IDEAS home Printed from https://ideas.repec.org/a/sae/globus/v13y2012i3p421-432.html
   My bibliography  Save this article

An Empirical Test of the Arbitrage Pricing Theory—The Case of Indian Stock Market

Author

Listed:
  • Debarati Basu

    (Debarati Basu is Fellow Programme Participant at IIM-Calcutta, Kolkata, India. E-mail: debaratib19@yahoo.co.in)

  • Deepak Chawla

    (Deepak Chawla is Professor at International Management Institute, New Delhi, India. E-mail: dchawla@imi.edu)

Abstract

With increasing doubt about the validity of the one-factor Capital Asset Pricing Model in pricing financial assets, development of newer models or extensions has become the order of the day. This paper applies one of these developments—the multi-factor Arbitrage Pricing Theory (APT) to explore the relationship between portfolio returns and selected macroeconomic variables. While the chosen model has been extensively tested in developed markets, few such attempts have been made in emerging capital markets. Thus, the purpose of this study is to test the validity of the APT model in India, which has, over the years, gained immense importance in the investors’ minds, the world over. Moreover, the surge in volatility and growth in the Indian capital markets over the past five years makes it an interesting market to study given the rising significance of the risk-return trade-off in such a market. The paper examines ten portfolios, covering 50 stocks, over a five-year period from 1 January 2003 to 1 February 2008 to verify the efficiency and efficacy of the model and finds that APT is a suitable descriptor of asset prices in the Indian context. To overcome the problem of multicollinearity among the macroeconomic explanatory variables, a factor analysis was carried out that resulted in two factors namely the inflation factor and the market index. The excess portfolio returns were regressed on these factors. The regression results display accurate relationships that are significant for each of the 10 portfolios and moderate to high explanatory power. Thus, it concludes that APT is a good fit in India over the chosen sample period.

Suggested Citation

  • Debarati Basu & Deepak Chawla, 2012. "An Empirical Test of the Arbitrage Pricing Theory—The Case of Indian Stock Market," Global Business Review, International Management Institute, vol. 13(3), pages 421-432, October.
    • Handle: RePEc:sae:globus:v:13:y:2012:i:3:p:421-432
    DOI: 10.1177/097215091201300305
    as

    Download full text from publisher

    File URL: https://journals.sagepub.com/doi/10.1177/097215091201300305
    Download Restriction: no
    File URL: https://libkey.io/10.1177/097215091201300305?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    References listed on IDEAS

