Empirical evidence of conditional asset pricing in the Indian stock market

Abstract

Studies of various alternative empirical asset pricing models have mostly concentrated on developed markets. However, despite the importance of this issue, surprisingly little is known about how different asset pricing models behave in emerging capital markets. The purpose of this paper is to determine the suitability of conditional compared to unconditional versions namely, the capital asset pricing model and the Fama-French three-factor model for the Indian stock market. The key distinction between the present empirical tests and previous tests is the application of the Kalman filter method for dynamic beta estimation in the Indian market. The findings indicate that the cross-sectional variation in expected returns is driven by mainly two firm characteristics size and book-to-market ratio.Unlike the unconditional model, the market beta is able to capture the variation of expected return in conditional model. The results imply that information has a role and investors use the prior belief and macroeconomic variables as predictive variables to determine the cost of capital. These results are supported by some recent findings that Fama-French three-factor model is the only multifactor model that consistently sources three different types of risk included in the list of anomalies.