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Devinaga Rasiah,et,al.,Int. J. Eco. Res., 2011 2(3), 125-135 ISSN: 2229-6158

THE EFFECTIVENESS OF PRICING MODEL IN MODERN FINANCIAL THEORY DevinagaRasiah, Faculty of Business and Law, Multimedia University (Malacca Campus) [email protected] PeongKwee Kim, Faculty of Business and law, Multimedia University (Malacca Campus) [email protected]

ABSTRACT The Arbitrage Pricing Model (AP) is a famous model used to determine the factors such as market which influences expected returns on individual asset prices in the financial markets. Many believe that the stochastic returns of capital assets are consistent with a factor structure. One of the benefits on the Arbitrage Pricing Model is taking the benefit of the mispriced securities as profit by arbitrageurs. In this study AP is compared with CAPM and also how AP is used in other parts of the globe. Keywords: The Arbitrage Pricing Model, Capital Model (CAPM), Common . developed into one of the modern financial INTRODUCTION theory. However, the use of APT in Asset prices are universally believed to determining the factors which influences react sensitively to economic news. Every expected returns is too general. APT often day experience seems to carry the view viewed as a substitute to the capital asset that individual asset prices are influenced pricing model (CAPM). Market's expected by a broad variety of unpredictable events return is used in the CAPM formula, and that some events have a more whileAPT uses risky asset's expected pervasive outcome on asset prices than o return and the premium. APT model others (Chen et al., 1986). Thus, various are used by arbitrageurs to profit by taking asset pricing models can be used to benefit of mispriced securities (Azhar Bin determine equity returns. Zakaria, 2006). A mispriced will Investopedia.com defines arbitrage pricing have a price which is different from the model as an asset pricing model using one model prediction hypothetical price. By or more common factors to price returns. It going an overpriced security, while is called a single factor model with only in going the portfolio the APT one factor, representing the market calculations were based on the arbitrageur portfolio. It is called a multifactor model to make a risk-free turnover. with more factors. Primarily, Ross (1976a, 1976b) developed the Arbitrage Pricing BACKGROUND RESEARCH Theory (APT). It is a one-period model in which every believes that the The (APT) stochastic properties of returns of capital ModelThe return on a stock can be assets are consistent with a factor structure. calculated by the following APT formula Ross argues that if equilibrium prices offer stated by Ross (1976): no arbitrage opportunities over static = rf + b1 x (factor 1) + b2 portfolios of the assets, then the expected x (factor 2)... + bn x (factor n) returns on the assets are approximately Where: linear related to the factor loadings. The  rf= The risk free interest rate factor loadings or betas are proportional to (interest rate the investor would the returns’ co-variance with the factors. expect to receive from a risk free According to Azhar Bin Zakaria (2006), investment) the equilibrium-pricing model using  b =The sensitivity of the stock to Arbitrage Pricing Theory (APT) has each factor