    as
    1. Fama, Eugene F & French, Kenneth R, 1992. "The Cross-Section of Expected Stock Returns," Journal of Finance, American Finance Association, vol. 47(2), pages 427-465, June.
    2. Stephen A. Ross, 2013. "The Arbitrage Theory of Capital Asset Pricing," World Scientific Book Chapters, in: Leonard C MacLean & William T Ziemba (ed.), HANDBOOK OF THE FUNDAMENTALS OF FINANCIAL DECISION MAKING Part I, chapter 1, pages 11-30, World Scientific Publishing Co. Pte. Ltd..
    3. Burmeister, Edwin & McElroy, Marjorie B, 1988. " Joint Estimation of Factor Sensitivities and Risk Premia for the Arbitrage Pricing Theory," Journal of Finance, American Finance Association, vol. 43(3), pages 721-733, July.
    4. De Bondt, Werner F M & Thaler, Richard, 1985. "Does the Stock Market Overreact?," Journal of Finance, American Finance Association, vol. 40(3), pages 793-805, July.
    5. Chamberlain, Gary & Rothschild, Michael, 1983. "Arbitrage, Factor Structure, and Mean-Variance Analysis on Large Asset Markets," Econometrica, Econometric Society, vol. 51(5), pages 1281-1304, September.
    6. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
    7. Basu, S, 1977. "Investment Performance of Common Stocks in Relation to Their Price-Earnings Ratios: A Test of the Efficient Market Hypothesis," Journal of Finance, American Finance Association, vol. 32(3), pages 663-682, June.
    8. Blume, Marshall E & Friend, Irwin, 1973. "A New Look at the Capital Asset Pricing Model," Journal of Finance, American Finance Association, vol. 28(1), pages 19-33, March.
    9. Bower, Dorothy H & Bower, Richard S & Logue, Dennis E, 1984. "Arbitrage Pricing Theory and Utility Stock Returns," Journal of Finance, American Finance Association, vol. 39(4), pages 1041-1054, September.
    10. Chen, Nai-Fu & Roll, Richard & Ross, Stephen A, 1986. "Economic Forces and the Stock Market," The Journal of Business, University of Chicago Press, vol. 59(3), pages 383-403, July.
    11. Banz, Rolf W., 1981. "The relationship between return and market value of common stocks," Journal of Financial Economics, Elsevier, vol. 9(1), pages 3-18, March.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Zura Kakushadze & Willie Yu, 2016. "Multifactor Risk Models and Heterotic CAPM," Papers 1602.04902, arXiv.org, revised Mar 2016.
    2. Zura Kakushadze, 2015. "Heterotic Risk Models," Papers 1508.04883, arXiv.org, revised Jan 2016.
    3. Zura Kakushadze & Willie Yu, 2016. "Statistical Risk Models," Papers 1602.08070, arXiv.org, revised Jan 2017.
    4. Zura Kakushadze, 2014. "4-Factor Model for Overnight Returns," Papers 1410.5513, arXiv.org, revised Jun 2015.
    5. Zura Kakushadze & Jim Kyung-Soo Liew, 2015. "Custom v. Standardized Risk Models," Risks, MDPI, vol. 3(2), pages 1-27, May.
    6. Fernando Rubio, 2005. "Eficiencia De Mercado, Administracion De Carteras De Fondos Y Behavioural Finance," Finance 0503028, University Library of Munich, Germany, revised 23 Jul 2005.
    7. Ericsson, Johan & Karlsson, Sune, 2003. "Choosing Factors in a Multifactor Asset Pricing Model: A Bayesian Approach," SSE/EFI Working Paper Series in Economics and Finance 524, Stockholm School of Economics, revised 12 Feb 2004.
    8. Zura Kakushadze, 2014. "Russian-Doll Risk Models," Papers 1412.4342, arXiv.org, revised Nov 2017.
    9. Zura Kakushadze & Jim Kyung-Soo Liew, 2014. "Custom v. Standardized Risk Models," Papers 1409.2575, arXiv.org, revised May 2015.
    10. Fernando Rubio, 2005. "Estrategias Cuantitativas De Valor Y Retornos Por Accion De Largo," Finance 0503029, University Library of Munich, Germany.
    11. Amit Goyal, 2012. "Empirical cross-sectional asset pricing: a survey," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 26(1), pages 3-38, March.
    12. Rocciolo, Francesco & Gheno, Andrea & Brooks, Chris, 2022. "Explaining abnormal returns in stock markets: An alpha-neutral version of the CAPM," International Review of Financial Analysis, Elsevier, vol. 82(C).
    13. Sainan Jin & Liangjun Su & Yonghui Zhang, 2015. "Nonparametric testing for anomaly effects in empirical asset pricing models," Empirical Economics, Springer, vol. 48(1), pages 9-36, February.
    14. Ebrahim, M. Shahid & Girma, Sourafel & Shah, M. Eskandar & Williams, Jonathan, 2014. "Rationalizing the value premium in emerging markets," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 29(C), pages 51-70.
    15. Committee, Nobel Prize, 2013. "Understanding Asset Prices," Nobel Prize in Economics documents 2013-1, Nobel Prize Committee.
    16. M. Eskandar Shah & Sourafel Girm & R. Hudson, 2012. "Rationalizing the Value Premium under Economic Fundamentals in an Emerging Market," Working Papers 12010, Bangor Business School, Prifysgol Bangor University (Cymru / Wales).
    17. Geertsema, Paul & Lu, Helen, 2020. "The correlation structure of anomaly strategies," Journal of Banking & Finance, Elsevier, vol. 119(C).
    18. Trabelsi, Mohamed Ali, 2010. "Choix de portefeuille: comparaison des différentes stratégies [Portfolio selection: comparison of different strategies]," MPRA Paper 82946, University Library of Munich, Germany, revised 01 Dec 2010.
    19. Ray Ball & Gil Sadka & Ayung Tseng, 2022. "Using accounting earnings and aggregate economic indicators to estimate firm-level systematic risk," Review of Accounting Studies, Springer, vol. 27(2), pages 607-646, June.
    20. Gabriel Hawawini & Donald B. Keim, "undated". "The Cross Section of Common Stock Returns: A Review of the Evidence and Some New Findings," Rodney L. White Center for Financial Research Working Papers 08-99, Wharton School Rodney L. White Center for Financial Research.

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:sae:globus:v:13:y:2012:i:3:p:421-432. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: SAGE Publications (email available below). General contact details of provider: http://www.imi.edu/ .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.