Conditional CAPM Research Articles

Assessing the extent of exchange rate risk pricing in equity markets: emerging versus developed economies

PurposeThis paper contributes to the literature on exchange rate exposure by assessing the extent to which exchange rate risk is priced in both African emerging and developed equity markets. It examines whether this risk leads to a premium or discount in market returns. The study uses the United States and South Africa as representatives for developed and emerging economies, respectively.Design/methodology/approachThe paper employs two-factor and three-factor conditional CAPM approaches with a two-stage estimation process. In the first stage, time-varying risk exposures are derived using the ICAPM model estimated through rolling regression. In the second stage, the impact of these risk exposures, particularly exchange rate risk exposure, is assessed on stock market returns using Generalized Linear Model (GLM) regression.FindingsUnlike previous studies that suggest exchange rate risk is not necessarily priced in the equity market due to hedging, this paper finds that exchange rate risk is indeed priced in both African and developed equity markets, albeit to different extents. The African equity market demands a higher premium compared to the developed equity market.Practical implicationsThe findings of this paper have significant implications for policymakers, asset managers, and investors. They provide insights for making more informed decisions, implementing effective risk management strategies, and fostering a more stable and appealing investment environment.Originality/valueTo the best of our knowledge, this is the first study to evaluate the degree of exchange rate exposure in environments characterized by high currency volatility versus those with low volatility, all within the context of the conditional ICAPM model.

Financial Crises and the Success of Global Portfolio Management: A Study of the Middle East and North Africa

Our principal objective is to implement a conditional CAPM that, in addition to the global market risk, specifies the level of market integration, evaluates exchange rate risk, and accounts for local market risk. To investigate the potential for portfolio diversification for foreign investors in this region by examining the impact of financial crises on the evolution of national markets in the MENA region's financial integration with the global market as well as with the three selected developed markets, namely France, Great Britain, and the United State. In order to test a conditional version of De Santis and Gerard's ICAPM by admitting a specification of a multivariate GARCH process, this line of research has used a particular methodology (MGARCH).

Which is Better: Value Strategy or Growth Strategy?

Purpose: On the backdrop of the recent value versus growth debate in both academics and investment community, this paper investigates which is a better strategy, value or growth strategy. Design/methodology/approach: Reworking the Euler equation, this paper derives the relationship among return, profit growth, and risk. We use three different risk metrics proposed by Park and Fang (2021). We regress the value minus growth return on profit growth and risk variables to determine which is the primary driver of the return in the Korean stock market. The data run from 2000 through 2021. Findings: Our data show that the accumulated return on value minus growth stocks steadily increases over 2000- 2012 in Korea, indicating that value stocks outperform growth stocks over the long horizon. Our regression results show that the time-varying risk effect reverts from negativity contemporaneously to positivity with a time lag, and its temporal effect is negligible when aggregated in time. There exists a positive long-run risk effect on the value minus growth return. However, the effect of profit growth on return is not significant, indicating that growth firms’ profit prospect is not a factor in the determination of value minus growth return. Research limitations/implications: In the past, stock market uncertainty (risk) have been most caused by either financial system failures or technological innovations. Whether value stocks outperform growth stocks or vice versa may crucially depends on the causes of stock market uncertainty. We need to refine our model to account for the differences in the causes of stock market uncertainty. Originality/value: Our model is a first attempt to combine profit growth and risk in a unifying framework to explain the value and growth spread in the stock market. The conditional CAPM is a risk-based approach in which profit growth is not accounted for.

Testing the Conditional CAPM Using Short-Window Regressions : A Critique

Using short-window regressions, prior studies have shown that the conditional CAPM performs as poorly as the unconditional CAPM and that unconditional alphas are too large to be explained by the covariance between conditional betas and market risk premium. I examine the extent to which these results are driven by estimation biases in short-window regressions. Even when the true time-varying beta has highly transient components, beta estimates from these short-window regressions can be estimated to highly persistent because of yearly portfolio reformulations that are commonly employed in empirical studies. I show that, under these circumstances, large non-zero alpha estimates from short-window regressions are consistent with the conditional CAPM and the covariance estimates between conditional betas and market risk premium are biased downward and can have large estimation errors.

