Bivariate Analysis of Capital Asset Pricing Model in Indian Capital Market

Abstract

Capital Asset Pricing Model (CAPM) establishes the relationship between risks and returns in the efficient capital markets. A review of studies conducted for various markets in the world reveals that researchers have used a number of methodologies to test the validity of CAPM. While some studies have supported the validity of CAPM, some others have revealed that beta alone is not a suitable determinant of asset pricing and that a number of other factors could explain the cross-section of returns. This paper has attempted to test the validity of the combination effect of the two parameter CAPM to determine the security⁄portfolio returns. The results show that: Intercept is not significantly different from zero. The combination of sizei and ln(BE/ME)i explains the variation in security returns under both percentage and log returns series. The combination of βi and ln(BE/ME)i, βi and (Rm-Rf)i, sizei and (E/P)i, and (E/P)i and (BE/ME)i explains the variation in security returns when log return series is used and the combination of βi and (Rm-Rf)i explains the variation in security returns when percentage return series is used. In case of portfolios, the combination of βp and Rm-Rf explains the variation of portfolio returns when portfolios formed with market value weights under both percentage and log returns and βp and ln(BE/ME)p explain the portfolio percentage returns when market value weights are used. It is observed that while combinations of some of the independent variables, as opposed to the univariate variable considered in Manjunatha and Mallikarjunappa's (2006) paper, explain the variations in security⁄portfolio returns, the other combinations do not explain the variation in the security⁄portfolio returns. Further analysis in this paper has shown that beta, with some of the combinations of the independent variables, explains the variation in security⁄portfolio returns. However, beta alone, when considered individually in the two parameter regressions, does not explain the variation in security⁄ portfolio returns. This casts doubt on the validity of the standard form of CAPM. In the light of these findings, it can be concluded that beta alone is not sufficient to determine the expected returns on the securities⁄portfolios. The empirical findings of this paper would be useful to financial analysts in the Indian capital market. Further research on the combination of market factors, firms' specific factors, and macroeconomic factors is needed to enlarge the understanding of modern finance and to cover fresh ground to unravel the mysteries and ramifications of the CAPM puzzle.