Author
- ABHAY RAJA
- PRIYA CHOCHA
- NITA LALAKIYA
Abstract
Capital Assets Pricing Model (CAPM) has always fascinated researchers’ interest. It is the most researched as well as critically examined area in the field of finance. The concepts of Capital Market Line (CML) and Security Market Line (SML) are used as tools for the estimation of expected return on securities and portfolios. This study attempts to examine the applicability of CAPM on the Indian stock market.
The study was carried out on the sample of 12 companies representing 3 prominent sectors of the Indian economy i.e. Banking, IT and Automobile. These companies are analysed for the period of five years from 2009 to 2013.Yearly Expected Returns as per CAPM are computed to compare them with Actual Returns. As per CAPM, expected return on risky securities is the product of risk premium and beta added with the risk-free rate. Most of the computations were performed using Microsoft Excel. The conclusions reveal weak correlation between realized excess returns (i.e. actual returns over and above the risk-free rate) and the expected return as per CAPM. However, higher R square statistics suggest higher importance of systematic factors on stock returns. The study further infers the need for modifying beta for better representation of systematic factors.
Introduction
The stock market is known for its volatile nature, wherein numerous factors can affect prices. The uncertainty of reward from stock market investment is referred to as risk, which is to be borne by investors against the expectation of higher returns. As risk is inherent in the investments made in the stock market, a good portfolio manager has to understand and acknowledge the components of risk. Unsystematic risk refers to industry / company specific factors while systematic risk refers to market factors. According to Markowitz (Markowitz, 1959), unsystematic risk can be managed and reduced through proper diversification. In this regard, it becomes obvious that investors investing in securities with high unsystematic risk cannot outperform the market. They will not receive any extra reward for including such securities in their portfolio. On the other hand, systematic risk cannot be reduced through diversification. On the foundations of Markowitz, Sharpe (1964) and Lintner (1965) raised a concept of Capital Assets Pricing Model which holds a linear relationship between systematic risk and expected
return.
Being the area of interest for many researchers, empirically there are many varied results of CAPM. Initially, in the first two to three decades, CAPM was highly welcomed and accepted. During that period, CAPM was regarded as a proper tool for predicting stock returns. Later on, it was observed empirically that single beta cannot accurately predict stock returns as there are many other factors that can affect stock returns substantially. Changes in the market, changes in macro and micro fundamentals, emergence of competition, etc. are also factors that should be taken into serious consideration while predicting stock returns.