Financial Risk Management
A Comparative Analysis of Capital Asset Pricing Model and Arbitrage Pricing Theory in the Indian Stock Market Using Davidson-MacKinnon Equation

Article Details
Pub. Date : December, 2020
Product Name : The IUP Journal of Financial Risk Management
Product Type : Article
Product Code : IJFRM11220
Author Name : Shikha Menani
Availability : YES
Subject/Domain : Finance Management
Download Format : PDF Format
No. of Pages : 9

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Abstract

Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT) are the two models that assess the risk-return relationship and help in the stock and/or portfolio evaluation. The two models, however, differ in the way factors are priced in the return-generating process. While the CAPM considers a single factor, that is beta, being the determinant of the cross-sectional differences in the asset pricing, APT considers various macroeconomic factors that determine the asset prices. The present study has used Davidson-MacKinnon equation to compare the two models using 221 securities listed on the Indian stock market, covering the period January 2000 to December 2018. The results favor the single-factor model, i.e., CAPM, wherein the additional factors propounded by APT had not improved the explanatory power of the risk-return relationship for the study period.


Introduction

Investors make investments in the real or financial assets with the objective of earning returns that are proportionate to the amount of the risk taken. This risk can arise because of various financial and economic factors, out of which a few are more dominant in impacting the returns and can help the investors to make forecasts about the future asset movements. The two most researched and popular asset pricing theories that help the investors in such forecasts are the Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT). While the former considers only systematic risk (beta) as the sole determinant of the pricing of the asset returns, the latter is based on multiple macroeconomic factors that have an impact on the returns of an asset. CAPM can be considered to be a special case of APT having only one factor which is being priced in estimating the expected returns. Both the models have their own strengths and weaknesses and have been extensively used in estimating the parity between risk and return not because they are 100% accurate in determining the expected returns but because of the reason that they help in identifying the dominant factors in asset pricing. This study makes a comparison between the two models to estimate the efficiency of the factors in estimating and predicting the portfolio returns.


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