ‘M’

By borrowing and lending at the riskless rate rf, investors can alter the risk/ expected return
profile of any efficient portfolio to meet personal preferences for risk and expected return. In the
below figure, regardless of whether investor want to borrow or lend, portfolio M is the best
efficient portfolio. This is because investors can invest in portfolio M and then borrow or lend at
Rf to suit their preference. That is, by borrowing and lending at Rf in conjunction with investing
in portfolio M, they can create portfolio combinations along the line RfM in such a way that for a
given level of risk it is possible to find a combination of M and risk free borrowing/ lending
which offers a return that is higher than the one available for a portfolio on the efficient frontier.
The figure is illustrated as follows:

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Figure 4: Dominant Portfolio
Because of this dominance, all investors should choose efficient portfolio M in conjunction with
their preference for lending or borrowing at the risk free rate Rf. Graphically, portfolio M
represent the tangent between a ray drawn from the intercept Rf, to the efficient frontier. This
tangency drawn from Rf to m has the greatest slope for any line drawn from Rf to the efficiency
set of risky portfolio. That is, point M is the efficient portfolio that maximize the value of
[E(r)-rf]/σ , risk premium.
Thus portfolio along with the line will maximize E(r ) at their respective σ levels, when
compared to portfolios along lower rays drawn from Rf, to any other portfolio along the
efficient frontier.

Market Portfolio
Since every investor should choose to hold portfolio M, it follows that portfolio M must be a
portfolio containing all securities in the market. Such a portfolio that contains all available
securities is called Market Securities. Because all investors should choose market portfolio, it
should contain all available securities. If it does not, securities that are not included would not be
demanded by any investor and prices of these securities, therefore, would fall and their expected
returns would rise. At the same point the increased expected returns would be attractive to some
investors.

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THE CAPITAL MARKET LINE
With the ability to borrow and lend at the risk free rate Rf, in conjunction with an investment in
the market portfolio M, the old curved efficient frontier is transformed into a new efficient
frontier, which is a line passing from Rf, through market portfolio M. this new linear efficient
frontier is called the Capital Market Line, or simply the CML. This CML, together with the old
efficient frontier, is illustrated in the below Figure. The inspection of the figure indicates that all
portfolios lying along the CML will dominate, in terms of E(r) and σ, the portfolio along the
previous curve efficient frontier.

Figure 6: The Capital Market Line(CML)

The CML not only represent the new efficient frontier, but it also expresses the equilibrium
pricing relationship between E( r) and σ for all efficient portfolios lying along the line. Since the
equation of any line can be expressed as y=a + bx, where a represents the vertical intercept and B
represents the slope of the line, the pricing relationship given by CML can be easily determined.
In the above figure a = Rf, and b = [E(Rm) – Rf]/σm.
Thus the CML, relationship for any efficient portfolio I is provided in equation:
E(ri) = Rf + {[E(Rm) – Rf]/σm}σi
In other words, the above equation states that the expected return on any efficient portfolio I,
E(ri), is the sum of two component: (1) the return on the risk free investment Rf, and (2) a risk
premium, {[E(Rm) – Rf]/σm}σi that is proportional to the portfolio’s σi. The slope of the CML
[E(Rm) – Rf]/σm is called the market price of the factor that distinguishes the expected return

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among CML portfolios is the magnitude of the risk, σi. The greater is the σi, the greater would be
the risk premium and the expected return on the portfolio.
It is important to recognize that the CML pricing holds only for efficient portfolio that lies along
its line. That is, only the most efficient in term of risk-reducing potential, portfolio that are
constructed of combination of risk free asset f and market portfolio M lie along the CML. All
individual securities and inefficient portfolios lie under the curve. For the efficient set of
portfolios along the CML, their total risk, as measured by σi, represents their systematic risk,
since all unsystematic risk has been diversified. Thus the efficient frontier not only produce the
set of optimal portfolio in terms of risk and expected returns, but it also represents portfolios that
are efficient in a risk/expected return sense, but it also represent zero unsystematic risk
portfolios. Since total risk σi, is the sum of systematic risk, σi, can be thought of as either total
risk or systematic risk. Thus, the CML states that the appropriate measure of risk that is to be
priced for these efficient portfolios is the level of systematic risk present I these portfolios.

CML Vs CAPM
The CML set forth the relationship between expected return and risk for efficient well-
diversified portfolios, whereas the CAPM is a pricing relationship that is applicable to all
securities and portfolios, whether efficient or inefficient. In both the CML and CAPM, the
appropriate measure of risk is the systematic portion of total risk. However CML assumes well
diversified Portfolios, its systematic risk, since there is no unsystematic risk present in well
diversified portfolios. The CAPM utilizes the Beta, βi, or covariance σm, as its measure of
systematic risk.
Finally it is interesting to note that the CML relationship is a special case of CAPM.
E(Ri) = Rf + [E(Rm) – Rf]β
Recall that βi = σi,m/σ2m = [Coeff. Of Cov (i,m)* σi*σm]/σ2m
Inserting the result into the above equation, we get,
E(Ri) = Rf + {[E(Rm) – Rf]coeff. Of Cov (i,m)*σi}/σm
For portfolios, whose returns are perfectly, positively correlated with the market and thus lie
along the CML, Coeff. Of Cov (I,m) = 1. Therefore for these portfolios, the CAPM relationship
reduces to:
E(Ri) = Rf + {[E(Rm) – Rf]/σm}σi

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This is the CAPM relationship. Thus, the CAPM is the general risk/ expected pricing relationship
for all assets, whereas the CML is a special case of the CAPM and represents an equilibrium
pricing relationship that holds only for widely diversified, efficient portfolios.

SECURITY MARKET LINE

Security market line or market Line is another way to perceive risk return equilibrium
relationship. With expected return on X axis and β on Y axis, if the market portfolio is drawn and
the line is extended to risk free rate of return, SML is obtained. It is a line which passes through
risk fre return and expected return of a market portfolio.
The CML specifies the equilibrium relationship between expected risk and return for efficient
portfolios. It cannot be used to evaluate the equilibrium relationship on single securities because
the standard deviation of the securities return is not the proper measure of security’s true risk,
since the risk of the security depend on the portfolio to which it is added and must reflect the co
variability of the security’s return with the other asset of the portfolio. Security Market Line
(SML) is broader and able to treat individual securities as well as portfolios. It expresses the
return that should be expected in terms of securities (or portfolios).
The SML expresses the expected return on any securities or portfolio in terms of the systematic
risk of the asset, beta.
E(Rp) = Rf + β(E(Rm) – Rf)
As with CML, there is a risk free and risk component, risk premium of an asset i, βi(E(Rm)-Rf).
But SML explains the risk of securities in relative terms through Beta whereas the CML treats
the total portfolio risk. In addition SML treats any security whereas CML treats efficient
portfolio only.
SML also describes whether a particular asset is defensive or aggressive. As the beta of the
markets is one, it serves as a reference to assess the assets. Assets for which the beta of the
market is less than 1 are called defensive assets and those whose beta is greater than one are
called aggressive assets.

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Figure 7: Security Market Line

SML also describes whether a particular asset is underpriced, overpriced or correctly priced. In
the above figure, asset A is plotted above the SML line. It is expected to earn higher return,
corresponding to the risk level. It is undervalued because expected rate of return is higher than
the SML- based return. On the other hand, asset B is said to be overvalued as the expected rate of
return is lower than the SML based return.

