Testing conditional asset pricing models: An emerging market perspective

Javed Iqbal,Robert Brooks,Don U.A Galagedera

doi:10.1016/j.jimonfin.2009.12.004

Javed Iqbal, Robert Brooks + Show 1 more

Open Access

https://doi.org/10.1016/j.jimonfin.2009.12.004

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Abstract

The CAPM as the benchmark asset pricing model generally performs poorly in both developed and emerging markets. We investigate whether allowing the model parameters to vary improves the performance of the CAPM and the Fama–French model. Conditional asset pricing models scaled by conditioning variables such as Trading Volume and Dividend Yield generally result in small pricing errors. However, a graphical analysis reveals that the predictions of conditional models are generally upward biased. We demonstrate that the bias in prediction may be the consequence of ignoring frequent large variation in asset returns caused by volatile institutional, political and macroeconomic conditions. This is characterised by excess kurtosis. An unconditional Fama–French model augmented with a cubic market factor performs the best among some competing models when local risk factors are employed. Moreover, the conditional models with global risk factors scaled by global conditioning variables perform better than the unconditional models with global risk factors.

Highlights

Pricing risky assets is a daunting task
We investigated two plausible improvements in the benchmark unconditional CAPM (i) accounting for the time variation in expected returns and parameters and (ii) allowing for thicker tails and excess kurtosis relative to the normal distribution which is an inherent assumption of the CAPM
In this paper we address two of these issues. (i) We compare asset pricing models where the model parameters are fixed with those where the parameters are allowed to vary with the business cycle and future expectations. (ii) Due to relatively high frequency of extreme observations related to institutional and political instability the asset returns may have thick tails when modelling emerging market returns we need to consider excess kurtosis as well

Summary

Introduction

Pricing risky assets is a daunting task. This is especially true for emerging markets where institutional, political and macroeconomic conditions are generally volatile. Using the J-test of over identifying restrictions as evidence they conclude that the predictability in the emerging market returns can be explained by time varying risk premia and conclude that asset pricing in these markets is rational They analyse from the point of view of a Swiss investor. Using a set of ten emerging markets they tested the structural stability of the parameter through the Sup LM test using both views of the markets i.e. integrated and segmented They conclude that models which assume integration using a global instrument results in instable parameters while local models provide the time variation asset pricing with stable coefficients. In earlier studies on the Pakistan’s stock market Iqbal and Brooks (2007) found evidence of non-linearity in the risk return relationship. Iqbal et al (2008) found that the restrictions of the Black CAPM in a multivariate simultaneous equation framework could not be rejected for Pakistan but the power of the Wald and GMM tests remain a concern as in the case of the GMM test in Garcia and Ghysels (1998)

Modelling and Estimation framework

Model Specification Tests

Test of Asset Pricing Models

Some Robustness Checks

Conclusion