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 factor = the permits the researcher to select whatever associated with each factor factors provide the best explanation for the particular sample at hand; it is weakness in The following two factorsthat influence practical applications because, in contrast the risk premium in the APT model:- to the CAPM, it cannot explain variation in asset returns in terms of limited and I. The risk premiums associated with easily identifiable factors, such as equity’s each of the factors described above . (Groenewoldand Fraser, 1997). II. The sensitivity of stock to each of Berry et al. (1988) gave good and the factors - similar to the beta simple instructions of what kind of concept variables qualify as legitimate risk factors Risk Premium = r -rf = b(1) x (r in the APT framework. They state that factor(1) - rf) + b(2) x (r factor(2) - legitimate risk factors must possess three rf)... + b(n) x (r factor(n) - rf) important properties: Ross (1976) added that theinvestor I. At the beginning of every would sell the stock if the expected period, the factor must be risk premium on a stock was lesser. completely unpredictable to Thepatron would buy the stock if the market. the risk premium was higher, until II. Each APT factor must have both sides of the equation were in a pervasive influence on balance. Investors could go about stock returns. getting this formula back into III. Relevant factors must equilibrium, by using the arbitrage influence expected return; term. i.e. they must have non- Arbitrage Pricing Theory Assumptions zero prices. According to Rodney Boehme(n.d) there There had been a lot of tests of the are 2 assumptions for the model. Firstly, APT (Chen et al., 1986; Burmeisterand only the is relevant in McElroy, 1988) for the United States, determining expected returns which is (Beenstockand Chan, 1988; Poon & similar to CAPM.However, there may be Taylor, 1991; and Clare and Thomas, 1994) several non-diversifiable risk factors for the United Kingdom. It is well known (different from CAPM,since CAPM that the macroeconomic variables chosen assumes only one ) that are by Chen et al. (1986) have been the systematic or macroeconomic innature and foundation of the APT. According to thus affect the returns of all to some Paavola (2006), its worth pointing out, degree. Secondly in relation to firm why these variables could affect equities’ specific risk, since it is easily diversified returns: out of any well-diversified portfolio, is notrelevant in determining the expected 1. returns of securities (similar to CAPM). Inflation impacts both the level of the discount rate and the size of the future cash Factors Used In Arbitrage Pricing flows. Theory 2. The term structure of interest rates. There is no formal theoretical guidance in Differences between the rate on bonds choosing the appropriate group of with a long maturity and a short maturity economic factors to be included in the affect the value of payments far in the APT model (AzeezandYonoezawa, future relative to near-term payments. 2003).Paavola (2006) explains further that 3. Risk premium. this is both its strength and its weakness. It Differences between the return on safe is strength in empirical work since it bonds (AAA) and more risky bonds (BAA)

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are used to measure the market’s reaction with the number of securitiesbeing factor to risk. analyzed (Dhrymes et al., 4. Industrial production. 1984).Furthermore, the tendency of factors Changes in industrial production affect the to increase cannot be explained by opportunities facing investors and the real “priced”and “non-priced” risk factors. This values of cash flows (Elton et al., 2003). problem arises because the theory in itself doesnot identify relevant factors. Objective of the Study 1. To review the arbitrage pricing The major assumption of the APT model is model that assetreturns are linearly related to a set 2. To look at the alternative model of unspecified common factors and that 3. Global evidence there areno arbitrage opportunities. This generality of the theoretical APT has Literature Review turned out to bea major weakness for the General Disagreements and empirical APT (Koutmos et al., 1993). Contradictions of The Arbitrage Pricing There is also a greatdeal of skepticism Model (APT) about the test methods of the APT. Cheng (1996) states that themethod of Chen et al. Paavola (2006) argued that the APT (1986) is very sensitive to the number of naturally out-performs the CAPM in a independent variablesincluded in the statistical sense for two reasons: the APT regression. Cheng (1996) also noted that permits more than a single factor and the when a researcher is testingthe APT, a APT constructs the factors to best fit data factor may be significant in one whereas the CAPM uses a single factor multivariate analysis and then will not clearly defined by the theory. If a besignificant when testing in a univariate researcher includes another variable to model. The multicollinearity among explain returns, R² can never be smaller economicvariables presents another with the added variable (Groenewold and drawback of this approach (Paavola, 2006). Fraser, 1997). The alternative asset pricing model Morel (2001) added the most which is the Capital Asset Pricing disappointing feature of the APT is that it Model (CAPM) does not identify the commonfactors (nor even their number). It is not also supported The APT along with the capital asset by the theoretical foundationsof the CAPM pricing model (CAPM) is one of two that describes the investors’ behavior. influential theories on asset pricing. The Gilles andLeRoy(1990) state that the APT APT differs from the CAPM in that it is contains no useful information about less restrictive in its assumptions. It allows prices, because theythink that the APT for an explanatory (as opposed to does not include any clear restrictions and statistical) model of asset returns. It it can be thought as atoo general asset assumes that each investor will hold a pricing model. They also state that many unique portfolio with its own particular economists have all alongbeen skeptical array of betas, as opposed to the identical about the content of the APT, because they ". believe that the APTshould depend on the validity of assumed restrictions on The APT has the potential to overcome preferences and technology.One of the CAPM weaknesses: it requires less and main weaknesses of the of more realistic assumptions to be generated the APT is that the numberof relevant by a simple arbitrage argument and its factors in empirical APT models increases explanatory power is potentially better