Evaluating the Conditional CAPM using Consumption-based State Variables: Evidence from the Korean Stock Market

In this study, we evaluate the empirical performance of conditional asset pricing models using consumption-based measures as state variables. We incorporate three consumption variables known to forecast the equity risk premium as conditioning variables to capture time variations in the risk premium. These three variables are the consumption-aggregate wealth ratio, the surplus consumption ratio, and the labor income to consumption ratio. The asset pricing models evaluated in this study are the CAPM, the CAPM with human capital, the consumption CAPM, and the Fama-French three-factor model. We compare the unconditional and conditional specifications of these four asset pricing models using the two-pass cross-sectional regression methodology, using the size, book-to-market, turnover, and idiosyncratic risk sorted portfolios and sector portfolios as test assets. We demonstrate that the conditional CAPM with human capital performs far better than the unconditional specifications and about as well as the Fama and French three-factor model in explaining the crosssection of average stock returns in Korea.

Observable Implications of the Conditional CAPM

The derivation of observable implications of the conditional CAPM theory often includes the joint (internally inconsistent) hypothesis that the stock portfolio used in the tests is the theoretical, mean-variance efficient, market portfolio. The present paper generalizes this derivation by avoiding this joint hypothesis. The generalization reveals that the conditional CAPM plausibly explains asset pricing anomalies, such as the unconditional alphas and betas of momentum, value, and size portfolios, while the unconditional CAPM theory is still rejected by portfolios with negative unconditional betas and positive unconditional alphas. Hence, relaxing this joint assumption does not render the CAPM theory untestable.

Impacto da crise econômica de 2015-2016 sobre o coeficiente beta do mercado de capitais brasileiro

Estudos empíricos têm encontrado evidências de que o risco de mercado, ou beta de mercado, tende a aumentar em períodos de crise. Dada a crise econômica brasileira de 2015-2016, o objetivo deste artigo é analisar se esta teve um impacto significativo sobre o risco de mercado das empresas brasileiras com ações negociadas na bolsa de valores brasileira (B3). Para isso, estimamos a trajetória do beta de uma carteira de ações negociadas na B3 para o período de fevereiro de 2010 a dezembro de 2018, considerando um modelo CAPM condicional em que a dinâmica de beta é dada por um processo estocástico combinado com um conjunto de variáveis condicionantes relacionadas ao ciclo econômico. Encontramos evidências de que o beta da carteira teve um aumento a partir de janeiro de 2015 e só retornou a patamares do período pré-crise a partir de março de 2018. Essas evidências estão de acordo com os resultados encontrados na literatura internacional e têm implicações importantes em termos de gerenciamento de risco.

Conditional relation between return and co-moments – an empirical study for emerging Indian stock market

Due to many theoretical and practical shortcomings of the traditional CAPM model, this study aims at analyzing the CAPM with possible extensions. The analysis aims to know the empirical soundness of Conditional Higher Moment CAPM in emerging India’s capital market. The sample consists of 69 company’s daily stock price data from April 2004 to March 2019 from NSE 100. Panel data analysis is used on 21 cross-sections. The overall results show that when both up and down markets are incorporated separately, all three moments, namely, co-variance, co-skewness, and co-kurtosis, are priced during the normal Indian economy phase. Further, this study states that including higher moments (co-skewness and co-kurtosis) in the two-moment model provides symmetry in both the up and down markets. This is one of the first studies in the Indian Stock market explaining the variation in portfolio returns through panel data analysis by extending CAPM with conditional higher-order co-moments. The portfolio managers should consider skewness and kurtosis along with variance in constructing the optimal portfolios.

Observable Implications of the Conditional CAPM

The derivation of observable implications of the conditional CAPM theory often includes the joint (internally inconsistent) hypothesis that the stock portfolio used in the tests is the theoretical, mean-variance efficient, market portfolio. The present paper generalizes this derivation by avoiding this joint hypothesis. The generalization reveals that the conditional CAPM plausibly explains asset pricing anomalies, such as the unconditional alphas and betas of momentum, value, and size portfolios, while the unconditional CAPM theory is still rejected by portfolios with negative unconditional betas and positive unconditional alphas. Hence, relaxing this joint assumption does not render the CAPM theory untestable.

Revisiting the CAPM model with quantile regression: creating investment strategies on the Zagreb Stock Exchange

This research explores whether conditional CAPM holds at different points of the return distribution by focusing on data from the Zagreb Stock Exchange and quantile regression methodology. Weekly data on 5 sector indices, market return on CROBEX and return on Treasury bills (91 days) for the period January 2012 to April 2018 was collected in order to empirically evaluate the CAPM model via quantile regression. The contribution of this research is given in the simulation part, where several specifications of investment strategies based on estimation results are discussed. Previous literature does not focus on utilising estimation results as guidance for dynamic investment strategies. Based upon simulations of several strategies, it was shown that quantile regression strategies could be beneficial for more conservative investors. Since this study is one of the few which try to link statistical aspects of estimating finance models with investment strategies, this research contributes to the existing literature.