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 Chapter - ii

CAPM: Literature review by

different scholars

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 Capital Asset Pricing Model: Evidence and Theory

The Logic of the CAPM

The CAPM builds on the model of portfolio choice developed by Harry Markowitz (1959). In
Markowitz’s model, an investor selects a portfolio at time t _ 1 that produces a stochastic return
at t. The model assumes investors are risk averse and, when choosing among portfolios, they care
only about the mean and variance of their one-period investment return. As a result, investors
choose “mean variance- efficient” portfolios, in the sense that the portfolios 1) minimize the
variance of portfolio return, given expected return, and 2) maximize expected return, given
variance. Thus, the Markowitz approach is often called a “mean variance model.”
The portfolio model provides an algebraic condition on asset weights in mean variance- efficient
portfolios. The CAPM turns this algebraic statement into a testable prediction about the relation
between risk and expected return by identifying a portfolio that must be efficient if asset prices
are to clear the market of all assets.
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 complete agreement:
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, it 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.
Figure 1 describes portfolio opportunities and tells the CAPM story. The horizontal axis shows
portfolio risk, measured by the standard deviation of portfolio return; the vertical axis shows
expected return. The curve abc, which is called the minimum variance frontier, traces
combinations of expected return and risk for portfolios of risky assets that minimize return
variance at different levels of expected return. (These portfolios do not include risk-free
borrowing and lending.)
The tradeoff between risk and expected return for minimum variance portfolios is apparent. For
example, an investor who wants a high expected return, perhaps at point a, must accept high
volatility. At point T, the investor can have an intermediate expected return with lower volatility.
If there is no risk-free borrowing or lending, only portfolios above b along abc are mean-

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variance-efficient, since these portfolios also maximize expected return, given their return
variances.
Adding risk-free borrowing and lending turns the efficient set into a straight line. Consider a
portfolio that invests the proportion x of portfolio funds in a risk-free security and 1 _ x in some
portfolio g. If all funds are invested in the risk-free security—that is, they are loaned at the risk-
free rate of interest—the result is the point Rf in Figure 1, a portfolio with zero variance and a
risk-free rate of return. Combinations of risk-free lending and positive investment in g plot on the
straight line between Rf and g. Points to the right of g on the line represent borrowing at the risk-
free rate, with the proceeds from the borrowing used to increase investment in portfolio g. In
short, portfolios that combine risk-free lending or borrowing with some risky portfolio g plot
along a straight line from Rf through g in Figure

Figure 8: Investment Oppurtunity

To obtain the mean-variance-efficient portfolios available with risk-free borrowing and lending,
one swings a line from Rf in Figure 1 up and to the left as far as possible, to the tangency
portfolio T. We can then see that all efficient portfolios are combinations of the risk-free asset
(either risk-free borrowing or lending) and a single risky tangency portfolio, T. This key result is
Tobin’s (1958) “separation theorem.”
The punch line of the CAPM is now straightforward. With complete agreement about
distributions of returns, all investors see the same opportunity set, and they combine the same
risky tangency portfolio T with risk-free lending or borrowing. Since all investors hold the same

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portfolio T of risky assets, it must be the value-weight market portfolio of risky assets.
Specifically, each risky asset’s weight in the tangency portfolio, which we now call M (for the
“market”), must be the total market value of all outstanding units of the asset divided by the total
market value of all risky assets. In addition, the risk-free rate must be set (along with the prices
of risky assets) to clear the market for risk-free borrowing and lending.
In short, the CAPM assumptions imply that the market portfolio M must be on the minimum
variance frontier if the asset market is to clear. This means that the algebraic relation that holds
for any minimum variance portfolio must hold for the market portfolio. Specifically, if there are
N risky assets,
(Minimum Variance Condition for M) E(Ri) = E(Rzm) + [E(Rm) – E(Rzm)]βi,m, i= 1,……, N.
In this equation, E(Ri) is the expected return on asset i, and _iM, the market beta of asset i, is the
covariance of its return with the market return divided by the variance of the market return,
(Market Beta) βim = cov(Ri , RM)/σ2(Rm). The first term on the right-hand side of the minimum
variance condition, E(RZM), is the expected return on assets that have market betas equal to zero,
which means their returns are uncorrelated with the market return. The second term is a risk
premium—the market beta of asset i, _iM, times the premium per unit of beta, which is the
expected market return, E(RM), minus E(RZM).
Since the market beta of asset i is also the slope in the regression of its return on the market
return, a common (and correct) interpretation of beta is that it measures the sensitivity of the
asset’s return to variation in the market return. But there is another interpretation of beta more in
line with the spirit of the portfolio model that underlies the CAPM. The risk of the market
portfolio, as measured by the variance of its return (the denominator of β iM), is a weighted
average of the covariance risks of the assets in M (the numerators of βiM for different assets).
Thus, βiM is the covariance risk of asset i in M measured relative to the average covariance risk
of assets, which is just the variance of the market return. In economic terms, βiM is proportional
to the risk each dollar invested in asset I contributes to the market portfolio. The last step in the
development of the Sharpe-Lintner model is to use the assumption of risk-free borrowing and
lending to nail down E(RZM), the expected return on zero-beta assets. A risky asset’s return is
uncorrelated with the market return—its beta is zero—when the average of the asset’s
covariances with the returns on other assets just offsets the variance of the asset’s return. Such a

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risky asset is riskless in the market portfolio in the sense that it contributes nothing to the
variance of the market return.
When there is risk-free borrowing and lending, the expected return on assets that are
uncorrelated with the market return, E(RZM), must equal the risk-free rate, Rf. The relation
between expected return and beta then becomes the familiar Sharpe-Lintner CAPM equation,
E(Ri) = Rf + [ E(Rm)- Rf)]βm, I = 1,….., N.
In words, the expected return on any asset i is the risk-free interest rate, Rf , plus a risk premium,
which is the asset’s market beta, _iM, times the premium per unit of beta risk, E(RM) _ Rf.
Unrestricted risk-free borrowing and lending is an unrealistic assumption. Fischer Black (1972)
develops a version of the CAPM without risk-free borrowing or lending. He shows that the
CAPM’s key result—that the market portfolio is meanvariance- efficient—can be obtained by
instead allowing unrestricted short sales of risky assets. In brief, back in Figure 8, if there is no
risk-free asset, investors select portfolios from along the mean-variance-efficient frontier from a
to b. Market clearing prices imply that when one weights the efficient portfolios chosen by
investors by their (positive) shares of aggregate invested wealth, the resulting portfolio is the
market portfolio. The market portfolio is thus a portfolio of the efficient portfolios chosen by
investors. With unrestricted short selling of risky assets, portfolios made up of efficient
portfolios are themselves efficient. Thus, the market portfolio is efficient, which means that the
minimum variance condition for M given above holds, and it is the expected return-risk relation
of the Black CAPM.
The relations between expected return and market beta of the Black and Sharpe-Lintner versions
of the CAPM differ only in terms of what each says about E(RZM), the expected return on assets
uncorrelated with the market. The Black version says only that E(RZM) must be less than the
expected market return, so the premium for beta is positive. In contrast, in the Sharpe-Lintner
version of the model, E(RZM) must be the risk-free interest rate, Rf , and the premium per unit of
beta risk is E(RM) _ Rf.
The assumption that short selling is unrestricted is as unrealistic as unrestricted risk-free
borrowing and lending. If there is no risk-free asset and short sales of risky assets are not
allowed, mean-variance investors still choose efficient portfolios—points above b on the abc
curve in Figure 1. But when there is no short selling of risky assets and no risk-free asset, the
algebra of portfolio efficiency says that portfolios made up of efficient portfolios are not

Page 23
typically efficient. This means the market portfolio, which is a portfolio of the efficient portfolios
chosen by investors, is not typically efficient. And the CAPM relation between expected return
and market beta is lost. This does not rule out predictions about expected return and betas with
respect to other efficient portfolios—if theory can specify portfolios that must be efficient if the
market is to clear. But so far this has proven impossible.
In short, the familiar CAPM equation relating expected asset returns to their market betas is just
an application to the market portfolio of the relation between expected return and portfolio beta
that holds in any mean-variance-efficient portfolio.
The efficiency of the market portfolio is based on many unrealistic assumptions, including
complete agreement and either unrestricted risk-free borrowing and lending or unrestricted short
selling of risky assets. But all interesting models involve unrealistic simplifications, which is
why they must be tested against data.

Recent Tests
Starting in the late 1970s, empirical work appears that challenges even the Black version of the
CAPM. Specifically, evidence mounts that much of the variation in expected return is unrelated
to market beta. The first blow is Basu’s (1977) evidence that when common stocks are sorted on
earnings-price ratios, future returns on high E/P stocks are higher than predicted by the CAPM.
Banz (1981) documents a size effect: when stocks are sorted on market capitalization (price
times shares outstanding), average returns on small stocks are higher than predicted by the
CAPM. 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. Finally, Statman (1980) and Rosenberg, Reid and Lanstein (1985) document
that stocks with high book-to-market equity ratios (B/M, the ratio of the book value of a common
stock to its market value) have high average returns that are not captured by their betas.
There is a theme in the contradictions of the CAPM summarized above. Ratios involving stock
prices have information about expected returns missed by market betas. On reflection, this is not
surprising. A stock’s price depends not only on the expected cash flows it will provide, but also
on the expected returns that discount expected cash flows back to the present. Thus, in principle,
the cross-section of prices has information about the cross-section of expected returns. (A high
expected return implies a high discount rate and a low price.) The cross-section of stock prices is,