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since it is a multifactor model. However, that investors will take into account not the power and the generality of the APT only their wealth, but also the uncertainty are its main strength and weakness: the of the future economy in their current APT permits the researchers to choose investment decisions. This suggests that whatever factors provide the best they will against possible economic explanation for the data but it cannot shocks that are likely to reduce the explain variation in asset return in terms of expected utility of their consumption. The a limited number of easily identifiable major implication of the model is that factors. In contrast, CAPM theory is multiple betas are needed to explain intuitive and easy to apply. expected return; and that the number of the a. Capital Asset Pricing Model (CAPM) betas equal one (i.e. the broad market The Capital Asset Pricing Model (CAPM) factor) plus additional state variables by William Sharpe (1964) and John which affect investors’ investment Lintner (1965) symbols the birth of asset opportunities and consumption preferences pricing theory. The CAPM is still widely (and hence their expected utility) over time used in applications, such as estimating the (Merton 1973). for firms and evaluating the performance of managed portfolios four The comparison between the APT and decades later (F.Fama, 2004). It is the CAPM attraction of MBA investment courses. It is Many textbooks and articles repeat two often the only asset pricing model taught common limitations about the CAPM: in these courses in fact (Sharpe, 1964;Lintner, 1965; and Black, 1972). I. Evidence that it takes more than one factor to explain the shared, or The model assumes investors are risk systematic, risk in securities discredits averse and, when choosing among the CAPM (Paavola, 2006). portfolios, they care only about the mean II. In demonstrating that the risk premium and variances of their one-period on an asset depends only on its investment return (Markowitz, 1959). As a systematic factor loadings, the APT result, investors choose “mean-variance- provides investors with a result of great efficient” portfolios, in the sense that the practical value that the CAPM does not portfolios firstly toreduce the discrepancy provide (Treynor, 1993). of portfolio return, given expected return, and secondly to maximize expected return, According to GurHuberman et al. (2005), given the variance. Thus, the Markowitz the APT is commonly put forward as a approach is often called a “mean-variance superior alternative to the criticized but model.” widely-used CAPM. The alleged weakness of the CAPM, its baggage of “unrealistic assumptions” and its empirical b. Inter-temporal Capital Asset Pricing shortcoming, are well known. Test of the Model (ICAPM) CAPM typically display poor explanatory The limitations of CAPM lead to the power as well as overestimating the risk- development of Inter-temporal Capital free rate and underestimating the market Pricing Model (ICAPM) by Merton (1973), risk premium. The main criticism is where holding periods are allowed to particularly the use of betas to predict an change through time. ICAPM assumed asset’s return – returns on high-beta stocks that investors aimed to maximize their will tend to be overestimated and vice expected consumption utility over the versa for low-beta stocks (Groenewoldand period of their lifetime, and that they are Fraser, 1997). The advances of the APT able to trade continuously. Merton showed over the CAPM are widely discussed in

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the literature and we will sum up a few of compared to CAPM which uses beta as the the main notes that have been discussed. only market of risk." Elton et al. (2003) First, in favor of the APT is that the APT that the APT remains the newest and most makes no assumptions about the empirical promising explanation of relative returns. distribution of asset returns. Second, the The APT promises to supply as with a strong assumptions made about utility more complete description of returns than theory in deriving the CAPM are not the CAPM model. necessary. The APT also admits several risk sources and therefore can be more Both models assert that every asset must operational and has a better forecasting be compensated only according to its ability than the CAPM. There is no special systematic risk. In the CAPM, the role for the market portfolio in the APT, systematic risk is the co variation of the whereas the CAPM requires that the asset with the market portfolio and in the market portfolio is efficient. The APT is APT it is the co variation with a number of also easily extended to a multi-period factors. framework (Elton et al., 2003; Morel, 2001). Prior Work

