Pricing behaviour of the Indian capital market: a comparative analysis in the CAPM, the APT and the macro-economic context

Abstract

Research regarding the behaviour of the Indian capital market has been very limited. The risk-return relationship has been studied using only the Capital Asset Pricing Model; and the factor-structure of the return-generating process has not been studied. The present study subjects the CAPM and the APT hypotheses about the risk-return relationship to a series of empirical tests. The factor-structure of the return-generating process is identified using a multi-factor macro-economic model, which draws from the results of the asset pricing research in the West and the macro-econometric studies of the Indian economy. The empirical tests for the two models are based on the standard CAPM and APT methodologies which are modified to suit the Indian conditions. The factor-structure represented by the factor-score series (generated during the factor extraction process of the APT) is identified using a set of eight independent macro-economic variables. The sample returns for this study consist of the weekly returns for 78 securities from the Specified group and 20 securities from the Cash group of the Bombay Stock Exchange for the five year period from 1986 to 1990. The sample period is divided into two overlapping three-year estimation periods (1986-88 and 1987-89) and two non-overlapping one-year test periods (1989 and 1990).Based on the degree of observed normality of the weekly returns, the Specified group sample is divided into two sub-groups. The results suggest that the risk-return relationship in the Indian market is not in accordance with the CAPM hypotheses. The hypothesis of positive relationship between expected returns and the market risk-factor is not supported by the results. However, the prediction about non-pricing of the residual risk-factor is observed to be valid. On the other hand, the hypothesis of joint significance of risk-premia for a set of APT risk-factors is supported during most part of the sample period, especially for the five-factor model. The results suggest that the factor-structure of the return-generating process is characterised by the following systematic risk factors: growth risk with the index of industrial production-electricity as the proxy; interest rate risk with interest rates in the call money and the long-term government securities markets as the proxies; return on alternative assets (gold); inflation risk with Ml as the proxy; external sector performance with exchange rates and imports as the proxies; and investment and credit conditions in the market with M4 as the proxy. Based on these results, it may be concluded that the return-generating process of Indian capital market is characterised by a multi-factor macro-economic model and the risk-return relationship is in accordance with the APT hypothesis.