Page 24
however, arbitrarily affected by differences in scale (or units). But with a judicious choice of
scaling variable X, the ratio X/P can reveal differences in the cross-section of expected stock
returns. Such ratios are thus prime candidates to expose shortcomings of asset pricing models.
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. Fama and French (1996) reach the same conclusion using the time-series regression
approach applied to portfolios of stocks sorted on price ratios. They also find that different price
ratios have much the same information about expected returns. This is not surprising given that
price is the common driving force in the price ratios, and the numerators are just scaling
variables used to extract the information in price about expected returns.
Fama and French (1992) also confirm the evidence (Reinganum, 1981; Stambaugh, 1982;
Lakonishok and Shapiro, 1986) that the relation between average return and beta for common
stocks is even flatter after the sample periods used in the early empirical work on the CAPM.
The estimate of the beta premium is, however, clouded by statistical uncertainty (a large standard
error). Kothari, Shanken and Sloan (1995) try to resuscitate the Sharpe-Lintner CAPM by
arguing that the weak relation between average return and beta is just a chance result. But the
strong evidence that other variables capture variation in expected return missed by beta makes
this argument irrelevant. If betas do not suffice to explain expected returns, the market portfolio
is not efficient, and the CAPM is dead in its tracks.
Explanations: Irrational Pricing or Risk
Among those who conclude that the empirical failures of the CAPM are fatal, two stories
emerge. On one side are the behavioralists. Their view is based on evidence that stocks with high
ratios of book value to market price are typically firms that have fallen on bad times, while low
B/M is associated with growth firms (Lakonishok, Shleifer and Vishny, 1994; Fama and French,
1995). The behavioralists argue that sorting firms on book-to-market ratios exposes investor
overreaction to good and bad times. Investors overextrapolate past performance, resulting in
stock prices that are too high for growth (low B/M) firms and too low for distressed (high B/M,
so-called value) firms. When the overreaction is eventually corrected, the result is high returns
for value stocks and low returns for growth stocks. The second story for explaining the empirical
contradictions of the CAPM is that they point to the need for a more complicated asset pricing

Page 25
model. The CAPM is based on many unrealistic assumptions. For example, the assumption that
investors care only about the mean and variance of one-period portfolio returns is extreme.
Merton’s (1973) intertemporal capital asset pricing model (ICAPM) is a natural extension of the
CAPM. The ICAPM begins with a different assumption about investor objectives. In the CAPM,
investors care only about the wealth their portfolio produces at the end of the current period. In
the ICAPM, investors are concerned not only with their end-of-period payoff, but also with the
opportunities they will have to consume or invest the payoff. Thus, when choosing a portfolio at
time t - 1, ICAPM investors consider how their wealth at t might vary with future state variables,
including labor income, the prices of consumption goods and the nature of portfolio
opportunities at t, and expectations about the labor income, consumption and investment
opportunities to be available after t.
Like CAPM investors, ICAPM investors prefer high expected return and low return variance.
But ICAPM investors are also concerned with the covariances of portfolio returns with state
variables. As a result, optimal portfolios are “multifactor efficient,” which means they have the
largest possible expected returns, given their return variances and the covariances of their returns
with the relevant state variables. Fama (1996) shows that the ICAPM generalizes the logic of the
CAPM. That is, if there is risk-free borrowing and lending or if short sales of risky assets are
allowed, market clearing prices imply that the market portfolio is multifactor efficient.
Moreover, multifactor efficiency implies a relation between expected return and beta risks, but it
requires additional betas, along with a market beta, to explain expected returns.
An ideal implementation of the ICAPM would specify the state variables that affect expected
returns. Fama and French (1993) take a more indirect approach, perhaps more in the spirit of
Ross’s (1976) arbitrage pricing theory. They argue that though size and book-to-market equity
are not themselves state variables, the higher average returns on small stocks and high book-to-
market stocks reflect unidentified state variables that produce undiversifiable risks (covariances)
in returns that are not captured by the market return and are priced separately from market betas.
In support of this claim, they show that the returns on the stocks of small firms covary more with
one another than with returns on the stocks of large firms, and returns on high book-to-market
(value) stocks covary more with one another than with returns on low book-to-market (growth)
stocks. Fama and French (1995) show that there are similar size and book-to-market patterns in

Page 26
the covariation of fundamentals like earnings and sales. Based on this evidence, Fama and
French (1993, 1996) propose a three-factor model for expected returns,
Three Factor Model:- E(Rit) – Rf = β[E(Rmt) – Rf] + βisE(SMBt) + βih HMLt +eit
The three-factor model is now widely used in empirical research that requires a model of
expected returns The three-factor model is hardly a panacea. Its most serious problem is the
momentum effect of Jegadeesh and Titman (1993). Stocks that do well relative to the market
over the last three to twelve months tend to continue to do well for the next few months, and
stocks that do poorly continue to do poorly. This momentum effect is distinct from the value
effect captured by book-to-market equity and other price ratios. Moreover, the momentum effect
is left unexplained by the three-factor model, as well as by the CAPM. Following Carhart (1997),
one response is to add a momentum factor (the difference between the returns on diversified
portfolios of short-term winners and losers) to the three-factor model.

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 Chapter – iii
Capm and apt: Comparisons
and interrelationship

Multifactor Models and Arbitrage Pricing Theory (APT)

All the multifactor asset pricing models try to explore the risk contribution of systematic factors
effective on expected returns by constructing linear multiple regression equations that are
expected to best represent the relationship between risk factors and asset returns. The most
important one of the multifactor prediction models is the Arbitrage

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Pricing Theory which was developed by Stephen A. Ross (1976: 341-360). This theory has been
considered an alternative to the Capital Asset Pricing Model and does not presume the presence
of a fully efficient market. But, there are a few assumptions mentioned below on which the
theory is based:
a) The capital market fits the conditions of perfect competition,
b) Investors are rational under certainty conditions, which means that they prefer more wealth to
be less,
c) The stochastic process explaining how asset returns exist can be explained by a linear K-factor
model,
d) Market does not allow for arbitrage opportunities arising from the violation of the law of one
price. If any arbitrage opportunity existed, investors would immediately react in order to benefit
from that situation by buying the asset in the market where it has been undervalued and then
selling where the asset has been relatively overvalued. All these attempts would make the
existing arbitrage opportunity suddenly disappear.
Ross starts his model explanation with a single factor model resembling the
CAPM and formulates the risk-return relationship using the following single equation (Bolak,
2001: 270):
ri = α i + β iF +e I ------------------------------------ (6)
In the equation, the actual rate of return is abbreviated by ri, αi refers to the expected rate of
return on the asset i, F denotes systematic risk factor, and βi represents the sensitivity of the
asset’s returns to the risk factor. The prediction error arising from the effect of idiosyncratic
factors is symbolized with ei.
The theory assumes that all the firm-specific risk factors (ei) can be fully eliminated if a portfolio
has been sufficiently diversified and therefore systematic risk component becomes the only case
for portfolios. The return estimation equation turns out to be in a new form presented below.
rp = E(Rp) + βp F --------------------------------- (7)
It is a simplifying assumption to say that there is only one systematic risk factor affecting asset
returns. To get closer to the reality, the theory suggests the use of multiple variables as
determinants on systematic risk in order to cover all the effects of potential systematic risk
factors. In most of the relevant studies performed, major macroeconomic indicators such as

Page 29
interest rate, inflation, gross domestic product (GDP), have been preferred as the representatives
of potential systematic risk factors.
A typical multifactor APT Model is similar to linear multiple regression models. Expected return
on any financial asset is finally formulated as in the Equation 8:
E(Rp) = rf + ∑βp,i.(E(Rfi) – rf) ------------------------ ( 8)
In the above equation, E (RP) is the expected rate of return on portfolio, E (RFi) is referred to as
the expected rate of return on ith factor portfolio, βp,i constitutes the sensitivity of portfolio’s
return to the factor portfolio i, and rf represents risk free rate of return. The difference term in
parenthesis is called the risk premium of the factor portfolio.
A factor portfolio is a portfolio whose return distribution has no correlation (zero correlation)
with those of other factor portfolios. This situation is seen as a bottleneck for the implementation
of the theory because examining separate factor portfolios not correlated to each other is so
difficult a business to succeed. The exploration of not correlated factor portfolios is a task similar
to searching for explanatory variables fulfilling the statistical requirement of absence of linear
multicollinearity (Maddala, 2004: 278).
The second remarkable theory in the relevant literature employing multifactor modeling
procedure is the Three-Factor Model proposed by Fama and French (1993: 3- 56). The Three-
Factor Model is another replication of the multifactor APT models. As different from the APT
models, three predetermined systematic risk factor are considered; market risk premium (the
return of market portfolio in excess of risk free return), the difference between the mean rates of
return of small and big-scaled companies, and the difference between the average return of the
companies with high book to market ratios and the average return of those with low book to
market ratios (Hu, 2007: 113).
The presence of two main theories, APT and CAPM, in the field of asset pricing has cast strong
concern in investigating the superiority of these models to each other. Following the introduction
of these theories to the literature, a huge number empirical studies were carried out aiming to
compare their performance. Most of the findings reported in these studies have provided results
favoring the APT models against the CAPM even in the emerging markets. There are few studies
that suggest the superiority of CAPM over APT.
The multifactor APT models could provide better results than the CAPM in the Indian Stock
Market on monthly and weekly returns data. In another research carried out by Sun and Zhang

Page 30
(2001: 617) in America using the data of eight forestry-related companies’ financial
performance, some empirical results were reported favoring the better performance of the APT
models as compared to CAPM. As a unique study arguing the applicability of the APT models,
Altay (2005: 217 – 237) pointed out that unexpected interest rate and inflation changes proved to
be statistically significant determinants on stock returns in Germany. However, he also stated
that the same judgment couldn’t be made for the stock market in Turkey.

