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

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.

Keywords

Arbitrage Pricing Theory asset pricing Capital Asset Pricing Model portfolio returns macroeconomic factors inflation factor analysis

Get full access to this article

View all access options for this article.

References

Amanulla

Kamaiah

(1997). Asset pricing behaviour in Indian stock market: How inadequate is Arbitrage Pricing Theory? International Journal of Development Banking, 15(2), 39–61.

Amanulla

Kamaiah

(1998). Asset price behaviour in Indian stock market: Is the ‘CAPM’ still relevant? Journal of Financial Management & Analysis, 11(1), 32–47.

Banz

(1981). The relationship between return and market value of common stocks. Journal of Financial Economics, 9(1), 3–18.

Basu

(1977). The investment performance of common stock in relation to their price-to-earnings ratios: A test of the efficient market hypothesis. Journal of Finance, 32(3), 663–682.

Basu

Chawla

(2010). An empirical test of CAPM—The case of Indian stock market. Global Business Review, 11(2), 209–220.

Berry

M.A.

Burmeister

McElroy

(1988). Sorting out risks using known APT factors. Financial Analyst Journal, 44(2), 29–41.

Black

Jensen

Scholes

(1972). The Capital Asset Pricing Model: Some empirical tests. Studies in the Theory of Capital Markets (pp. 79–121). New York: Praeger.

Blume

Friend

(1973). A new look at the Capital Asset Pricing Model. Journal of Finance, 28(1), 19–33.

Bower

Logue

(1984). Arbitrage pricing and utility stock returns. Journal of Finance, 39(4), 1041–1054.

10.

Burmeister

McElroy

(1988). Joint estimation of factor sensitivities and risk premia for the Arbitrage Pricing Theory. Journal of Finance, 43(3), 721–733.

11.

Chamberlain

Rothschild

(1983). Arbitrage, factor structure, and mean variance analysis on large asset markets. Econometrica, 51(5), 1281–1304.

12.

Chen

Roll

Ross

(1986). Economic forces and the stock market. Journal of Business, 59(3), 383–403.

13.

DeBondt

Thaler

(1985). Does the stock market overreact? Journal of Finance, 40(3), 739–805.

14.

Dhankar

Raj S.

Singh

Rohini

(2005). Arbitrage Pricing Theory and the Capital Asset Pricing Model—Evidence from the Indian stock market. Journal of Financial Management and Analysis, 18(1), 14–27.

15.

Faff

(1992). An empirical test of the Arbitrage Pricing Theory on Australian stock returns 1974–1985. Accounting and Finance, 28(2), 23–43.

16.

Fama

French

(1992). The cross-section of expected stock returns. Journal of Finance, 47(2), 427–465.

17.

Fama

French

(1993). Common risk factors in the returns of stocks and bonds. Journal of Financial Economics, 33(1), 3–56.

18.

Febrian

Herwany

(2007). CAPM and APT validation test before, during and after financial crisis in emerging market: Evidence from Indonesia. Social Science Research Network, Working Paper Series ID 1090047, 2007.

19.

Paavola

(2006). Tests of the Arbitrage Pricing Theory using macroeconomic variables in the Russian equity market. Bachelor’s Thesis, Lappeenranta University of Technology.

20.

Roll

Ross

(1980). A critical re-examination of the empirical evidence on the Arbitrage Pricing Theory: A reply. The Journal of Finance, 39(2), 347–350.

21.

Ross

Stephen A.

(1976). The arbitrage theory of capital asset pricing. Journal of Economic Theory, 13(3), 341–360.

22.

Sharpe

(1982). Factors in NYSE security returns 1931–1979. Journal of Portfolio Management, 8(2), 5–19.

23.

William

Akwimbi Ambaka

(2003). Application of the Arbitrage Pricing Model in predicting stock returns at the Nairobi Stock Exchange. Working Paper Series, Social Science Research Network.