Several rigorous assumptions have to be CAPM has been tested extensively, for made when deriving the CAPM such as over three decades, in various forms there are no market frictions, e.g., short primarily in developed capital markets and selling is unrestricted, investors can to some extent in developing markets. borrow and lend at risk-free rate and there Early work in this area including Black, are no taxes.There are numerous securities Jensen and Scholes (1972), Fama and so that idiosyncratic risk can be diversified MacBeth (1973) and Blume and Friend away and Investors are risk-averse and (1973) supported the standard and zero seek to maximize their wealth (Lofthouse, beta model of CAPM. However Banz 2001). (1981), Reinganum (1981), Gibbons (1982), Shanken (1985a) and Fama and Studies comparing the APT and the French (1992), highlighted the danger of CAPM have used both factor or principal focusing exclusively on mean-beta space. component analysis and selecting These studies found that the return macroeconomic variables a priori (Yli-olli generation process also depends on other et al., 1990). Connor andKorajczyk (1986) variables like size, book to market ratio used principal components analysis and and earnings price ratio. found five factors that could explain the size and January effect better than the Others, such as Maheshwari&Vanjara CAPM. Berry et al. (1988) concluded that (1989), Madhusoodanan (1997), Sehgal the APT model is better explaining (1997), Vipul (1998) and Dhankarand equities returns than the CAPM and that at Singh (2005b) found CAPM was not the 0.01 significance level the CAPM suitable for describing the Indian market. model can be rejected in favour of the APT model. Josev et al. (2001)conclude for A great deal of research work on APT has Australian industry equity portfolios that been undertaken in developed markets, "the results showed that there was strong particularly in the U.S. market using two evidence in favour of the APT model" in a approaches. Roll and Ross (1980), Chen recent study from the Indian (1983) and Dhrymes, Friend and Gultekin by Dhankar andEsq (2005) concludethat (1984) used the first approach, namely "APT provides a better warning of asset factor analysis. The drawback of this risk and estimates of required approach is that it is difficult to interpret

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the statistically derived factors in movement and in the stock economic terms. markets often reflect the direction of any economy. Chen, Roll and Ross (1986) Chen, Roll and Ross (1986) found four suggested that since the inception of stock macroeconomic factors have a significant markets, researchers have made attempts explanatory influence on returns. to establish relationship between change in differential between long and short term macroeconomic factors and stock market treasury bonds, inflation rate, yield returns. According to Maheshwari differential between bb rated corporate and andVanjara (1989) there are various treasury bonds, and growth rate in models developed so far by scholars, industrial production. Burmiester and globally for establishing the relationship McElroy (1988) concluded that CAPM can between stock returns and factorsof be rejected in favour of their APT model arbitrage-pricing model (APM). which included factors like default premium and time premium. Global Evidences

In another study of CAPM vs. APT using Chen, Roll and Ross (1986) was the first to principal component analysis, Dhankar study select macroeconomic variables to and Singh (2005a) found that monthly and estimate U.S. stock returns and apply the weekly returns gave almost similar results, APT models. They employed seven but weekly results showed APT in a more macroeconomic variables, namely: term favorable light than monthly results. A structure, industrial production, risk study by Singh (2008 b) showed that beta premium, inflation, market return, and varies considerably from year to year and consumptionand oil prices in the period of also varies with the interval between data Jan 1953-Nov 1984. During the tested points (daily, weekly, monthly). Singh period in their research, they found a (2008a) also found some evidence of non- positive relationship between the stationarity of beta between bull and bear macroeconomic variables and the expected periods and stationarity between bull stock returns. They noted that industrial periods. For these reasons, both weekly production, changes in risk premium, and monthly returns were examined, and twists in the , measure of the twelve year period was divided into unanticipated inflation of changes in four sub periods to check for changes over expected inflation during periods when time. these variables were highly volatile related Review of APT In Relation To Common to expected returns. Consumption, oil Stock Return prices and market index are not priced by Stock market plays an important role in the has been discovered. stimulating economic growth of a country. They concluded that asset prices reacted It helps to channel funds from individuals sensitively to economic news, especially to or firms without investment opportunities unanticipated news. to firms who have them and thus improve the country’s economic efficiency. It is the lifeblood of the economy of a nation that is United States concerned about individuals, firms as well Burmeister and Wall (1986) continued as government (Md Isa, 2008). down a similar path of research laid down by Chen, Roll and Ross (1986). Having They are often defined as conducted that previous research suggested barometer of any economy because they that the variability of stock returns could reflect the change and direction of pressure be explained by unanticipated changes in on the economy(Srivastava, 2009). The certain macroeconomic variables mainly:

