Erasmus university rotterdam

LIST OF TABLES

Table Page

Table 1. Summary statistics of individual company data 27

Table 2. Descriptive statistics for the market returns and the risk-free rate 28

series in four emerging markets

Table 3. Historical correlations matrix of the four emerging stock markets 30

and the world market

Table 4. Credit Default Swap (CDS) data 31

Table 5. Excess market returns of four emerging markets 32

Table 6. Minimum and Maximum values of the estimated betas 33

Table 7. Global CAPM 35

Table 8. Three Moment CAPM 37

Table 9. Four Moment CAPM 39

Table 10. Local CAPM 41

CHAPTER 1.INTRODUCTION

Investors are always looking for new investment opportunities around the world. During the last few years, more and more investors are focusing on emerging equity markets. One reason for this change in investment behavior is probably the high returns offered by these markets. Furthermore many of these markets provide interesting diversification benefits. However, some problems arise with the upcoming interest in these emerging markets. One of the main difficulties is the problem of the valuation of the investments.

Financial investors use many valuation techniques to assess the risk and return on their investments. One of the most commonly used valuation techniques by financial practitioners in developed markets is the Capital Asset Pricing Model (CAPM) as developed by Sharpe (1964), Lintner (1965) and Mossin (1966). The CAPM suggests a relationship between the risk and the expected return of an investment. The expected return on an asset above the risk-free rate is linearly related to the non-diversifiable risk as measured by beta. According to the CAPM, the market beta alone is sufficient to explain security return. Although the CAPM is the most widely used model as well as the basis of modern portfolio theory, evidence suggests that there is some doubt about the models ability to explain the cross-section of stock returns. Several researchers (Banz, 1981; Fama and French, 1992; Jagannathan and Wang, 1996; Lettau and Ludvigson, 2001) show evidence that the cross-section of returns cannot be explained only by beta. For instance, Fama and French (1992) show that the size and book-to-market ratios provide better explanations for the cross-section of stock returns than beta. Research by Banz (1981) indicates that average stock returns are better explained by firm size, than by beta. Furthermore, Roll (1977) states that the CAPM cannot be tested since the market portfolio should encompass all potential investment options, and not just stocks. Despite its debatable practical value, the model gives great insight in the risk and return relationship.

Besides the troubles with the CAPM in developed markets, when applied to emerging markets the situation gets even more complicated. Most valuation techniques applied in developed markets cannot be straightforwardly applied in emerging equity markets. The main principles of developed markets are diversification and transparency, which are not present in emerging markets. Financial investors do not agree about the existence of efficiency in emerging markets, since these equity markets are small and concentrated. In addition, stock market prices are scarce and unreliable. Consequently, the straight application of the CAPM in emerging markets is controversial (Pereiro, 2002). In order to try to solve some of the problems associated with the application of the CAPM in emerging markets, several authors have made modifications to the CAPM (Pereiro, 2001; Godfrey and Espinosa, 1996). In addition, to account for the problems with the emerging stock market data, a number of corrections are available, such as a correction for thin trading (Omran, 2007).

The validity of the CAPM in emerging markets is not completely verified by empirical evidence. According to Erb, Harvey and Viskanta (1996), the CAPM shows some merit in developed markets, but in emerging markets the evidence is mixed. Surveys by Harvey (1995) and Estrada (2000) show that the betas of emerging markets are not correlated with returns when computed against the world market. Moreover, the emerging equity markets are highly volatile and beta values appear to be too low, these beta values result in cost of equity capital values that are not considered as reasonable by most investors. This had led to the idea that the CAPM is inapplicable in the case of emerging market stock exchanges. However, since investments in emerging markets are increasing and a there is a growing demand for appropriate valuation tools, this research will focus on emerging markets.

In the light of the increasing investments in emerging equity markets, it is important to appropriately appraise the investment opportunities. The goal of this article is to examine which asset pricing model is best able to explain the stock market returns of emerging equity capital markets of Egypt, Israel, Morocco and Turkey¹. Furthermore, it is examined whether the CAPM or different versions of the CAPM are applicable in the emerging capital markets. The performance of four asset pricing models are evaluated. Tests are conducted for a period of 8 years (January 2001- September 2009), which is characterized by severe return volatility (covering several crisis, 9-11,Credit Crisis). These market return characteristics make it possible to empirically investigate the pricing models on differing financial conditions. There is not much literature about the financial markets used in this study. The goal is to widen the theoretical analysis of these markets by using modern finance theory and provide useful insights for future analysis of these emerging markets.

The main question in this article is whether the CAPM is applicable in emerging markets, and if so, which model performs best. Following the methodology used by Fama & Macbeth (1973), historical returns of the individual stocks are calculated and beta is estimated using the Ordinary Least Squares (OLS) regression method. For each company in the sample the returns are regressed on the stock index to estimate beta. It is expected that the CAPM does work in emerging markets therefore a linear relationship between the expected return on a security and its risk is expected. Moreover higher risk is expected to be associated with higher expected return and risk aversion. In light of previous research multifactor models are expected to add information.

This paper makes a few contributions to the literature. First, few papers investigate the asset pricing models on differing financial conditions in the finance literature. This paper sheds light on the risk-return relationship during periods of financial crisis. Second, this investigation covers several Middle Eastern markets. There has been few research on asset pricing models in these markets. Moreover, these countries have interesting diversification possibilities. Third, this comparison covers emerging markets, which are usually not the main topic of studies of the CAPM. This research may have important implications for investors interested in opportunities available in these markets as well as for academics studying the international aspects of finance. Investors will have more guidance as to which risk-free rate and market proxy they should use when valuing their investments, so they can better determine their cost of equity capital values. For scholars, the insights gained in this research are an addition to the research on the applicability and usefulness of the CAPM and add to the knowledge of the workings of emerging equity markets. The results indicate that the CAPM cannot be clearly rejected when applied to emerging markets. However, the evidence cannot be seen as support of the CAPM. The results also show that the model that performs best in emerging markets, depends on which country and which time period is considered. The CAPM models do not perform well in explaining emerging stock markets returns. Moreover, evidence indicates that the risk return relationship is not always positive in emerging markets.

The remainder of this paper is organized as follows. Chapter 2 presents the emerging countries financial systems and gives a detailed description of the CAPM, Chapter 3 describes the data and methodology. The empirical results are presented in Chapter 4. The final section contains concluding comments.