Revisiting the CAPM model with quantile regression: creating investment strategies on the Zagreb Stock Exchange

This research explores whether conditional CAPM holds at different points of the return distribution by focusing on data from the Zagreb Stock Exchange and quantile regression methodology. Weekly data on 5 sector indices, market return on CROBEX and return on Treasury bills (91 days) for the period January 2012 to April 2018 was collected in order to empirically evaluate the CAPM model via quantile regression. The contribution of this research is given in the simulation part, where several specifications of investment strategies based on estimation results are discussed. Previous literature does not focus on utilising estimation results as guidance for dynamic investment strategies. Based upon simulations of several strategies, it was shown that quantile regression strategies could be beneficial for more conservative investors. Since this study is one of the few which try to link statistical aspects of estimating finance models with investment strategies, this research contributes to the existing literature.

A dynamic conditional regime-switching GARCH CAPM for energy and financial markets

This paper develops a methodology for estimating a time-varying conditional version of the CAPM with regime changes in conditional variance dynamics. Our research goal is related to documenting the power of the beta when it is estimated dynamically. The empirical performance is tested across a sample of 81 financial, energy, and other commodity markets for the period August 1999–January 2018. The conditional regime-switching GARCH CAPM, with time-varying betas explaining both bull and bear markets, outperforms the unconditional (static) CAPM. Among stocks, there are significant time variations in betas across our models and regimes. This empirical feature is even more pronounced in the USA, the UK, Germany, France, China, and Malaysia. Among energy and other commodities, we find similar variations in the market price of risk. The direction of the relation with market returns for Crude Oil, Gold, Copper, Tin, Rubber, Aluminum, and Platinum is the same across our nested models. This result also holds for aggregate markets indices. Secondly, we provide a ranking by mean filtered volatility series where Natural Gas stands out at a high level. Average pricing errors are inferior in the case of the conditional model, and for Crude Oil. Lastly, we demonstrate that the regime-switching model delivers better estimates of one-day-ahead Value-at-Risk than its non-switching counterpart. Our results shed light on the supremacy of the market factor alone associated with time variation in risk premia across the energy and financial markets.

A large-scale approach for evaluating asset pricing models

Recent studies show that the standard test portfolios do not contain sufficient information to discriminate between asset pricing models. To address this issue, we develop a large-scale approach that expands the cross-section to several thousand portfolios. Our novel approach is simple, widely applicable, and allows for formal evaluation/comparison tests. Its benefits are confirmed in empirical tests of CAPM- and characteristic-based models. While these models are all misspecified, we uncover striking performance differences between them. In particular, the human capital and conditional CAPMs largely outperform the CAPM, which suggests that labor income and time-varying recession risks are primary concerns for investors.

The CAPM Holds

When the cost of hedging is nil, the conditional CAPM holds (Merton, 1973). We empirically test the conditional CAPM by regressing asset returns onto the product of their conditional betas and market returns. Estimated intercepts are not statistically different from zero, implying that the conditional CAPM successfully explains the conditional level of asset returns. Yet, unconditional betas do not explain the cross-section of average asset returns; the unconditional CAPM fails. We show why and how the success of the conditional CAPM actually explains the failure of the unconditional CAPM, thereby rationalizing the coexistence of these two intriguing results.

State-dependent size and value premium: evidence from a regime-switching asset pricing model

The conditional CAPM suggests that the market beta and market risk premium should vary over time. In this paper, we provide evidence that the size and value premiums are also state dependent. We develop a joint Markov regime-switching model for the CAPM and the VIX index to study the regime variation of CAPM parameters and to investigate the regime-dependent size and value anomalies. Stock returns from a two-state regime-switching model exhibit the pattern of amplified size (or value) premium in the low VIX state and reversed premium in the high VIX state. A three-state regime-switching model further confirms that the value premiums might be driven by extreme market conditions. These findings have important implications for market timing and portfolio selection decisions.