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unanticipated change in term structure, changes in both the risk premium and the unanticipated change in inflation, slope of the term structure of interest rates. unanticipated change in the risk premium Through the APT, Brown and Otsuki and unanticipated change in asset return (1990) explore the effects of the money but they suggested more research was supply, a production index, crude oil price, needed. In addition, Abdullah and exchange rates, call money rates, and a Hayworth (1993) observed that the U.S. residual market error on the Japanese stock stock returns wererelatively positive to market. They observe that these factors are inflation and growth in money supply, yet associated with significant risk premium in negatively to budget and trade deficits, and Japanese equities. also to short and long term interest rates. Singapore United Kingdom The relationships between the Singapore Poon and Taylor (1991) study also showed stock index and chosen macroeconomic similar outcomes as Chen, Roll and Ross variables over a seven-year period from (1986) on the United Kingdom market. 1988 to 1995 were experimented by According to the results, macroeconomic Maysami and Koh (2000). It resulted in variables do not affect share returns in the existenceof a positive relationship between United Kingdom but affected in the U.S. stock returns and changes in money supply They suggested that either different but negative relationships between stock macroeconomic factors have an influence returns with changes in price levels, short- on share returns in the United Kingdom or and long-term interest rates and exchange the tactic employed by Chen, Roll and rates. Ross (1986) is inept. On the other hand, Clare and Thomas (1994) investigate the South East Asia effect of 18 macroeconomic factors on To examine the interdependence between stock returns in the U.K. They found that stock markets and fundamental oil prices, retail price index, bank lending macroeconomic factors in the five South and corporate default risk to be important East Asian countries (Indonesia, Malaysia, risk factors for the U.K. stock returns. Philippines, Singapore, and Thailand) was Priestley (1996) pre-specified that the main purpose of Wongbangpo and thesefactors may carry a risk premium in Sharma (2002). Monthly data from 1985 to the U.K. stock market. Seven 1996 is used in this study to represent macroeconomic and financial factors; GNP, the consumer price index, the money namely default risk, industrial production, supply, the interest rate, and the exchange , retail sales, money supply rate for the five countries. Their results unexpected inflation, change in expected showed that high inflation in Indonesia inflation, terms structure of interest rates, and Philippines influences the long-run commodity prices and market portfolio. negative relation between stock prices and For the APT model, with the factor the money supply, as the money growth in generating from the rate of change Malaysia, Singapore, and Thailand induces approach all factors are significant. the positive effect for their stock markets. The exchange rate variable is positively Japan related to stock prices in Indonesia, For Japanese stock market, Hamao (1988) Malaysia, and Philippines, yet negatively replicated the Chen, Roll and Ross (1986) related in Singapore and Thailand. study in the multi-factor APT framework. He put on view that the stock returns are Asian Pacific significantly influenced by the changes in The dynamics relationship between stock expected inflation and the unexpected prices and fiscal variables in six Asian-

