Higher Co-Moments and Downside Beta in Asset Pricing

Imran Umer Chhapra,Muhammad Kashif

doi:10.21315/aamjaf2019.15.1.6

Abstract

The Capital Asset Pricing Model (CAPM) assumes a linear relationship between an assetAs return and financial market. However, empirical invalidity of linearity of returns has given birth to other CAPM models. Therefore, this study aims to examine the implication of preference by a risk-averse investor for higher moments and downside risk as investors are assumed to be prudent, temperate and cautious and prefer firms with negative co-skewness, positive co-kurtosis, and downside risk as they yield higher risk premium. To empirically test these theoretical assumptions data of all 901 firms (listed and delisted) in Pakistan Stock Exchange (PSX) from 2000 to 2016 have been used. Decile portfolios are constructed for cross-sectional and time series analysis. Generalized Method of Moments (GMM) and Wald Test are applied to check the robustness of results. The results indicate that co-skewness, co-kurtosis and downside beta are important risk factors but only downside beta is genuinely priced over and above what co-variance risk can explain and CAPM does not significantly capture market risk premium indicating the existence of other risk measures in PSX. The findings can help investors in formulating investment strategies for constructing well-diversified and efficient portfolios and can enable firm managers to take appropriate capital budgeting decisions by appropriately costing equities.

Highlights

Pricing of a financial asset especially determination of the price of a risky financial asset is the most critical question in financial economics
Pricing a risk asset is one the most difficult part of an investor’s life and empirical results of Capital Asset Pricing Model (CAPM) have to validate its failure in asset pricing which has motivated researchers to reexamine the basis on which this model has been developed
To achieve the purpose of this study, decile portfolios are constructed on the basis of co-skewness, co-kurtosis and downside beta and t-test results reveal that only DSB is efficiently priced in Pakistan Stock Exchange (PSX) and the other two risk measure (CSK and CKT) fail to yield abnormal average returns and cannot be considered as additional risk source that is priced in PSX

Summary

Introduction

Pricing of a financial asset especially determination of the price of a risky financial asset is the most critical question in financial economics It is in the field of asset pricing theory that has provided the answer to this critical question and is a dominant theme in financial economics. This has enticed the consideration of many investigators and academicians in finance plus a huge number of research publications have been penned on asset pricing (Dempsey, 2013). In MV framework, it is assumed that investor’s preferences are defined with respect to the mean and variance of an asset return. It is assumed that asset returns are random variables and only the financial aspects of the portfolio (i.e. risk and return) affects the investor’s investment decision and nothing else does (Vasant, Irgolic, Rajaratnam, & Kruger, 2014)

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