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AN EMPIRICAL TESTING OF CAPITAL ASSET PRICING

MODEL IN PAKISTAN

Abstract
The purpose of the study is empirical testing of Capital Asset Pricing Model in Pakistan
Equity market. The study is conducted for a period of 10 years ranging from January 2009 to
april 2019 and the data collected is daily data for 10 years. The sample size is selected of the
18 companies of pharmaceutical sector and energy sector. This study is done with the help of
Rolling regression Methodology. This method is applied on rolling sample of years. Further
the modrl developed for the regression is constrained model .a comparison between the
developed and the traditional model has been done. The returns are computed to know the
correlation covariance between the returns and to compute the +ve and -ve portfolios of the
companies. The result shows that the……

Key words: CAPM,Roll regression model,Paakistan Equity market


CHAPTER 1 INTRODUCTION
The model considers the assets sensitivity to non-diversifiable risk (otherwise systematic risk
or market risk), regularly shown by the amount beta (β) in the money related and financial
industry, just as the normal or expected return of the market and the normal or expected
return of a hypothetical risk free asset. CAPM accept a specific type of utility functions (in
which just first and second moments matter, that is risk is estimated by change, for instance a
quadratic utility) or on the other hand asset returns whose probability distribution are totally
described by the first two minutes (the normal distribution )and zero exchange costs (vital for
expansion to dispose of all particular risk). Under these conditions, CAPM demonstrates that
the cost of equity capital is evaluated just by beta. Despite it coming up with numerous
empirical tests, and the presence of increasingly current ways to deal with asset pricing and
portfolio choice, (for example arbitrage theory and Merton's portfolio issue), the CAPM still
stays well known because of its effortlessness and utility in an variety of circumstances.
CAPM hypothesizes that investors need higher rates of return for larger levels of
Risk. Its single factor model as a result of it's based on the hypothesis that required rate
Of return will be expected using one factor, i.e. systematic risk. Despite challenges,
Restricted assumptions and mixed evidence on its validity, CAPM remains widely utilized in
applications, such as estimating the cost of capital for companies and evaluating the
Performance of managed portfolios.

CAPM is predicated on the subsequent necessary assumptions:


 All investors are rational and risk averse.
 All investors have identical expectations regarding expected returns, standard
 Deviations and correlation coefficients for all securities.
 All investors have a similar one-period investment time horizon and that they aim to
maximize economic utilities.
 All investors will borrow or lend unlimited amount of money at the riskless rate of
return.
 There aren't any transaction costs and taxes.
 There aren't any personal income taxes so investors are indifferent between capital
gains and dividends.
 There are several investors, and no single investor will have an effect on the value of a
stock through his or her buying and selling choices or selection therefore investors are
price takers.
This model explains the relationship between the returns and the risk components involved
with the returns. This model explains that there is only one thing through which it explains
the returns generating process of an asset which is systematic risk or the market risk. That is
why this model is also known as single factor model. This model provide the equilibrium
relationship between risk and return and this relationship is called security market line
(SML). In the late 20th century the model started losing its popularity according to other
theories and then model of asset pricing came into existence. Beta reflects asset-specific
sensitivity to non-diversifiable, i.e. market risk, the market as a whole includes a beta of 1.
Stock market indices are often used as native substitutions for the market and in this case
have a beta of 1. An investor during a giant, diversified portfolio (such as a mutual fund),
therefore, expects performance in line with the market.
There are many other researchers who empirically tested this model by different methods.
There are few studies conducted in the developing markets relating to the testing of CAPM.
This gap provided the motivation to focus on such kind of studies.
The study covers a period of 10 years from January 2009 to April 2019.the sample is selected
from the pharmaceutical sector and energy sector.
 Capital markets are in
equilibriu
1.1 Study background

