Abstract
Several studies of the Capital Asset Pricing Model (CAPM) in South Africa find that beta cannot explain returns. However, these studies do not consider the effect of bull and bear markets, yet over the period 1995-2009, excess market returns were positive in only 98 of 180 months. The influence of market conditions on the risk-return relationship is examined internationally by evaluating the conditional risk-return relationship where risk premiums are allowed to vary in bull and bear markets, and the dual-beta CAPM, which allows for the sensitivity of an asset to the market to vary under the two economic states. In this study, the ability of these two models to explain returns on South African shares is compared to the CAPM using the Fama and MacBeth (1973) and panel data approaches. The dual-beta model is found to be more successful than either the conditional relation or CAPM, as bull- and bear-market betas differ; but the estimates of the risk premiums in this model are significant only after adjusting for market segmentation. The findings thus indicate that asset-pricing models with time-varying risk should be the focus of future asset-pricing tests.
Highlights
The frequently cited ‘first principle of finance’ is that higher risk should be compensated for by higher returns
This study extends the analysis to review the dual-beta Capital Asset Pricing Model (CAPM), which has not been examined for Johannesburg Stock Exchange (JSE)-listed shares, to assess whether risk measures may vary in bull and bear markets
This analysis provides a foundation on which the conditional risk-return relationship and the dual-beta model can be compared
Summary
The frequently cited ‘first principle of finance’ is that higher risk should be compensated for by higher returns. The CAPM depicts the equilibrium risk-return relationship, showing that the expected return on a risky security or portfolio is the sum of the return on the risk-free asset and a premium for bearing non-diversifiable risk, as any firm-specific risk is assumed to have been eliminated by the investor through diversification (Sollis, 2012:115). Van Rensburg and Robertson (2003), Strugnell, Gilbert and Kruger (2011) and Ward and Muller (2012) document overwhelming evidence against its suitability Most notably, these three studies find a negative relationship between beta and returns, which contradicts the theory that risk should be commensurate with returns. In their seminal paper, Fama and French (1992) found that beta was not able to explain the cross-section of share returns in the United States (US) and that the relationship between risk and return was flat
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