Validity of Capital Asset Pricing Model (CAPM): Empirical Evidence from Indian Stock Market

1. INTRODUCTION

The capital market plays an important role in the development of the economy and is an integral part of the economic system. In the capital market, the way in which securities are priced is a major issue and has long attracted the attention of researchers. The risk-return relationship plays a central role in the price of securities and as a result helps in making the right investment decision. Investment decisions are primarily guided by the risk-return relationship of the securities. Over the past few decades, economists, economists and statisticians have been developing models of stock price behaviour. Based on the risk-return characteristics of the securities, a rational investor will always expect a premium on each additional risk taken. Thus, investors will demand higher returns for risky assets. The theory of asset prices has been the subject of much debate over the past few decades. Many of the proposed theories and their respective models are primarily involved in mapping the relationship between risk and return. In general, there are two risk factors associated with a portfolio. One is systemic risk and the other is systemic risk. In the development of the Capital Asset Pricing Model, the following assumptions have been considered: • All investors are risk-averse for a single period and prefer to make maximum use of the usefulness of the terminal assets. • They can select the portfolio only on the basis of mean and variation, • no taxes or transaction costs, • all investors have a common view on the parameters of the distribution of the combined potential of all security returns, and • All investors can borrow and lend at a given risk-less interest rate. Nearly five decades later, CAPM is still widely used in applications, such as estimating capital costs for companies and evaluating the performance of a managed portfolio. It is the focus of many investments and financial market courses. Indeed, this is the only asset value model taught in these courses. There is still a great deal of discussion in the finance literature on the experiential validity of CAPM. Some of the research studies back the testing of CAPM and shows the results in the favour of the model which (K.M. and Shaji, 2018) leads to the conclusion that portfolio combination may be of importance in price and should be established with more empirical tests. In nutshell, the results show that CAPM has not been definitively verify during the study period and does not mean that the data rejects CAPM outright. Current studies have shown that beta can explain the difference in we do not see this trend in all portfolios.

Choudhary and Choudhary (2010) observed in their study titled ‗Testing Capital Asset Pricing Model: Empirical Evidences from Indian Equity Market‘ that the CAPM estimate for the intercept is that it should be equal to zero and the slope should be equal to the additional return on the market portfolio. The findings of the study contradict the above hypothesis and suggest evidence against CAPM. The inclusion of the square of the beta coefficient to test the nonlinearity in the relationship between the return and the beta indicates that the findings are hypothetical and the expected return beta relationships are linear. In addition, tests conducted to check whether CAPM captures all the important aspects of reality, including the residual variation of the stock, indicate that the residual risk has no effect on the expected return on the portfolio. The results of the tests performed on the sample data for the period January 1996 to December 2009 do not clearly reflect CAPM. In light of the above findings, it can be concluded that the beta is not sufficient to determine the expected return on securities/ portfolio. Bajpai and Sharma (2015) examined and concluded in their research paper ‗An Empirical Testing of Capital Asset Pricing Model in India‘ that CAPM can be estimated by removing the intercept term from the second phase of the model, which is a cross sectional regression equation. With the help of this limited model CAPM works much better than the limited model. The use of the intercept term in the second phase of CAPM is a complete failure of the model in the context of the Indian equity market, while the removal of the intercept term provides a new model that further clarifies the risk-return relationship in the Indian equity market 62% of the time. The high value of the adjusted R square in the case of a limited model supports the fact that systematic risk is the only factor that helps to explain the process of creating a return on risky assets. Nyangara, Ndlovu and Tyavambiza (2016) concluded in their research paper ‗An Empirical Test of the Validity of the Capital Asset Pricing Model on the Zimbabwe Stock Exchange‘ that using cross-sectional stock returns on 31 stocks listed on the ZSE between March 2009 and February 2014, we have shown that beta is an important factor in explaining average monthly stock returns, although explanatory power decreases significantly after the first 6 months estimated horizon. We failed to find the effect of any size on the average return, but instead found some significant negative liquidity and repulsive effects. Given the testing criteria for CAPM used in the current literature, we reject CAPM as a sufficient model to explain the average return on ZAP. The primary reason is that there are significant fluidity and repulsive effects on the same range that Furthermore, we refrain from policies based on the existence of a premium of size on the ZSE. Instead, investors may consider neglected and negative skewed stocks, albeit on the right horizon. Shetty and D‘Souza (2019) examined in their study ‗An Empirical Examination of the CAPM on NSE SENSEX Stocks‘ that CAPM is a widely used technique for finding stock returns based on the risk characteristics of shares. Numerous researchers have researched the applicability of CAPM and found a positive relationship between the sample data and the CAPM model. But this study did not qualify CAPM for 30 BSE stocks for the period 1st January 2009 to 31st December 2018. The six portfolio companies in this study are a mixture of overvalued and undervalued stocks, and the seven grouped portfolios are purely portfolio low value stocks. Bajaj Finance Limited, which is a financial services portfolio, is performing better than other portfolios and the least performing portfolio is ONGC. According to the analysis of this study, it is clear that beta stock returns alone will not cause prices to rise or fall on the contrary many other administrative factors may be equally responsible for the movement of stock prices.