Comparison of CAPM and APT

CAPM requires something more than APT to support its prediction that sensitivity to one
economic force- the force reflected in the returns to the market portfolio- is the only determinant
of expected or required return on an asset. On the other hand, APT views several economic
forces as the systematic determinants of actual returns on an asset.
The development of the CAPM risk-return relationship is more involved than the APT
relationship. But the relationship itself is the same as APT would have if there was only one
pervasive economic force influencing the return generation process.
CAPM’s assumption that sensitivity to the market is the only required indicator of risk, and thus
the only determinant of expected or required return, may perhaps be good enough even if APT
provides a better description of how markets generate returns. This is because, different
sensitivities of each asset to the collection of economic forces could ‘net out’, so that sensitivity
to a single market index would do as good a job as any multi-factor model in explaining the
expected return differences among assets. Further, the factors other than the market index
considered under APT would also have influences that market index as it would have affected
the security. If it were so, the market index would capture that effect too. Hence, if the
unanticipated changes in economic factor were highly correlated, then stock sensitivity to any
one factor like market index could well represent sensitivity to all factors. In either case, the
CAPM model would be a satisfactory proxy for the multi-index model. But, it seems more than
likely those stocks have different sensitivity to various economic factors and that unanticipated
changes in economic factors do not have much correlation.
Apart from these, the CAPM is characterized by simplicity as it expresses, the pricing
relationship in terns if just two elements – the riskless asset ( or the minimum- variance zero beta
security) and the market portfolio. However, empirical tests of the basic CAPM have not been

Page 31
fully supportive of the theory. While most tests indicate a relatively linear relationship between
realized returns and their systematic risks, the empirical results, in general indicate an intercept
that exceeds the returns on the riskless asset and a market risk premium that is lower than its
theoretical value, Furthermore, even though the zero beta version of the basic CAPM provides a
theoretical model that is consistent with the empirical anomalies of the basic CAPM, empirical
tests of any form of the CAPM is questioned by many researchers owing to the reliance of the
theory on an unobservable market portfolio.
To sum up, APT does not overcome all of the objectives, and it has some shortcomings of its
own. Nevertheless, it is the first model to challenge CAPM and has a real chance of replacing it.
The feature that makes APT of greater potential value to decision makers lies in its attempt to
explain the risk-return relationship using several factors instead of a single market index.

Chapter - IV

Page 32
Testing Capital Asset Pricing
Model in Indian Stock market

Page 33
 TESTING THE CAPITAL ASSET PRICING MODEL

INTRODUCTION
Investors and financial researchers have paid considerable attention during the last few years to
the new equity markets that have emerged around the world. This new interest has undoubtedly
been spurred by the large, and in some cases extraordinary, returns offered by these markets.
Practitioners all over the world use a plethora of models in their portfolio selection process and
in their attempt to assess the risk exposure to different assets.
One of the most important developments in modern capital theory is the capital asset pricing
model (CAPM) as developed by Sharpe [1964], Lintner [1965] and Mossin [1966]. CAPM
suggests that high expected returns are associated with high levels of risk. Simply stated, CAPM
postulates that the expected return on an asset above the risk-free rate is linearly related to the
non-diversifiable risk as measured by the asset’s beta. Although the CAPM has been
predominant in empirical work over the past 30 years and is the basis of modern portfolio theory,
accumulating research has increasingly cast doubt on its ability to explain the actual movements
of asset returns.
The purpose is to examine thoroughly if the CAPM holds true in the capital market of India.
Tests are conducted for a period of ten years (2001-2011), which is characterized by intense
return volatility (covering historically high returns for the Indian Stock market as well as
significant decrease in asset returns over the examined period). These market return
characteristics make it possible to have an empirical investigation of the pricing model on
differing financial conditions thus obtaining conclusions under varying stock return volatility.
Existing financial literature on the Athens stock exchange is rather scanty and it is the goal of
this study to widen the theoretical analysis of this market by using modern finance theory and to
provide useful insights for future analyses of this market.

Empirical appraisal of the model and competing studies of the model’s validity
Empirical appraisal of CAPM
Since its introduction in early 1960s, CAPM has been one of the most challenging topics in
financial economics. Almost any manager who wants to undertake a project must justify his
decision partly based on CAPM. The reason is that the model provides the means for a firm to
calculate the return that its investors demand. This model was the first successful attempt to

Page 34
show how to assess the risk of the cash flows of a potential investment project, to estimate the
project’s cost of capital and the expected rate of return that investors will demand if they are to
invest in the project.
The model was developed to explain the differences in the risk premium across assets.
According to the theory these differences are due to differences in the riskiness of the returns on
the assets. The model states that the correct measure of the riskiness of an asset is its beta and
that the risk premium per unit of riskiness is the same across all assets. Given the risk free rate
and the beta of an asset, the CAPM predicts the expected risk premium for an asset.
The theory itself has been criticized for more than 30 years and has created a great academic
debate about its usefulness and validity. In general, the empirical testing of CAPM has two broad
purposes
(Baily et al, [1998]): (i) to test whether or not the theories should be rejected (ii) to provide
information that can aid financial decisions. To accomplish (i) tests are conducted which could
potentially at least reject the model. The model passes the test if it is not possible to reject the
hypothesis that it is true.
Methods of statistical analysis need to be applied in order to draw reliable conclusions on
whether the model is supported by the data. To accomplish (ii) the empirical work uses the
theory as a vehicle for organizing and interpreting the data without seeking ways of rejecting the
theory. This kind of approach is found in the area of portfolio decision-making, in particular with
regards to the selection of assets to the bought or sold. For example, investors are advised to buy
or sell assets that according to
CAPM are underpriced or overpriced. In this case empirical analysis is needed to evaluate the
assets, assess their riskiness, analyze them, and place them into their respective categories. A
second illustration of the latter methodology appears in corporate finance where the estimated
beta coefficients are used in assessing the riskiness of different investment projects. It is then
possible to calculate “hurdle rates” that projects must satisfy if they are to be undertaken.
This part of the paper focuses on tests of the CAPM since its introduction in the mid 1960’s, and
describes the results of competing studies that attempt to evaluate the usefulness of the capital
asset pricing model (Jagannathan and McGrattan [1995]).

Page 35
The classic support of the theory
The model was developed in the early 1960’s by Sharpe [1964], Lintner [1965] and Mossin
[1966]. In its simple form, the CAPM predicts that the expected return on an asset above the
risk-free rate is linearly related to the non-diversifiable risk, which is measured by the asset’s
beta.
One of the earliest empirical studies that found supportive evidence for CAPM is that of Black,
Jensen and Scholes [1972]. Using monthly return data and portfolios rather than individual
stocks, Black et al tested whether the cross-section of expected returns is linear in beta. By
combining securities into portfolios one can diversify away most of the firm-specific component
of the returns, thereby enhancing the precision of the beta estimates and the expected rate of
return of the portfolio securities. This approach mitigates the statistical problems that arise from
measurement errors in beta estimates. The authors found that the data are consistent with the
predictions of the CAPM i.e. the relation between the average return and beta is very close to
linear and that portfolios with high (low) betas have high (low) average returns.
Another classic empirical study that supports the theory is that of Fama and McBeth [1973]; they
examined whether there is a positive linear relation between average returns and beta. Moreover,
the authors investigated whether the squared value of beta and the volatility of asset returns can
explain the residual variation in average returns across assets that are not explained by beta alone

Challenges to the validity of the theory

In the early 1980s several studies suggested that there were deviations from the linear CAPM
risk return trade-off due to other variables that affect this tradeoff. The purpose of the above
studies was to find the components that CAPM was missing in explaining the risk-return trade-
off and to identify the variables that created those deviations.
Banz [1981] tested the CAPM by checking whether the size of firms can explain the residual
variation in average returns across assets that remain unexplained by the CAPM’s beta. He
challenged the CAPM by demonstrating that firm size does explain the cross sectional-variation
in average returns on a particular collection of assets better than beta. The author concluded that
the average returns on stocks of small firms (those with low market values of equity) were higher
than the average returns on stocks of large firms (those with high market values of equity). This
finding has become known as the size effect.

