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The Conditional Capital Asset Pricing Model: Evidence from Karachi Stock Exchange

Author

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  • Attiya Y. Javid

    (Pakistan Institute of Development Economics, Islamabad)

  • Eatzaz Ahmad

    (Quaid-i-Azam University, Islamabad)

Abstract

This is an attempt to empirically investigate the risk and return relationship of individual stocks traded at Karachi Stock Exchange (KSE), the main equity market in Pakistan. The analysis is based on daily as well as monthly data of 49 companies and KSE 100 index is used as market factor covering the period from July 1993 to December 2004. The natural startingpoint of this study is to test the adequacy of the standard Capital Asset Pricing Model (CAPM) of Sharpe (1964) and Lintner (1965). The empirical findings do not support the standard CAPM model as a model to explain assets pricing in Pakistani equity market. The critical condition of CAPM—that there is a positive trade-off between risk and return—is rejected and residual risk plays some role in pricing risky assets. This allows for the return distribution to vary over time. The empirical results of the conditional CAPM, with time variation in market risk and risk premium, are more supported by the KSE data, where lagged macroeconomic variables, mostly containing business cycle information, are used for conditioning information. The information set includes the first lag of the following business cycle variables: market return, call money rate, term structure, inflation rate, foreign exchange rate, growth in industrial production, growth in real consumption, and growth in oil prices. In a nutshell, the results confirm the hypothesis that risk premium is time-varying type in Pakistani stock market and it strengthens the notion that rational asset pricing is working, although inefficiencies are also present in unconditional and conditional settings. The observation is that the dynamic size and book-to-market value coefficient explain the cross-section of expected returns in a few sub-periods. The conditional approach to testing the CAPM and the three-factor CAPM shows that the asset prices relationship is better explained by accommodating business cycle variables as information set. The findings of the conditional three-factor CAPM also give support to the fact that time-varying firm attributes have only a limited role in Pakistani market to explain the asset price behaviour.

Suggested Citation

  • Attiya Y. Javid & Eatzaz Ahmad, 2008. "The Conditional Capital Asset Pricing Model: Evidence from Karachi Stock Exchange," PIDE-Working Papers 2008:48, Pakistan Institute of Development Economics.
    • Handle: RePEc:pid:wpaper:2008:48
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    2. Ayub, Usman & Shah, Syed Zulfiqar Ali & Abbas, Qaisar, 2015. "Robust analysis for downside risk in portfolio management for a volatile stock market," Economic Modelling, Elsevier, vol. 44(C), pages 86-96.
    3. Jawad Mohammad & Attiya Yasmin Javid, 2015. "An Analysis of Accrual Anomaly in Case of Karachi Stock Exchange," PIDE-Working Papers 2015:116, Pakistan Institute of Development Economics.
    4. Ruqia Shaikh & Guo Fei & Muhammad Shaique & Muhammad Rizwan Nazir, 2019. "Control-Enhancing Mechanisms and Earnings Management: Empirical Evidence from Pakistan," JRFM, MDPI, vol. 12(3), pages 1-23, August.
    5. Javid, Attiya Yasmin, 2008. "Time Varying Risk Return Relationship: Evidence from Listed Pakistani Firms," MPRA Paper 37561, University Library of Munich, Germany.
    6. Hafiz Muhammad Zia ul haq & Muhammad Sohail Shafiq & Muhammad Kashif & Saba Ameer, 2020. "Determining Force behind Value Premium: The Case of Financial Leverage and Operating Leverage," JRFM, MDPI, vol. 13(9), pages 1-15, September.
    7. Yasmeen & Masood, Sarwar & Saghir, Ghauri & Muhammad, Waqas, 2012. "The Capital Asset Pricing Model: Empirical Evidence from Pakistan," MPRA Paper 41961, University Library of Munich, Germany.
    8. Muhammad, Irfan, 2012. "Non-standardized form of CAPM and stock returns," MPRA Paper 35604, University Library of Munich, Germany.
    9. Jacek Lipiec, 2014. "Capital Asset Pricing Model Testing at Warsaw Stock Exchange: Are Family Businesses the Remedy for Economic Recessions?," IJFS, MDPI, vol. 2(3), pages 1-14, July.
    10. Nida SHAH* & Javaid DARS* & Ambreen ZEB**, 2015. "Market Varying Conditional Risk-Return Relationship," Pakistan Journal of Applied Economics, Applied Economics Research Centre, vol. 25(1), pages 25-43.

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    More about this item

    Keywords

    Capital Asset Pricing Model; Fama-French Three Factor Model; Market Risk; Residual Risk; Size; Book-to-market Value; Information Set; Business Cycle Variables;
    All these keywords.

    JEL classification:

    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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