AN EMPIRICAL STUDY OF SELECT ASSET PRICING MODELS: EVIDENCE FROM INDIA

Abstract

In the financial world, asset pricing is one of the most important areas as it deals with ascertaining the prices of the various financial assets. An efficient asset pricing mechanism identifies the equilibrium price of an asset that helps in establishing an efficient capital market. Thus, the asset pricing influences the economic life of the capital seekers as well as the providers. For determining the correct prices of financial assets, we have a number of asset pricing theories, developed by the financial economists in the past. However, it is very hard to find that which theory is the best to determine the prices of stocks in any capital market as we have mixed evidence on their empirical performance. Hence, this study is an attempt to identify the best asset pricing model(s) in the context of the Indian equity capital market. The present study uses a secondary data set of the adjusted closing prices of NIFTY 500 stocks, traded on the National Stock Exchange (NSE). This study has carried out a comprehensive empirical analysis of the three important asset pricing models. These three asset pricing models are, viz., (i) the Capital Asset Pricing Model (CAPM), (ii) the Fama-French threefactor model, and (iii) the Carhart four-factor model. Additionally, the effect of liquidity on the stock prices is also analysed by augmenting the Carhart four-factor model with the liquidity factor. Furthermore, to understand the effect of downside risk on the asset prices, the liquidity augmented Carhart four-factor model is improved by accommodating a new factor, the tail beta (developed for the first time in this study in the Indian context). The notable findings of this study are that the single factor model (the CAPM) fails in explaining the risk-return relationship of stocks for a majority of the portfolios considered in this study. As expected, we confirm that the multifactor asset pricing models perform better than the single factor model and explain the cross-section of expected stock returns to a great extent. The Fama-French three-factor model explains the cross-section of stock returns fairly well. The Carhart four-factor model offers the same with a higher explanatory power. Though, the fourth factor of the Carhart four-factor model (momentum factor) does not show a high significance in the analysis. Similarly, the liquidity factor demonstrates the same pattern of significance as that of the momentum factor. Notably, the model augmented with the liquidity and tail beta factors shows the highest explanatory power amongst all the models considered. Furthermore, it is pertinent to note that the tail beta factor iii shows a higher significance than the momentum and liquidity factors in the model. This result suggests that the tail beta factor is an important factor in the asset pricing. Based on the findings of the research, the following recommendations have been made: (i) The single factor model CAPM is not obsolete; it does perform under certain conditions. However, to get a holistic view, the other multifactor asset pricing models should also be studied, before going for any investment decisions. (ii) While explaining the cross-section of expected stock returns, the multifactor asset pricing models like Fama-French three-factor model and Carhart four-factor model might be preferred. (iii) Also, while assessing the risk and return of any mutual fund/ security (to identify the underpriced ones), the manager may consider an augmented multifactor model that takes into account the two important risk factors, viz., the extreme loss exposure (tail beta) and illiquidity to assess the downside risk and liquidity risk of funds or securities. (iv) During the crisis period, the stocks with a low downside risk seem to earn a higher average return. This implies that the stocks with low downside risk may be added to the portfolio during the recessionary period.