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The research has been expanded by examining different sets of variables that might affect the
risk return tradeoff. In particular, the earnings yield (Basu [1977]), leverage, and the ratio of a
firm’s book value of equity to its market value (e.g. Stattman [1980], Rosenberg, Reid and
Lanstein [1983] and Chan, Hamao, Lakonishok [1991]) have all been utilized in testing the
validity of CAPM. was to support the view that although the data may suggest deviations from
CAPM, these deviations are not so important as to reject the theory.
However, this idea has been challenged by Fama and French [1992]. They showed that Banz’s
findings might be economically so important that it raises serious questions about the validity of
the CAPM. Fama and French [1992] used the same procedure as Fama and McBeth [1973] but
arrived at very different conclusions. Fama and McBeth find a positive relation between return
and risk while Fama and French find no relation at all.

The Academic Debate Continues

The Fama and French [1992] study has itself been criticized. In general the studies responding to
the Fama and French challenge by and large take a closer look at the data used in the study.
Kothari,
Shaken and Sloan [1995] argue that Fama and French’s [1992] findings depend essentially on
how the statistical findings are interpreted.
Amihudm, Christensen and Mendelson [1992] and Black [1993] support the view that the data
are too noisy to invalidate the CAPM. In fact, they show that when a more efficient statistical
method is used, the estimated relation between average return and beta is positive and
significant. Black [1993] suggests that the size effect noted by Banz [1981] could simply be a
sample period effect i.e. the size effect is observed in some periods and not in others.
Despite the above criticisms, the general reaction to the Fama and French [1992] findings has
been to focus on alternative asset pricing models. Jagannathan and Wang [1993] argue that this
may not be necessary. Instead they show that the lack of empirical support for the CAPM may be
due to the inappropriateness of basic assumptions made to facilitate the empirical analysis. For
example, most empirical tests of the CAPM assume that the return on broad stock market indices
is a good proxy for the return on the market portfolio of all assets in the economy. However,
these types of market indexes do not capture all assets in the economy such as human capital.

Page 37
Other empirical evidence on stock returns is based on the argument that the volatility of stock
returns is constantly changing. When one considers a time-varying return distribution, one must
refer to the conditional mean, variance, and covariance that change depending on currently
available information. In contrast, the usual estimates of return, variance, and average squared
deviations over a sample period, provide an unconditional estimate because they treat variance as
constant over time.
The most widely used model to estimate the conditional (hence time- varying) variance of stocks
and stock index returns is the generalized autoregressive conditional heteroscedacity (GARCH)
model pioneered by Robert.F.Engle.
To summarize, all the models above aim to improve the empirical testing of CAPM. There have
also been numerous modifications to the models and whether the earliest or the subsequent
alternative models validate or not the CAPM is yet to be determined.

Sample Selection and Data

Sample Selection
The study covers the period from January 2001 to January 2011. This time period was chosen
because it is characterized by intense return volatility with historically high and low returns for
the Indian Stock Market.
The selected sample consists of 100 stocks that are included in a sampling frame to make the
portfolio. The stock varies in size, P/E ratio, financial Leverage. All the securities included in the
portfolio are traded on the Bombay Stock Exchange on the continuous basis throughout the full
BSE trading day.
For the Purpose of the study, 50 stocks were selected from the pool of securities of 100 stocks. I
have selected only 50 stocks out of 100 securities because of various constraints like Data
unavailability, De-listing of the stocks from the Index etc. Each series of stocks consists of 10
observations of yearly closing prices. The selection of stocks varies on the basis of market
capitalization, P/E, leverage etc.

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Data Selection
The study uses weekly stock returns from 50 companies listed on the Bombay Stock Exchange
for the period of January 2001 to January 2011. The data are obtained from BSE Stock Data
Base and from PROWESS Database
In order to obtain better estimates of the value of the beta coefficient, the study utilizes yearly
stock returns. Returns calculated using a longer time period (e.g. yearly) might result in changes
of beta over the examined period introducing biases in beta estimates. On the other hand, high
frequency data such as daily observations covering a relatively short and stable time span can
result in the use of very noisy data and thus yield inefficient estimates.
All stock returns used in the study are adjusted for dividends as required by the CAPM.
The BSE Composite Share index is used as a proxy for the market portfolio. This index is a
market value weighted index, is comprised of the 60 most highly capitalized shares of the main
market, and reflects general trends of the Indian stock market.
Furthermore, the Indian Government Bonds is used as the proxy for the risk-free asset. The
yields were obtained from the Reserve Bank of India website. The yield on the Indian
Government Bonds is specifically chosen as the benchmark that better reflects the short-term
changes in the Indian financial markets.

Methodology
The first step was to estimate a beta coefficient for each stock using weekly returns during the
period of January 1998 to December 2002. The beta was estimated by regressing each stock’s
yearly return against the market index according to the following equation:
Rit -R ft = αi +βi (Rmt - Rft) + eit
Where,
R it is the return on stock i (i=1…100),
R ft is the rate of return on a risk-free asset,
R mt is the rate of return on the market index,
βi is the estimate of beta for the stock i , and
eit is the corresponding random disturbance term in the regression equation.
[Equation 1 could also be expressed using excess return notation, where ( - )= it ft it R R r and
ft mt ( - )=r mt R R ]

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Here the beta is calculated for all the individual stocks for 10 years using Regression tool in MS
Excel. The returns of individual stock are calculated on the basis of:
Rit = [Pit – Pi (t-1)]/ P(t-1)i
Where,
Rit = Return of individual stock i for time period (t = 1 …… 10)
Pit = closing price of the stocks of current year
Pi(t-1) = closing price of the stock of previous year.

Empirical results and Interpretation of the findings

The first part of the methodology required the estimation of betas for individual stocks by using
observations on rates of return for a sequence of dates. Useful remarks can be derived from the
results of this procedure, for the assets used in this study. The beta of the individual security is
given below:
Table 1: Beta of individual securities (Companies)
Company Beta Company Beta
ABB 3.989952 PNB 1.121698
ACC 0.91 Ranbaxy 0.8134
Ambuja Cements 0.68 HCL 1.435777
BHEL 1.28 Reliance industries 0.875433
BPCL 0.62 Satyam 0.336327
Bharti Airtel 1.21 Bajaj Electricals 2.08628
Cipla 0.51 Wipro 2.08628
Glaxosmith 0.46 Zee 1.073134
Grasim 1.53 Unitech 1.466225
HDFC 0.87 Tata Comm 0.466867
Hero Honda 0.70 Tata Power 1.34148
Hindalco Industry 1.48625 Tata Motors 2.300307
GAIL 1.660744 Sun Pharma 0.365135
Dr. Reddy Lab 0.83813 Sterlite 4.039579
HP 0.348161 SAIL 2.687173
HUL 0.090135 SBI 0.928988
Housing Dev Fin Cor 1.01929 Siemen 1.705396
ITC 0.417147 Abbot 0.641285
ICICI Bank 1.202891 Adani Enterprise 2.264626
Infosys Tech 0.775173 Raymonds 1.126948
Larsen & Turbo 1.583617 Novartis 0.744671
Mahanagar Telephone 0.550618 Aditya Birla 1.44455
M&M 2.298222 Titan 1.040378
ONGC 0.761257 Kotak 1.535358

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 Maruti Suzuki 1.127525 Berger Paints 1.101799
The range of the estimated stock betas is between 0.090 the minimum and 4.039 the maximum
with a standard deviation of 0.2240. Most of the beta coefficients for individual stocks are
statistically significant at a 95% level and all estimated beta coefficients are statistical significant
at a 90% level.