The Maturity Premium

This paper shows that firms with longer debt maturities earn risk premia not explained by unconditional standard factor models. We develop a dynamic capital structure model and find that firms with long-term debt exhibit more countercyclical leverage, making them more highly levered in downturns, when the market price of risk is high. The induced covariance between risk exposure and the market price of risk generates a maturity premium which we estimate at 0.21% per month. Empirical results from a conditional CAPM as well as observed beta dynamics are consistent with the model. We also exploit exogenous variation of debt maturities at the onset of the financial crisis and find that firms with shorter debt maturities experienced a smaller increase in leverage during the crisis. Also, after an initial spike, the betas of short-maturity firms reverted to levels below those of long-maturity firms by the end of 2008.

International diversification during financial crises

Purpose The purpose of this paper is to provide empirical evidence on how 1999–2001 dot-com crisis and 2007–2009 subprime crisis affect the gains from international diversification from the perspective of US investors. Design/methodology/approach A conditional international CAPM with asymmetric multivariate GARCH-M specification is used to estimate international diversification gains. Findings The authors find that over the entire sample period, the average gains from international diversification is statistically significant and about 1.253 percent per year. During the subprime crisis period, the average gains decreases to about 0.567 percent per year, but it increases to 2.829 percent per year during the dot-com crisis. Research limitations/implications These research findings although confirm the conjectures that international financial turmoil tends to increase the co-movements among global financial markets, are in contrast to the conjectures that international diversification does not work during the financial crisis as evidence from the dot-com crisis. Therefore, future research on international diversification should not just focus on the correlation among international financial markets and should adopt a fully parameterized asset pricing model to study this research topic. Practical implications Given the empirical results found in this paper that international diversification gains may be decreasing or increasing during the financial crisis, as long as investors are not able to predict international financial crises, it is the average gains from international diversification over the longer periods that should encourage investors to diversify, regardless of potentially lower benefits over the shorter periods of time. Originality/value The major value of this paper is that although the increase in the conditional correlation during the financial turmoil is consistent with previous studies, the empirical results clearly show that the impact of a financial crisis on the gains from international diversification cannot be solely determined by the correlation between domestic and world stock market returns since the gains also depend on the unsystematic risk from the domestic stock market. Consequently, it is premature for previous studies to conclude that the gain from international diversification is diminishing due to an increasing correlation among international stock markets during the financial crisis.

Expected Equity Returns Should Correlate with Idiosyncratic Risk

Because levered equity is an option on the firm, variations in asset idiosyncratic risk (ivol) induces a negative relationship between equity ivol and expected returns. We show that the effect is caused by the nonlinear payoff of equity and the law of one price, and is present in all but risk-neutral economies. We test the cross-sectional predictions of our theory by contrasting the ivol-return relationship at the equity and asset levels. The ivol-return relationship is stronger for equity than for assets, and stronger for more levered firms — consistent with the theory. We test also the timeseries implications of the theory. Time variation in asset ivol causes time variation in the option value of equity that translates into time varying risk factor loadings. Unconditional alpha subsequently becomes biased when asset ivol correlates with the market price of risk. We show empirically that a conditional CAPM that accounts for time variation in equity nonlinearity helps explain earlier findings that high-minuslow ivol-portfolios generate negative unconditional alpha.

Stock Return Predictability in Central and Eastern European Countries

We investigate the stock return predictability for the aggregate Central and Eastern European (CEE) markets from 1998 through the mid-2017. Using the firm-level data we construct country portfolios and sets of component portfolios: 10 industry portfolios, 10 size portfolios, 10 market-to-book portfolios. Predictive regressions with various fundamental variables and technical indicators are conducted. In-sample and out-of-sample tests highlight return predictability across different portfolios. Out-of-sample decomposition of predictability shows that time-varying macroeconomic risk premium can be captured by the conditional CAPM model.

Nonmarketable Assets Version of the CAPM: The Case of the Russian Stock Market

The paper deals with a modification of the CAPM, being called the Mayers model, which takes into account the existence of nonmarketable assets. Human capital is the classic example of such assets though we present and discuss some other important examples. This approach, as well as more advanced conditional CAPM, gives a correction to traditional CAPM beta coefficient as a measure of market risk. In this paper we present two attempts to test CAPM with nonmarketable assets. First, we start from analysis of the small size effect of the Russian stock market. We show that in this case the Mayers model gives the possibility of substantial improvement of risk exposure estimate. Second, empirical analysis in the case of human capital shows no impact of the Mayers model in all sectors of the Moscow Stock Exchange other than Innovation.