Arbitrage Pricing Theory: Evidence from an Emerging Stock Market

This paper examines the stock price behaviour of an emerging stock market, the Stock Exchange of Thailand (SET), by applying a new equilibrium stock price theory formulated by Ross (1976). The theory postulates stock market risks and returns are determined by fundamentals under a linear relationship established on the basis of a homogeneous multi-factor model return generating process and the assumptions of perfectly competitive and frictionless markets. Employing the data for the period before the Asian Financial Crisis 1997-1998, between Jan 1987 and Dec 1996 under the light of the methodology proposed by Fama and McBeth (1973), the research investigates the relationship between the stock returns in the Stock Exchange of Thailand and some economic fundamentals, namely returns on the SET-Index, changes in exchange rates, industrial production growth rates, unexpected changes in inflation, changes in the current account balance, differences between domestic interest rates and international interest rates, changes in domestic interest rate. The test's results show that, within the scope of the methodology and data employed, the Arbitrage Pricing Theory (APT) does hold in the very emerging stock market of Thailand, while the CAPM (Capital Asset Pricing Model) fails to do so. While changes in exchange rates consistently explain the stock returns, there is one chance the exchange rates and the industrial growth rates together systematically affect the stock returns. The negative risk premiums associated with these factors shows investors in the SET are risk averse and tend to hedge against risks of changes in fundamentals.