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Pacific selected countries were examined Pakistan by Mahmood and Dinniah (2009). The Mohammad, Hussain and Ali (2009) monthly statisticsfrom January 1993 to examine the relationship between December 2002 on stock price indices, macroeconomics variables and Karachi foreign exchange rates, consumer price in Pakistan context. They index and industrial production index that have used quarterly data of foreign spans are used. More specifically, they exchange rate, foreign exchange reserve, focused their study on the long run gross fixed capital formation, money equilibrium and short run multivariate supply, interest rate, industrial production causality between these variables. The index and whole sales price index. The outcome indicated the existing of a long result shows that exchange rate and run equilibrium relationship between stock exchange reserve and highly affected the price indices and among variables in only stock prices. four countries, i.e., Japan, Korea, Hong Kong and Australia. As for short run Turkey relationship, all countries except for Hong Tursoy, Gunsel and Rjoub (2008) is Kong and Thailand show some contacts. another example of the APT test in The Hong Kong portrays relationship only Turkish stock market. They tested the APT on exchange rate and stock price while the in Istanbul Stock Exchange for the period Thailand reports major interaction between of February 2001 up to September 2005 on output and stock prices only. monthly base. They tested 13 macroeconomic variables (money supply, Malaysia industrial production, crude oil price, Tan, Loh and Zainudin (2006) looked at consumer price index, import, export, gold the dynamic between macroeconomic price, exchange rate, interest rate, gross variables and the Malaysian stock indices domestic product, foreign reserve, (Kuala Lumpur Composite Index) during unemployment rate and market pressure the period of 1996-2005. They found that index) against 11 industry portfolios of the inflation rate, industrial production, Istanbul Stock Exchange to observe the crude oil price and Treasury Bills’ rate effects of those variables on stocks’ returns. have long-run relation with Malaysian Using ordinary least square technique, they stock market. Results indicated that observed that there are some differences consumer price index, industrial among the industry sector portfolios. production index, crude oil price and treasury bills are significantly and A research by Kandir (2008) can be negatively related to the Kuala Lumpur considered an example of the APT testing Composite Index in the long run, except in Istanbul StockExchange. He industrial production index coupled with a investigates the role of seven positive coefficient. macroeconomic factors in explaining Turkish stock returnsin the period from Philippines July 1997 to June 2005. Macroeconomic Bailey and Chung (1996), examined the variables used in his study are growth impact of macroeconomic on the rateof industrial production index, change equity market of the Philippines. Findings in consumer price index, growth rate of of the study showed that, financial narrowly defined moneysupply, change in fluctuations, exchange rate movements and exchange rate, interest rate, growth rate of political changes on owners of Philippine international crude oil price and return equities cannot explain Philippine stock onthe MSCI World Equity Index and the returns. analysis is based on stock portfolios rather than single stocks.His empirical findings

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reveal that exchange rate, interest rate and empirical research on asset pricing world market return seem to affect allof relationships, and on related topics such as the portfolio returns, while inflation rate is performance measurement and cost of significant for only three of the twelve capital estimation. Lack of arbitrage portfolios. On theother hand, industrial opportunities implies that assets can be production, money supply and oil prices priced by a single random variable, do not appear to have any significantaffect variously referred to in the literature as the on stock returns. His findings also suggest pricing kernel, stochastic discount factor, that macroeconomic factors have a intertemporal marginal rate of substitution, widespread effecton stock returns, since or state price density (Ross, 1978; Dybvig characteristic portfolios do not seem to be and Ross, 1989;Ferson, 1993).G. Conner influenced in a different manner bythe (1993) added one might wonder, then, macroeconomic variables. what the advantage would be to using a multiple factor model. Particular asset Greece pricing models differ in their specification Niarchos and Alexakis (2000) investigated of the stochastic discount factor. If there is if it is possible to forecast stock market an advantage to using multifactor models, prices with the use of macroeconomic it must be that the multifactor models variables in the Athens Stock Exchange. provide a closer approximation to the Macroeconomic variables include inflation, stochastic discount factor than alternative money supply and exchange rate. The time approaches. To date, the empirical period under study was from January 1984 literature has tended to emphasize tests of to December 1994 on a monthly basis. The the restrictions of a single model rather statistical evidence suggests that monthly than emphasize comparisons across stock prices in the Athens Stock Exchange models. When comparisons across models are positively correlated to those variables. have been made, the APT has tended to do well against the competing models. CONCLUSION

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