Testing the Validity of Conditional Four Moment Capital Asset Pricing Model: Empirical Evidence from the Colombo Stock Exchange

Jayaweera M Nishantha

doi:10.4038/ss.v48i1.4710

Abstract

The Capital Asset Pricing Model (CAPM) is one of the most used model in finance during the last five decades. This is despite heavy criticism against it along with an ongoing debate among academia about the empirical validity of the model. Three major extensions to the conventional model have been suggested; higher-moment CAPM, multi-factor model and conditional CAPM. All these models have shown mixed results in empirical studies. In the recent past, these extensions are integrated and tested for empirical validity and show some positive results (Vendrame, Tucker & Guermat, 2016). In this study, the empirical validity of conditional four-moment CAPM is tested on the Colombo Stock Exchange (CSE) of Sri Lanka. Individual stock returns on 74 listed companies covering a 17-year period from 2000 to 2016 are used. A two step procedure is followed with the estimation of the short window time series regressions in the first step, while cross-sectional regressions are estimated in the second step. Test results show inconclusive evidence about the conditional four-moment CAPM. Risk of coskewness is significant though risk of covariance and co-kurtosis are not significant explaining the average return on individual stocks on the CSE during the period under study.

Highlights

The Capital Asset Pricing Model (CAPM) plays a major role in the current finance industry and in making investment decisions
The CAPM is introduced by Sharpe (1964), Lintner (1975) and Mossin (1966) following the mean-variance portfolio theory introduced by Henry Markowitz (1952)
Basu (1977), Banz (1981) and Fama and French (1992) find evidence that beta but other factors such as earnings to price (E/P) ratio, size and book value to market value (B/M) ratio have the explanatory power of average returns

Summary

Introduction

The Capital Asset Pricing Model (CAPM) plays a major role in the current finance industry and in making investment decisions. The CAPM is introduced by Sharpe (1964), Lintner (1975) and Mossin (1966) following the mean-variance portfolio theory introduced by Henry Markowitz (1952). The model primarily describes the linear relationship between expected return on an asset and expected market return in excess of risk free return. Following the mean-variance portfolio theory of Markowitz (1952), Sharpe (1964) and Lintner (1975) proposed a model to explain the average return on individual assets. Since the CAPM is derived based on the Markowitz mean-variance portfolio theory, the CAPM requires the same assumptions to be held and two more assumptions about investors ability to lend and borrow money and their homogenies expectations. They prefer higher expected return to lower expected return for a given level of risk as measured by standard deviation or lower risk to a higher risk for a given level of expected return

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