HYPOTHESIS
According to the CAPM theory, the theory indicates higher risk (beta) is associated with higher
returns which is the basic hypothesis of the study.
Higher β = Higher Rit The beta and return of individual securities are:
Table 2: Average Return and Beta of all Securities
Company Beta Return Company Beta Return
Sterlite 4.039579 89.23636 Zee 1.073134 4.354545
ABB 3.989952 31.73727 Titan 1.040378 70.20909
SAIL 2.687173 78.88545 Housing Dev Fin Cor 1.01929 17.43364
Tata Motors 2.300307 67.56727 SBI 0.928988 33.60636
M&M 2.298222 48.07727 ACC 0.91 26.65273
Adani Enterprise 2.264626 60.55818 Reliance industries 0.875433 20.62818
Bajaj Electricals 2.08628 52.48091 HDFC 0.87 28.08
Wipro 2.08628 -0.57455 Dr. Reddy Lab 0.83813 12.5
Siemen 1.705396 47.84455 Ranbaxy 0.8134 9.950909
GAIL 1.660744 40.55909 Infosys Tech 0.775173 5.729091
Larsen & Turbo 1.583617 48.48182 ONGC 0.761257 34.27909
Kotak 1.535358 49.68364 Novartis 0.744671 11.29909
Grasim 1.53 38.42727 Hero Honda 0.70 22.60364
Hindalco Industry 1.48625 23.95455 Ambuja Cements 0.68 13.06727
Unitech 1.466225 43.53273 Abbot 0.641285 18.54091
Aditya Birla 1.44455 42.79364 BPCL 0.62 21.96818
HCL 1.435777 19.25364 Mahanagar Telephone 0.550618 -6.72
Tata Power 1.34148 40.65091 Cipla 0.51 0.482727
BHEL 1.28 38.89273 Tata Comm 0.466867 9.089091
Bharti Airtel 1.21 56.46 Glaxosmith 0.46 20.02182
ICICI Bank 1.202891 30.13 ITC 0.417147 -0.27636
Maruti Suzuki 1.127525 24.91 Sun Pharma 0.365135 3.819091
Raymonds 1.126948 24.12455 HP 0.348161 12.87545
PNB 1.121698 39.17364 Satyam 0.336327 -6.84
Berger Paints 1.101799 18.42909 HUL 0.090135 4.231818

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The result of the study supports the hypothesis. The beta coefficient o the 50 securities indicate
that higher beta portfolio are related with higher return. For example: the highest beta in the
indices is of Sterlite (i.e β = 4.039) and Sterlite also provide highest return among all other
security (i.e Rit = 89.23).

CONCLUSION
The article examined the validity of the CAPM for the Greek stock market. The study used
monthly stock returns from 100 companies listed on the Athens stock exchange from January
2001 to January 2011.
The findings of the article are not supportive of the theory’s basic hypothesis that higher risk
(beta) is associated with a higher level of return. In order to diversify away most of the firm-
specific part of returns thereby enhancing the precision of the beta estimates, the securities where
combined into portfolios to mitigate the statistical problems that arise from measurement errors
in individual beta estimates.
The model does explain, however, excess returns. The results obtained lend support to the linear
structure of the CAPM equation being a good explanation of security returns. The high value of
the estimated correlation coefficient between the intercept and the slope indicates that the model
used, explains excess returns. However, the fact that the intercept has a value around zero
weakens the above explanation.

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 CHAPTER- v

EFFICIENT MARKET
HYPOTHESIS ANF ITS
ANAMOLIES

EFFICIENT MARKET HYPOTHESIS AND ITS ANAMOLIES

INTRODUCTION

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Many investors try to identify securities that are undervalued, and are expected to increase in
value in the future, and particularly those that will increase more than others.
Many investors, including investment managers, believe that they can select securities that will
outperform the market. They use a variety of forecasting and valuation techniques to aid them in
their investment decisions. Obviously, any edge that an investor possesses can be translated into
substantial profits. If a manager of a mutual fund with $10 billion in assets can increase the
fund’s return, after transaction costs, by 1/10th of 1 percent, this would result in a $10 million
gain. The EMH asserts that none of these techniques are effective (i.e., the advantage gained
does not exceed the transaction and research costs incurred), and therefore no one can
predictably outperform the market.
Arguably, no other theory in economics or finance generates more passionate discussion between
its challengers and proponents. For example, noted Harvard financial economist Michael Jensen
writes “there is no other proposition in economics which has more solid empirical evidence
supporting it than the Efficient Market Hypothesis,” while investment maven Peter Lynch claims
“Efficient markets? That’s a bunch of junk, crazy stuff” (Fortune, April 1995).

The efficient markets hypothesis (EMH) suggests that profiting from predicting price movements
is very difficult and unlikely. The main engine behind price changes is the arrival of new
information. A market is said to be “efficient” if prices adjust quickly and, on average, without
bias, to new information. As a result, the current prices of securities reflect all available
information at any given point in time. Consequently, there is no reason to believe that prices
are too high or too low. Security prices adjust before an investor has time to trade on and profit
from a new a piece of information.
The key reason for the existence of an efficient market is the intense competition among
investors to profit from any new information. The ability to identify over- and underpriced
stocks is very valuable (it would allow investors to buy some stocks for less than their “true”
value and sell others for more than they were worth). Consequently, many people spend a
significant amount of time and resources in an effort to detect "mis- priced" stocks. Naturally, as
more and more analysts compete against each other in their effort to take advantage of over- and
under-valued securities, the likelihood of being able to find and exploit such mis-priced
securities becomes smaller and smaller. In equilibrium, only a relatively small number of

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analysts will be able to profit from the detection of mispriced securities, mostly by chance. For
the vast majority of investors, the information analysis payoff would likely not outweigh the
transaction costs.
The most crucial implication of the EMH can be put in the form of a slogan: Trust market prices!
At any point in time, prices of securities in efficient markets reflect all known information
available to investors. There is no room for fooling investors, and as a result, all investments in
efficient markets are fairly priced, i.e. on average investors get exactly what they pay for. Fair
pricing of all securities does not mean that they will all perform similarly, or that even the
likelihood of rising or falling in price is the same for all securities. According to capital markets
theory, the expected return from a security is primarily a function of its risk. The price of the
security reflects the present value of its expected future cash flows, which incorporates many
factors such as volatility, liquidity, and risk of bankruptcy.
However, while prices are rationally based, changes in prices are expected to be random and
unpredictable, because new information, by its very nature, is unpredictable.
Therefore stock prices are said to follow a random walk.

THREE VERSIONS OF THE EFFICIENT MARKETS HYPOTHESIS

The efficient markets hypothesis predicts that market prices should incorporate all available
information at any point in time. There are, however, different kinds of information that
influence security values. Consequently, financial researchers distinguish among three versions
of the Efficient Markets Hypothesis, depending on what is meant by the term “all available
information”.
Weak Form Efficiency
The weak form of the efficienct markets hypothesis asserts that the current price fully
incorporates information contained in the past history of prices only. That is, nobody can detect
mispriced securities and “beat” the market by analyzing past prices. The weak form of the
hypothesis got its name for a reason – security prices are arguably the most public as well as the
most easily available pieces of information. Thus, one should not be able to profit from using
something that “everybody else knows”. On the other hand, many financial analysts attempt to
generate profits by studying exactly what this hypothesis asserts is of no value - past stock price
series and trading volume data. This technique is called technical analysis.

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The empirical evidence for this form of market efficiency, and therefore against the value of
technical analysis, is pretty strong and quite consistent. After taking into account transaction
costs of analyzing and of trading securities it is very difficult to make money on publicly
available information such as the past sequence of stock prices.

Semi-strong Form Efficiency

The semi-strong-form of market efficiency hypothesis suggests that the current price fully
incorporates all publicly available information. Public information includes not only past prices,
but also data reported in a company’s financial statements (annual reports, income statements,
filings for the Security and Exchange Commission, etc.), earnings and dividend announcements,
announced merger plans, the financial situation of company’s competitors, expectations
regarding macroeconomic factors (such as inflation, unemployment), etc. In fact, the public
information does not even have to be of a strictly financial nature. For example, for the analysis
of pharmaceutical companies, the relevant public information may include the current
(published) state of research in pain-relieving drugs. The assertion behind semi-strong market
efficiency is still that one should not be able to profit using something that “everybody else
knows” (the information is public).
Nevertheless, this assumption is far stronger than that of weak-form efficiency. Semi-strong
efficiency of markets requires the existence of market analysts who are not only financial
economists able to comprehend implications of vast financial information, but also
macroeconomists, experts adept at understanding processes in product and input markets.
Arguably, acquisition of such skills must take a lot of time and effort. In addition, the “public”
information may be relatively difficult to gather and costly to process. It may not be sufficient to
gain the information from, say, major newspapers and company-produced publications. One
may have to follow wire reports, professional publications and databases, local papers, research
journals etc. in order to gather all information necessary to effectively analyze securities.
As we will see later, financial researchers have found empirical evidence that is overwhelming
consistent with the semi-strong form of the EMH.