Economy of Asian country is that the 24th largest economy of world in terms of buying
power. Asian country having semi industrialized economy covers textile, automobile, sugar,
and cement, and food, chemical, agricultural and different industries. Since industry plays a
Commanding role for the socio economic development of Asian country so it's vital section
of business sector.
Pharmaceutical sector plays a vital role within the economic development of Asian nation.
There various pharmaceutical products that are created and used as a basic input across
varied industries.
There total of 12 pharmaceutical firms listed in KSE which are wide travel of
GlaxoSmithKline Pakistan Limited, Ferozsons Laboratories Limited, High noon
Laboratories Limited, The Searle Company Limited, Sanofi-Aventis Pakistan Limited,
Wyeth Pakistan Limited, IBL HealthCare Limited etc.
The role of industry within the economic development is extremely cheap because it
contributes within the economy in terms of profit, investment, come to investors, taxes,
assets, equities, sales volumes and variety of workers.

Even then there are some challenges to be countered. The industry of Islamic Republic of
Pakistan is lagging behind due to some challenges. The most challenge is that it's to deem its
imports and foreign materials. It doesn't profit the economy and ends up in production of
high-priced product.

The test taken by the friend and blume in 1970 black janson and scholes in 1972 and fama
and Macbeth in 1973 results showed about the CAPM testing that the returns that are
computed of the risky aassets are a linear function of beta.

Basu in 1977 studied that the earning price ratios elaborate the returns of risky assets.Banz in
1981 discussed the size effect and the comparison between the stock returns and market
capitalization.
Bhandri in 1988 explained the debt to equity ratio effect that its plays a significant role in
describing the returns that are in generating process.

The work of Fama French 1992,1993,1995 then declined that beta is is only factor that can
describe the return generating process of risky assets and other factors such as book to market
ratio ,size effect only helps in explaining the relationship of risk return.

Imports and foreign materials. It doesn't profit the economy and ends up in production of
high-priced product.

The test taken by the friend and blume in 1970 black janson and scholes in 1972 and fama
and Macbeth in 1973 results showed about the CAPM testing that the returns that are
computed of the risky aassets are a linear function of beta.

Basu in 1977 studied that the earning price ratios elaborate the returns of risky assets.Banz in
1981 discussed the size effect and the comparison between the stock returns and market
capitalization.

Bhandri in 1988 explained the debt to equity ratio effect that its plays a significant role in
describing the returns that are in generating process.

The work of Fama French 1992,1993,1995 then declined that beta is is only factor that can
describe the return generating process of risky assets and other factors such as book to market
ratio ,size effect only helps in explaining the relationship of risk return.
1.3 Objective of Research

The main objective of the study is

 An empirical testing of Capital Asset Pricing Model in Pakistan Equity Market.


 To study with the help of Rolling regression.
 To find the covariance and correlation between the returns of the companies.
Portfolios of the companies

 To make the +ve and -vePortfolios of the companies

1.6 Structure of Research


We are studying the behavior of pharmaceutical and energy sectors in Pakistan by empirical
testing the Capital Asset Pricing Model in Pakistan through the Rolling regression Model and
comparison between developed and traditional models. The testing is done by computing the
returns of some of the firms of pharmaceutical sector and some of the firms of energy sector
in Pakistan. The research consists of 5 chapters:

 Chapter 1 consist of Introduction,


 Chapter 2 consist of Literature review ,
 Chapter 3 consist of Research and methodology,

 Chapter 4 consist of Data analysis and discussion and


 Chapter 5 consists of Conclusion.
CHAPTER 2 LITERATURE REVIEW

Literature review includes some previous researches that are linked to the testing of CAPM
across global perspective and the results of these are mixed. The analysis of some major
studies has undertaken to build up a clear picture related with the relationship among firms of
returns co variance and correlation etc.

Many different scholars have studied about the CAPM.

Rahman.M.M, Baten .A.M, (2006) Said that CAPM Provides an equilibrium linear
relationship between expected return and risk of an asset. The purpose of the paper is to
investigate a risk-return relationship within the CAPM framework. The study also aims at
exploring whether CAPM is a good indicator of asset pricing in Bangladesh. They use Fama
French model on five variables stock market return, beta, book to market value, size (Market
capitalization) and sales were used to test this model. In the present findings on the CAPM it
has been shown that the variables studied have significant relationship with stock return, are
still too alive on this ground.

