Risk, return, and equilibrium in the emerging markets: Evidence from the Korean stock market

Abstract

This study examines, with the methodology of Fama and MacBeth ( Journal of Political Economy 71: 607–636, 1973), whether the capital asset pricing model (CAPM) is applicable to the Korean stock market, which is small and relatively underdeveloped in comparison with the U.S. and other advanced nation stock markets. Our empirical findings indicate that the Sharpe-Lintner-Mossin CAPM paradigm is not adequate in the Korean stock market. First, the critical condition of the CAPM, a positive trade-off between market risk and return, is rejected. Second, we find that residual risk played an important role in pricing risky assets. The inadequacy of the CAPM in the Korean stock market may be attributed to market inefficiency and the highly undiversified portfolios held by the Korean investors.