The Validity of Capital Asset Pricing Model and Factors of Arbitrage Pricing Theory in Saudi Stock Exchange

Only available on StudyMode
  • Download(s) : 84
  • Published : October 1, 2012
Open Document
Text Preview
The Validity of Capital Asset Pricing Model and Factors of Arbitrage Pricing Theory in Saudi Stock Exchange

The main purpose of this study is to investigate the ability of two alternative models in finance, Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT), to explain the excess return of a portfolio of stocks in Saudi Stock Exchange (TADAWUL). The regression analyses were conducted on the portfolio, which consists of 54 listed and actively traded stocks in TADAWUL. Comprising the ex-ante sample from the period of January 2000 and December 2005 and the ex-post sample from the period of January 2006 and December 2008, this study shows that none of the conditions of the validity of the CAPM was satisfied as well as Beta is insignificant factor in explaining the portfolio excess return revealing the outcome that CAPM is not supported in TADAWUL. On the other hand, S&P 500, one of the six chosen factors in the APT, is found significant and thus is able to justify the excess return of the portfolio in TADAWUL. Accordingly, the result of this study suggests that APT model is slightly better in explaining excess return in TADAWUL than CAPM model.

Keywords: CAPM, APT, Saudi Stock Exchange (Tadawul)

1. Introduction

There have been considerable efforts and numerous empirical studies in almost every discipline to test the validity of models using real life data. Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT) occupy an essential place among the models in finance and there have of course been notable amount of studies conducted to test the CAPM and the APT. Investors, researchers as well as practitioners have paid significant attention during the last decades to the new emerging markets. This new interest has certainly been spurred by the large returns offered by these markets. There is a well-known fact that practitioners as well as investors 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.

Although the CAPM is one of the most important developments in modern capital theory and has been leading in empirical work over the past three decades, accumulating research has increasingly cast doubt on its ability to explain the expected return of an investment. The CAPM is a model that describes the relationship between risk and expected return and used in the pricing of risky securities. The general formula of CAPM is the following;

ra = rf + (a (rm - rf)

where (ra) is the return of the security, (rf) is the risk free rate, ((a) is the beta of the security and finally (rm) is the expected market return.

The main idea behind the CAPM is that investors need to be compensated in two ways; time value of money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for putting the money in any investment over a period of time. The other half of the formula represents the risk taken by the investor and calculates the amount of compensation the investor needs for taking an additional risk. That is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (rm-rf). Accordingly, it can be said that the CAPM postulates that high expected returns are associated with high levels of risk and thus, 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. Hence, the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium and if this expected return does not meet or beat the required return, the investment should not be undertaken.

The CAPM was introduced independently by (Treynor, 1961, 1962), (Sharpe, 1964), (Linther, 1965a, 1965b), and (Mossin, 1966) depending on Harry Markowitz's previous...
tracking img