The Asset Pricing Model

INTRODUCTION

The asset pricing model bears a vital importance, for individual as well as institutional investors, as it helps in the pricing aspects of individual asset in the capital market. The Capital Asset Pricing Model (CAPM), the most widely known and used, is one such model that prices the underlying asset based on the relationship between risk and the expected return. CAPM is a single index model (market factor) that was proposed by Sharpe (1964), Lintner (1965) and Mossin (1966).

Till 1980’s, CAPM dominates the financial literature and was widely advocated owing to its simplicity in calculating expected returns of underlying asset. However, in the more recent times the empirical records of the model were found to be unsatisfactory.

The rationale given by Fama and French in proposing a multi factor model was the enduring need for the complicated asset pricing model that can explain stock market anomalies. Fama and French (1992, 1993) proposed a multifactor model that was based on the market risk as well as risk based on size and value (measured by Book-to-market ratio) for better estimates of returns. Fama and French (1993) argued that since academic empirical findings evident higher returns on stocks with small size and high book-to-market ratio than those predicted by CAPM, both size and book-to-market (B/M) ratios can be used as better proxies for exposure to sources of systematic risk that CAPM failed to capture. Fama and French (1993) proposed that the three factor model captures much of the variations in the stock returns as well as size, value, cash-flow-to-price effect and long-term reversal effect that were missed by traditional one factor CAPM. However, the proposition made by Fama and French still remains controversial on the economically meaningful risks of the Fama French factors (Black, 1993; Hong and Stein, 1999; Bodie et al., 2009). There is an ongoing debate on interpreting Fama-French three factor model as a rational risk model (Black, 1993; Griffin, 2002; Cooper et al., 2004). Even though Fama and French three factor model claim to capture most of the stock market

Even though there are number of international studies supporting the validity of these company specific characteristics based asset pricing models in the U.S. and other developed stock markets, not much have been done to investigate the same in emerging markets. Emerging stock markets are identified as markets with unusual characteristics that differ from developed markets (Harvey, 1995; Barry et al., 1998; Antoniou et al, 2005; Chan and Hameed, 2006; Cakici et al., 2013). Moreover, Griffin (2002) observed that multifactor asset pricing model have different explanatory power in different countries. Hence, it is difficult to comment on the general ability of these models to explain stock returns globally. Given these caveats, there is a clear need for additional studies that test the validity of multifactor asset pricing models in wide variety of stock markets outside U.S. The current study contributes the literature on the same