Conditional relation between return and co-moments – an empirical study for emerging Indian stock market

Rashmi Chaudhary,Priti Bakhshi,Dheeraj Misra

doi:10.21511/imfi.17(2).2020.24

Rashmi Chaudhary, Priti Bakhshi + Show 1 more

Open Access

https://doi.org/10.21511/imfi.17(2).2020.24

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Abstract

Due to many theoretical and practical shortcomings of the traditional CAPM model, this study aims at analyzing the CAPM with possible extensions. The analysis aims to know the empirical soundness of Conditional Higher Moment CAPM in emerging India’s capital market. The sample consists of 69 company’s daily stock price data from April 2004 to March 2019 from NSE 100. Panel data analysis is used on 21 cross-sections. The overall results show that when both up and down markets are incorporated separately, all three moments, namely, co-variance, co-skewness, and co-kurtosis, are priced during the normal Indian economy phase. Further, this study states that including higher moments (co-skewness and co-kurtosis) in the two-moment model provides symmetry in both the up and down markets. This is one of the first studies in the Indian Stock market explaining the variation in portfolio returns through panel data analysis by extending CAPM with conditional higher-order co-moments. The portfolio managers should consider skewness and kurtosis along with variance in constructing the optimal portfolios.

Highlights

Sharpe (1964), Lintner (1965), and Mossin (1966) proposed Capital Asset Pricing Model (CAPM), which is based on the assumption that expected market risk premium can never be negative and returns on security always have a normal distribution
The analysis aims to know the empirical soundness of Conditional Higher Moment CAPM in emerging India’s capital market
This study states that including higher moments in the two-moment model provides symmetry in both the up and down markets

Summary

Introduction

Sharpe (1964), Lintner (1965), and Mossin (1966) proposed Capital Asset Pricing Model (CAPM), which is based on the assumption that expected market risk premium can never be negative and returns on security always have a normal distribution. The CAPM model considers only the first two moments, which are mean and variance of security returns to explain the expected return variation. Traditional CAPM is based on many unrealistic assumptions that are not prevailing in the current scenario. Academicians and practitioners of finance have gone ahead to do a thought-provoking examination of the traditional CAPM and its possible extensions. This has been done to find rational explanations for empirical failures.

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