Strong Form Efficiency

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The strong form of market efficiency hypothesis states that the current price fully incorporates all
existing information, both public and private (sometimes called inside information). The main
difference between the semi-strong and strong efficiency hypotheses is that in the latter case,
nobody should be able to systematically generate profits even if trading on information not
publicly known at the time. In other words, the strong form of EMH states that a company’s
management (insiders) are not be able to systematically gain from inside information by buying
company’s shares ten minutes after they decided (but did not publicly announce) to pursue what
they perceive to be a very profitable acquisition. Similarly, the members of the company’s
research department are not able to profit from the information about the new revolutionary
discovery they completed half an hour ago. The rationale for strong-form market efficiency is
that the market anticipates, in an unbiased manner, future developments and therefore the stock
price may have incorporated the information and evaluated in a much more objective and
informative way than the insiders. Not surprisingly, though, empirical research in finance has
found evidence that is inconsistent with the strong formof the EMH.

COMMON MISCONCEPTIONS ABOUT THE EMH

As was suggested in the introduction to this chapter, EMH has received a lot of attention since its
inception. Despite its relative simplicity, this hypothesis has also generated a lot of controversy.
After all, the EMH questions the ability of investors to consistently detect mispriced securities.
Not surprisingly, this implication does not sit very well with many financial analysts and active
portfolio managers.
Arguably, in liquid markets with many participants, such as stock markets, prices should adjust
quickly to new information in an unbiased manner. However, much of the criticism leveled at the
EMH is based on numerous misconceptions, incorrect interpretations, and myths about the
theory of efficient markets. We present some of the most persistent “myths” about the EMH
below.
Myth 1: EMH claims that investors cannot outperform the market. Yet we can see that some of
the successful analysts (such as George Soros, Warren Buffett, or Peter Lynch) are able to do
exactly that. Therefore, EMH must be incorrect.
EMH does not imply that investors are unable to outperform the market. We know that the
constant arrival of information makes prices fluctuate. It is possible for an investor to “make a
killing” if newly released information causes the price of the security the investor owns to

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substantially increase. What EMH does claim, though, is that one should not be expected to
outperform the market predictably or consistently. It should be noted, though, that some
investors could outperform the market for a very long time by chance alone, even if markets are
efficient. Imagine, for the sake of simplicity, that an investor who picks stocks “randomly” has a
50% chance of “beating the market”. For such an investor, the chance of outperforming the
market in each and every of the next ten years is then 0.5. However, the chance that there will be
at least one investor outperforming the market in each of the next 10 years sharply increases as
the number of investors trying to do exactly that rises.
In a group of 1,000 investors, the probability of finding one “ultimate winner” with a perfect 10-
year record is 63%. With a group of 10,000 investors, the chance of seeing at least one who
outperforms the market in every of next ten years is 99.99%, a virtual certainty. Each individual
investor may have dismal odds of beating the market for the next 10 years. Yet the likelihood of,
after the ten years, finding one very successful investor, even if he or she is investing purely
randomly – is very high if there are a sufficiently large number of investors. This is the case
with the state lottery, in which the probability of a given individual winning is virtually zero, but
the probability that someone will win is very high. The existence of a handful of successful
investors such as Messrs. Soros, Buffett, and Lynch is an expected outcome in a completely
random distribution of investors. The theory would only be threatened if you could identify who
those successful investors would be prior to their performance, rather than after the fact.

Myth 2: EMH claims that financial analysis is pointless and investors who attempt to research
security prices are wasting their time. “Throwing darts at the financial page will produce a
portfolio that can be expected to do as well as any managed by professional security analysts”.
Yet we tend to see that financial analysts are not “driven out of market”, which means that their
services are valuable. Therefore, EMH must be incorrect
There are two principal counter-arguments against the equivalency of “dart-throwing” and
professional analysis strategies. First, investors generally have different “tastes” –some may, for
example, prefer to put their money in high-risk “hi-tech” firm portfolios, while others may like
less risky investment strategies. Optimal portfolios should provide the investor with the
combination of return and risk that the investor finds desirable. A randomly chosen portfolio
may not accomplish this goal. Second, and more importantly, financial analysis is far from

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pointless in efficient capital markets. The competition among investors who actively seek and
analyze new information with the goal to identify and take advantage of mis-priced stocks is
truly essential for the existence of efficient capital markets. In fact, one can say that financial
analysis is actually the engine that enables incoming information to get quickly reflected into
security prices. So why don’t all investors find it optimal to search for profits by performing
financial analysis? The answer is simple – financial research is very costly. As we have already
discussed, financial analysts have to be able to gather, process, and evaluate vast amounts of
information about firms, industries, scientific achievements, the economy, etc. They have to
invest a lot of time and effort in sophisticated analysis, as well as many resources into data
gathering, purchases of computers, software.
In addition, analysts who frequently trade securities incur various transaction costs, including
brokerage costs, bid-ask spread, and market impact costs. Therefore, any profits achieved by the
analysts while trading on "mispriced" securities must be reduced by the costs of financial
analysis, as well as the transaction costs involved. For mutual funds and private investment
managers these costs are passed on to investors as fees, loads, and reduced returns. There is
some evidence that some professional investment managers are able to improve performance
through their analyses. However, this may be by pure chance. In general, the advantage gained
is not sufficient to outweigh the cost of their advice.
In equilibrium, there will be only as many financial analysts in the market as optimal to insure
that, on average, the incurred costs are covered by the achieved gross trading profits. For the
majority of other investors, the chasing of "mispriced" stocks would indeed be pointless and they
should stick with passive investment, such as with index mutual funds.

Myth 3: EMH claims that new information is always fully reflected in market prices. Yet one
can observe prices fluctuating (sometimes very dramatically) every day, hour, and minute.
Therefore, EMH must be incorrect.
The constant fluctuation of market prices can be viewed as an indication that markets are
efficient. New information affecting the value of securities arrives constantly, causing
continuous adjustment of prices to information updates. In fact, observing that prices did not
change would be inconsistent with market efficiency, since we know that relevant information is
arriving almost continuously.

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Myth 4: EMH presumes that all investors have to be informed, skilled, and able to constantly
analyze the flow of new information. Still, the majority of common investors are not trained
financial experts. Therefore, EMH must be incorrect.
This is an incorrect statement of the underlying assumptions needed for markets to be efficient.
Not all investors have to be informed. In fact, market efficiency can be achieved even if only a
relatively small core of informed and skilled investors trade in the market, while the majority of
investors never follow the securities they trade.

EVIDENCE IN FAVOR OF THE EFFICIENT MARKETS HYPOTHESIS

Since its introduction into the financial economics literature over almost 40 years ago, the
efficient markets hypothesis has been examined extensively in numerous studies. The vast
majority of this research indicates that stock markets are indeed efficient.

The weak form of market efficiency:

The random walk hypothesis implies that successive price movements should be independent.
A number of studies have attempted to test this hypothesis by examining the correlation between
the current return on a security and the return on the same security over a previous period. A
positive serial correlation indicates that higher than average returns are likely to be followed by
higher than average returns (i.e., a tendency for continuation), while a negative serial correlation
indicates that higher than average returns are followed, on average, by lower than average returns
(i.e., a tendency toward reversal). If the random walk hypothesis were true, we would expect
zero correlation. Consistent with this theory, Fama (1965) found that the serial correlation
coefficients for a sample of 30 Dow Jones Industrial stocks, even though statistically significant,
were too small to cover transaction costs of trading. Subsequent studies have mostly found
similar results, across other time periods and other countries.
Another strand of literature tests the weak form of market efficiency by examining the gains
from technical analysis. While many early studies found technical analysis to be useless, recent
evidence (e.g., by Brock, Lakonishok, and LeBaron (1992) finds evidence to the contrary.
They find that relatively simple technical trading rules would have been successful in predicting
changes in the Dow Jones Industrial Average. However, subsequent research has found that the

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gains from these strategies are insufficient to cover their transaction costs. Consequently, the
findings are consistent with weak-form market efficiency.

The Semi-strong Form

The semi-strong form of the EMH is perhaps the most controversial, and thus, has attracted the
most attention. If a market is semi-strong form efficient, all publicly available information is
reflected in the stock price. It implies that investors should not be able to profit consistently by
trading on publicly available information.