Friend & blume (1970 ) janson.B & scholes (1972) and fama & Macbeth ( 1973) results
showed about the CAPM testing that the returns that are computed of the risky assets are a
linear function of beta.

Basu (1977) studied that the earning price ratios elaborate the returns of risky assets.Banz
(1981) discussed the size effect and the comparison between the stock returns and market
capitalization.

Bhandri ( 1988) explained the debt to equity ratio effect that its plays a significant role in
describing the returns that are in generating process.

The work of Fama French ( 1992,1993,1995) then declined that beta is only factor that can
describe the return generating process of risky assets and other factors such as book to market
ratio ,size effect only helps in explaining the relationship of risk return.

Dhankar & kumar ( 2007) showed that CAPM helps in explaining the risk return relationship
in the stock markets.
Major studies are conducted in the US markets while in developing countries there are very
few studies which resulted in the same issue but the findings of all the studies are mixed.

Yalwar & verma (1988) also supported the CAPM applicability in the Indian stock markets
while the other researchers such as Madhusoodan (1997) reject the applicability of CAPM in
the Indian stock market.

Yasmeen, Masood.S, , Saghir.G & Muhammad.W.(2012). The purpose of this study is to


examine the validity of the CAPM in the capital markets of the Pakistan. The study used daily
stock returns of the top 20 companies listed on the KSE (the main equity market in Pakistan)
from 16th December 2008 to 26th February 2010. The market 100 index is used as a proxy
for the market portfolio and 6-month Treasury bill rate is used as the risk free rate. The least
squares method (OLS) is used to find the beta of the stocks in the first step and then find the
regression equations in the second step. These regression equations are used to find the
coefficients which are used to test the validity of CAPM. The findings of the study are not in
support of CAPM.

Wu.M, Imran.M, Feng.Y , Zhang.L & Abbas.M( 2017) declared that The CAPM has been
applied to the Pakistan’s Stock Exchange to check the validity of CAPM for a sample of 306
individual firms and 18 industrial portfolios. Two pass regressions has been applied to check
the applicability of CAPM in Pakistan’s stock exchange. The results show that CAPM, single
factor model is not valid for the technical analysis in Pakistan's capital market. The investors
need to use other type of factor models which include other economic and non-economic kind
of variables for valuation of securities.

Khan.M.I, Gul.M, Khan.M.N,Nawaz.B,& Saanaullah (2012) tests the CAPM, (Capital Asset
Pricing Model) in Pakistan’s stock market, Karachi Stock Exchange KSE. Capital Asset
Pricing Model explains the links present between risk and return in efficient markets.
Therefore the current study has focused on the calculation of Beta of ten companies registered
on KSE, and actual and expected returns have been compared. The data analysis revealed the
limited applicability of CAPM to the KSE, 100-index.

Eatzaz & Attiya, (2008), where the results of their study supported the traditional CAPM in
explaining the risk and return relationship, but their results were satisfying only for few years.
Later on, another study conducted by Hanif, (2009), showed the in applicability of the
CAPM, in his study, which had taken the tobacco industry into account for four years of time.
Hanif & Bhatti, (2010). The capital asset pricing model has been criticized on many grounds,
i.e. the investigating power of CAPM, has been found low, as it depends on a single beta for
decision and uses market returns for calculation of returns.

Watson & Head, (1998) & Harrington, (1987), have considered the many assumptions of
CAPM, to be the reason for the shortcomings of this model, and thus have considered them
unrealistic and impractical.

Moyer et al, (2001) & Reilly and Brown, (1997) have declared the CAPM has somehow
fulfilled many of its assumptions, and the generally, the unrealistic assumptions do not have
any prominent negative effect on its applicability. Some researchers considers CAPM as
unable to consider all the factors that affect the returns, which then made them to develop a
multi-factor model, i.e. Arbitrage Pricing Theory (APT).

