Further Evidence on the Validity of CAPM: the Istanbul Stock Exchange Application

Abstract

As one of the most important models in the finance literature, the Capital Asset Pricing Model (CAPM) assumes the existence of a positive and linear relationship between the systematic risk and required rates of return on stocks. The model is extensively researched in the academia and frequently used in business world since its development half a century ago. Its popularity comes from the simplification it provides for the complex process of asset pricing by making the assumption that only one single factor affects stock returns. But, as this is an unrealistic assumption, the validity of the model in its standard (unconditional) form is repeatedly rejected by empirical tests. Pettengill et al. (1995) developed an alternative conditional CAPM approach where the standard model is improved by taking bull and bear market conditions into consideration. According to this model, there is a positive (negative) risk-return relationship during up (down) market periods. Using this reasoning, Pettengill et al. (1995) tested up and down market periods separately and reached highly significant results that support CAPM. In this study, both the unconditional and conditional versions of CAPM are tested in the Istanbul Stock Exchange (ISE) for the period of nine years from 2003 to 2011. The test period is divided into four sub-periods. The unconditional CAPM is rejected for the sample period. A result of the conditional test shows that there is a statistically significant conditional relationship during some sub-periods. However, since the risk-return relationship in up and down markets is not symmetric, this conditional relationship does not indicate a positive risk-return tradeoff. Thus, CAPM may not be a useful asset pricing model for the ISE. DOI: http://dx.doi.org/10.5755/j01.ee.25.1.1847