The Strong Form

Empirical tests of the strong-form version of the efficient markets hypothesis have typically
focused on the profitability of insider trading. If the strong-form efficiency hypothesis is
correct, then insiders should not be able to profit by trading on their private information. Jaffe
(1974) finds considerable evidence that insider trades are profitable. A more recent paper by
Rozeff and Zaman (1988) finds that insider profits, after deducting an assumed 2 percent
transactions cost, are 3% per year. Thus, it does not appear to be consistent with the strong-form
of the EMH

EVIDENCE AGAINST THE EFFICIENT MARKETS HYPOTHESIS

Although most empirical evidence supports the weak-form and semi-strong forms of the
EMH, they have not received uniform acceptance. Many investment professionals still meet the
EMH with a great deal of skepticism. For example, legendary portfolio manager Michael Price
does not leave anybody guessing which side he is on: “…markets are not perfectly efficient.
The academics are all wrong. 100% wrong. It’s black and white.” (taken from Investment
Gurus by Peter Tanous) We will discuss some of the recent evidence against efficient markets.

Over-reaction and Under-reaction

The efficient markets hypothesis implies that investors react quickly and in an unbiased manner
to new information. In two widely publicized studies, DeBondt and Thaler present contradictory
evidence. They find that stocks with low long-term past returns tend to have higher future returns
and vice versa - stocks with high long-term past returns tend to have lower future returns (long-

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term reversals). These findings received significant publicity in the popular press, which ran
numerous headlines touting the benefits of these so-called contrarian strategies. The results
appear to be inconsistent with the EMH. However, they have not survived the test of time.
Although the issues are complex, recent research indicates that the findings might be the result of
methodological problems arising from the measurement of risk. Once risk is measured correctly,
the findings tend to disappear.
One of the most enduring anomalies documented in the finance literature is the empirical
observation that stock prices appear to respond to earnings for about a year after they are
announced. Prices of companies experiencing positive earnings surprises tend to drift upward,
while prices of stocks experiencing negative earnings surprises tend to drift downward. This
“post-earnings-announcement drift” was first noted by Ball and Brown in 1968 and has since
been replicated by numerous studies over different time periods and in different countries. After
more than thirty years of research, this anomaly has yet to be explained.
Another study reported that stocks with high returns over the past year tended to have high
returns over the following three to six months (short-term momentum in stock prices). This
“momentum” effect is a fairly new anomaly and consequently significantly more research is
needed on the topic. However, the effect is present in other countries and has persisted
throughout the 1900s.
A variety of other anomalies have been reported. Some indicate market over-reaction to
information, and others under-reaction. Some of these findings are simply related to chance: if
you analyze the data enough, you will find some patterns. Dredging for anomalies is a rewarding
occupation. Some apparent anomalies, such as the long-term reversals of DeBondt and Thaler,
may be a by-product of rational (efficient) pricing. This is not evident until alternative
explanations are examined by appropriate analysis.

Value versus growth

A number of investment professionals and academics argue that so called “value strategies” are
able to outperform the market consistently. Typically, value strategies involve buying stocks
that have low prices relative to their accounting “book” values, dividends, or historical prices.
In a provocative study, Lakonishok, Schleifer, and Vishny find evidence that the difference in
average returns between stocks with low price-to-book ratios (“value stocks”) and stocks with

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high price-to-book ratios (“glamour stocks”) was as high as 10 percent year. Surprisingly, this
return differential cannot be attributed to higher risk (as measured by volatility) - value stocks
are typically no riskier than glamour stocks. Rather, the authors argue , market participants
consistently overestimate the future growth rates of glamour stocks relative to value stocks.
Consequently, these results may represent strong evidence against the EMH. It was also
interesting that nearly the entire advantage of the value stocks occurred in January each year.
However, current research indicates that the anomalous returns may be caused by a selection bias
in a popular commercial database used by financial economists.

Small Firm Effect

Rolf Banz uncovered another puzzling anomaly in 1981. He found that average returns on small
stocks were too large to be justified by the Capital Asset Pricing Model, while the average
returns on large stocks were too low. Subsequent research indicated that most of the difference
in returns between small and large stocks occurred in the month of January. The results were
particularly suprising because for years financial economists had accepted that systematic risk or
Beta was the single variable for predicting returns. Current research indicates that this finding is
not evidence of market inefficiency, but rather indicates a failure of the Capital Asset Pricing
Model

Seasonality Effect
Even in efficient markets, where security prices accurately reflect all relevant and recent
information, many well-documented seasonal effects continue to exist in many markets. In this
article, we'll take you through some of these existing seasonal anomalies and show you how to
take advantage of stock market seasonality by timing your buying and selling decisions
according to daily, weekly and monthly trends. 
 Monthy Effect
The markets tend to have strong returns around the turn of the year as well as during the
summer months, while September is traditionally a down month.

 January Effect

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 The month of January in the stock market has strong significance in predicting
the trend of the stock market for the rest of the calendar year. This phenomenon occurs
between the last trading day in December of the previous year and the fifth trading day of
the new year in January. The January Effect is a result of tax-loss selling which causes
investors to sell their losing positions at the end of December. The January Effect is
predicated on the idea that these stocks, which have been sold off to realize the tax losses,
will be at a discount to their market value. Bargain hunters step in and load up on these
laggards and this creates buying pressure in the market. At the beginning of January,
investors return to equity markets with a vengeance, pushing up prices of mostly small
cap and value stocks, according to "Stocks for the Long Run.
 Weekend Effect
The weekend effect (also known as the Monday effect, the day-of-the-week effect or
the Monday seasonal) refers to the tendency of stocks to exhibit relatively large returns
on Fridays compared to those on Mondays. This is a particularly puzzling anomaly
because, as Monday returns span three days, if anything, one would expect returns on a
Monday to be higher than returns for other days of the week due to the longer period and
the greater risk.

IMPLICATIONS OF MARKET EFFICIENCY FOR INVESTORS

Much of the existing evidence indicates that the stock market is highly efficient, and
consequently, investors have little to gain from active management strategies. Such attempts to
beat the market are not only fruitless, but they can reduce returns due to the costs incurred
(management, transaction, tax, etc). Investors should follow a passive investment strategy,
which makes no attempt to beat the market. This does not mean that there is no role for portfolio
management. Returns can be optimized through diversification and asset allocation, and by
minimization of investment costs and taxes. In addition, the portfolio manager must choose a
portfolio that is geared toward the time horizon and risk profile of the investor. The appropriate
mixture of securities may vary according to the age, goals, tax bracket, employment, and risk
aversion of the investor.

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CONCLUSIONS
The goal of all investors is to achieve the highest returns possible. Indeed, each year investment
professionals publish numerous books touting ways to beat the market and earn millions of
dollars in the process. Unfortunately for these so-called “investment gurus”, these investment
strategies fail to perform as predicted. The intense competition between investors creates an
efficient market in which prices adjust rapidly to new information. Consequently, on average,
investors receive a return that compensates them for the time value of money and the risks that
they bear – nothing more and nothing less. In other words, after taking risk and transaction
costs into account, active security management is a losing proposition. Although no theory is
perfect, the overwhelming majority of empirical evidence supports the efficient market
hypothesis. The vast majority of students of the market agree that the markets are highly
efficient. The opponents of the efficient markets hypothesis point to some recent evidence
suggesting that there is under- and over-reaction in security markets. However, it’s important to
note that these studies are controversial and generally have not survived the test of time.
Ultimately, the efficient markets hypothesis continues to be the best description of price
movements in securities markets

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 CHAPTER – VII

BIBLIOGRAPHY AND
ANNEXURE

BIBLIOGRAPHY

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 Agrawal, A., and Tandon, K., "Anomalies or Illusions", Evidence from Stock Markets in
Eighteen Countries", Journal of International Money and Finacne, 1994, 14, pp.83-106.
Ariel, R., "A Monthly Effect in Stock Returns", Journal of Financial Economics, 1987,
18, pp.161 174.
 Ariel, R., "High Stock Returns before Holidays: Existence and Evidence on Possible
Causes", Journal of Finance, 1990, 45, pp.1611-1626.
 Banz, Rolf W. “The Relationship between Return and Market Value of Common Stock”,
Journal of Financial Economics, March 1981, pp.3-18.
 Barbee, W., S. Mukherjee and G. Raines (1996), 'Do Sales-Price and Debt-Equity
Explain Stock Returns Better than Book-Market and Firm Size", Financial Analyses
Journal, 52, pp.56- 60.
 Bhandari, L.C., "Debt-Equity Ratio and Expected Common Stock Returns: Empirical
Evidence", Journal of Finance, 1988, 43, pp.507-528.
 Black, F., Jensen, M., and Scholes, M., "The Capital Asset Pricing Model: Some
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