This research paper aims to achieve the following objectives: • To study the experiential validity of the CAPM in Indian Stock Market. • To study the relation between market return and portfolio return in Indian Stock Market.

Research methodology comprises the plan which determines the tools, techniques, methods and procedures followed to collect, analyse and interpret the data to achieve the research objectives. The research design adopted for the present study is descriptive in nature.

The sample for the study includes 1-year daily data of 30 companies of Nifty and Nifty Junior Stock Index, a comprehensive-based index, data study conducted for the period from 1st April 2019 to 31 March 2020 from CMIE and Reserve Bank of India (RBI). The process data of RBI's websites is taken from the base. This study treats the 91-day Treasury bill rate as a proxy for risk-free assets, better reflecting short-term changes in financial markets.

The current study will also adopt a similar approach to the portfolio technique and use the time series regression of additional portfolio returns on additional market returns and also do a sectional regression in the form of risk premiums and will be expressed by the following equation. In the first stage, the beta (systematic risk) of personal securities is calculated and the beta coefficients of individual securities are calculated for the entire period and for the sub-period. A time series between daily percentage returns versus market returns is used to obtain the beta coefficient of each security in the regression pattern and the model is shown below. where, Rit = rate of return on asset ‗I‘ at ‗t‘ time Rft = free risk at t‘ time Rmt = return rate on market portfolio at ‗t‘ time Βit = beta stock of ‗i' Εit = random disturbance term in the regression equation at ‗t‘ time The portfolio beta is then calculated using the following model… where, rpt= excess average portfolio returns on ‗t‘ time βp= beta estimated portfolio ept = error term in the regression equation at ‗t‘ time Portfolio returns versus portfolio beta to predict the former post-security market line for each test period. Is the model… where, rpt = excess average portfolio returns at ‗t‘ time rmt = excess average return on market portfolio at ‗t‘ time epr = random disturbance term in the regression equation at ‗t‘ time coefficient of βp will be statistically significant. We used the following equation to examine the disparity between total portfolio returns and beta:

This section calculates the beta (systematic risk) of personal securities and the beta coefficients of individual securities are calculated for the entire period thereafter and for the sub-period. A time series between daily percentage returns versus market returns is used to obtain the beta coefficient of each security in the regression pattern. The following table shows the calculation.

Interpretation: It I assumed that the intercept or alpha value will not be significantly different from the 0 and Capital Asset Pricing Model holds its validity in the Indian Stock market but empirical findings show that only 5 stocks out of 30 stocks have their ‗t‘ value higher than 1.67 which indicates insignificant outcome for the majority of selected stocks. This depicts that stock returns have been described adequately by excess market return or risk premium as assumed by CAPM. Interpretation: When the analysis was repeated with 5 portfolios, the results again shows that alpha value is not significant while as the ‗t‘ value is significant for all the 5 portfolios. Whereas the market risk premium explains the security returns whereas the portfolio returns and excess return does not show relationship and provide evidence against the Capital Asset Pricing Model in Indian Stock Market.

The intercept should not be significantly different from zero and the retrograde slope coefficient in India should be critical for CAPM to be valid. The above tables show that only a few of the 30 stocks that are subject to empirical testing show intercept terms with a T-value greater than 1.97 that indicate statistical significance. The intercept term is not important for the rest of the stock. This indicates that the adequate description of the security return is provided by CAPM through Market Risk Premium. While examining the relationship between market return and portfolio return in Indian Stock Market, we do not find evidence in favour of CAPM - which assumes that high beta (risk) portfolios are entitled to high returns and securities market line has a positive slope and high beta portfolios provide higher returns. For five portfolios we replicate the same analysis and the result shown in the above table it shows the result that the term of intercept is for 4 portfolios only which are an important portfolio. While in other cases the intercept term is not significant. The regression slope coefficient for market risk premium is significant for all ten portfolios making market risk

One wonders what drives the returns in today's global capital markets. Also, the models may have come and have a variety of multifactor that have proven to be good models of property prices after the traditional CAPM. Jensen‘s alpha is a regression barrier and measures the abnormal returns of a portfolio that correlate the returns on assets with the returns on the market portfolio. If CAPM holds in general, the correlation of asset return with only market return can provide a sufficient explanation of the risk premium, such that the alpha should be zero. For this reason, the hypothesis is tested with null hypothesis where alpha is zero. It was further found that the trials in the sub-period were also consistent with the above tables and indicated evidence in support of CAPM but did not provide conclusive evidence or not fully support CAPM in all trials. This leads to the conclusion that some of the results are inconsistent with the theory and are therefore contrary to CAPM. In the present study, it was found that there is no linear relationship between portfolio returns and beta. One of the new revised pricing models is the Arbitrage Pricing model and at the time of its launch it was believed that it would solve theoretical and empirical problems related to CAPM. However, in the case of India the regression analysis shows that the former post-macro-economic factors have a limited impact on stock returns and here too there is a market risk premium which mostly explains the portfolio returns.

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Director, School of Management & Dean Research, Maharaja Agrasen University, Himachal Pradesh