The literature provides the mixed results and evidences in the favor of CAPM. But now in
21st century it is assumed that the equity market has turned into the bigger and better market.
In this phase of the equity market the CAPM become essential but the relationship of risk and
return has still kept the model of CAPM, very helpful to the investors and is still considered
for research studies, especially in analysis of risk and return.
Overview of Sectors

2.2 Research Gap

In Pakistan, few research studies relating to the CAPM model have been done, but the study
on the pharmaceutical and energy sector has not been yet done. The results might be agreed if
the study had investigated pharmaceutical and energy sector firms that have been listed and
actively been traded at KSE. There are other factors that helps in testing the CAPM than
those discussed in my study. Therefore this research seeks to fill this gap by doing this
research study on latest data of pharmaceutical and energy sector in Pakistan.
CHAPTER 3 RESEARCH AND METHODOLOGY

3.1 Data Collection

The data collected for the analysis and the fact finding is from internet and business recorder.
The data collected consists of 10 years from 2009 to 2019 for the testing. The secondary data
necessarily required to perform the research was gathered from the official sites of the kse
and psx. The quantitative research approach is employed to arrive at the findings of the
research study. All the data is collected from the daily price history of the companies. The
data is on daily bases.

3.2 Sample Selection

The sample is selected from the 18 firms of the Pakistan pharmaceutical and energy sector .
The sample is selected for the purpose of testing the CAPM and computing the returns and
the fact findings. The data for the 10 years from 2009 to 2019 has been collected from the 18
firms of the pharmaceutical and energy sector.

3.3 Statistical Techniques

Different types of analysis used in this study to empirical test the CAPM in Pakistan. The
techniques going to apply on data are

 Rolling regression Model


 Traditional and developing Model
 Correlation and covariance
3.4 Research Model

3.5 Identification
Daily closing prices of the stock cannot be directly evaluated for the analysis because the
time series of prices is a non-stationary process and to convert this non stationary process into
stationary we have to compute the returns of the prices of stock. With the help of (pt/pt-1).

CHAPTER 4 DATA ANALYSIS AND DISCUSSION

CHAPTER 5 CONCLUSION

5.1 Research Findings

5.2 Research Limitations


This study appearance the Following boundaries,
 The research is restricted only to the 18 listed firms of pharmaceutical and
energy sector.
 This research was mainly conducted based on the secondary data collection
the other data collection methods had not been considered.
 The testing of CAPM is restricted to only Rolling regressing methods other
methods are not considered.
 The work was constrained toward the pharmaceutical and energy sector in
Pakistan only.

Reference

Khan.M.I, Gul.M, Khan.M.N,Nawaz.B,& Saanaullah (2012). Assessing and Testing the


Capital Asset Pricing Model (CAPM): A Study Involving KSE-Pakistan . Journal of
Management and Business Research. National Defence University, Islamabad, Pakistan.
Volume 12.

Rahman.M.M, Baten .A.M, (2006). AN EMPIRICAL TESTING OF CAPITAL ASSET


PRICING MODEL IN BANGLADESH. Journal of Research (Science), Bahauddin Zakariya
University, Multan, Pakistan. School of Business, South East University, Dhaka, Bangladesh.
Vol.17,No.4.pp.225-2
Wu.M, Imran.M, Feng.Y , Zhang.L & Abbas.M( 2017). Review and Validity of Capital Asset
Pricing Model: Evidence from Pakistan Stock Exchange. International Research in
Economics and Finance. School of Finance and Economics, Jiangsu University, Zhenjiang,
China. Vol. 1, No.

Yasmeen, Masood.S, , Saghir.G & Muhammad.W.(2012). THE CAPITAL ASSET PRICING


MODEL: EMPIRICAL EVIDENCE FROM PAKISTAN. Department of Business
Administration, University of Sargodha.

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