European capital market integration: An empirical study based on a European asset pricing model

This paper investigates the integration between the capital markets of 15 European countries, all of which are members of the European Union. Integration is tested under the joint hypothesis of a European multifactor asset pricing model. A European portfolio is constructed from which common factors are extracted using maximum likelihood factor analysis. Empirical tests are undertaken to determine whether these European factors are not only priced, but also equally priced across the European capital markets. The results show that a number of common factors are extracted from the European portfolio and a degree of capital market integration is shown to exist across the European capital markets.     

Fundamentalists,chartists and asset pricing anomalies

This paper investigates whether excess volatility of asset prices and serial correlations of stock monthly returns may be explained by the interactions between fundamentalists and chartists. Fundamentalists forecast future prices cum dividends through an adaptive learning rule. In contrast, chartists forecast future prices based on the observation of past price movements. Numerical simulations reveal that the interplay of fundamentalists and chartists robustly generates excess volatility of asset prices, volatility clustering, trends in prices (i.e. positive serial correlations of returns) over short horizons and oscillations in prices (i.e. negative serial correlations of returns) over long horizons, often observed in financial data. Moreover, we find that the memory of the learning rule plays a key role in explaining the above-mentioned stylized facts. In particular, we establish that excess volatility of asset prices; volatility clustering and autocorrelation of returns at different horizons emerge when fundamentalists have short memory. However, volatility clustering as well as short-run and long-run dependencies, observed in financial time series, are more pronounced when fundamentalists have longer memory.     

Consumption-based capital asset pricing models: issues and controversies

This paper discusses the issues and controversies surrounding consumption-based capital asset pricing models (CCAPMs). While CCAPMs provide a chance to explain the phenomena observed in stock markets, their viability is jeopardized owing to the weak predictability of the equity premium and risk-free rate puzzles. Even given market frictions and market incompleteness, CCAPMs must test their validity constantly in the face of the formidable challenges of rival models. Measurement error with respect to time aggregation is also regarded as a major threat, causing the low volatility of consumption and eventually resulting in chaining itself to weak return predictability. In addition, the dual choice problem of portfolio and consumption rooted in CCAPMs guides us into how investors accumulate wealth through the financial market to reach the zenith of expected utility. This paper offers insights as well as understanding into the behavior of an agent and market phenomena in the context of a consumption-based economy.     

The evolution of capital asset pricing models

The capital asset pricing models (CAPM) has been the benchmark of asset pricing models and has been used to calculate asset returns and the cost of capital for more than four decades. Many researchers have tried to relax the original assumptions and generalize the static CAPM. We survey the important alternative theoretical models of capital asset pricing and provide a complete review of the evolution of asset pricing models. We also discuss the interrelationships among these models and suggest several possible directions for future research. Our results might be used as a guideline for future theoretical and empirical research in capital asset pricing.     

A note on capital asset pricing and heterogeneous taxes

In this paper, we present a stylized model where we show how asset prices, i.e., required expected rates of returns, may be characterized in a world with heterogeneous asset taxes. Within a simple CAPM-like framework, we derive an after-tax beta equal to the pre-tax beta multiplied by a (non-obvious) asset specific tax adjustment. We further show in what sense the Security Market Line here can be replaced by a Security Market Fan. Well-known CAPM relations are obtained as special cases, and policy implications are analyzed.     

The St. Petersburg paradox and capital asset pricing

Durand (J Finance 12:348–363, 1957) shows that the classical St. Petersburg paradox can apply to the valuation of a firm whose dividends grow at a constant rate forever. To capture a more realistic pattern of dividends, we model the dividend growth rate as a mean reverting process, and then use the capital asset pricing model to derive the risk-adjusted present value. The model generates an equivalent St. Petersburg game. The long-run growth rate of the payoffs (dividends) is dominant in driving the value of the game (firm), and the condition under which the value is finite is less restrictive than that of the standard game.     

Capital gains tax and the capital asset pricing model

This paper develops a version of the Capital Asset Pricing Model that views dividend imputation as affecting company tax and assumes differential taxation of capital gains and ordinary income. These taxation issues aside, the model otherwise rests on the standard assumptions including full segmentation of national capital markets. It also treats dividend policy as exogenously determined. Estimates of the cost of equity based on this model are then compared with estimates based on the version of the CAPM typically applied in Australia, which differs only in assuming equality of the tax rates on capital gains and ordinary income. The differences between the estimates can be material. In particular, with a high dividend yield, allowance for differential taxation can result in an increase of two to three percentage points in the estimated cost of equity. The overall result obtained here carries over to a dividend equilibrium, in which firms choose a dividend policy that is optimal relative to the assumed tax structure.     

Empirical evaluation of asset pricing models: Arbitrage and pricing errors in contingent claims

Hansen and Jagannathan (1997) have developed two measures of pricing errors for asset-pricing models: the maximum pricing error in all static portfolios of the test assets and the maximum pricing error in all contingent claims of the assets. In this paper, we develop simulation-based Bayesian inference for these measures. While the literature reports that the time-varying extensions substantially reduce pricing errors of classic models on the standard test assets, our analysis shows that the reduction is much smaller based on the second measure. Those time-varying models have large pricing errors on the contingent claims of the test assets because their stochastic discount factors are often negative and admit arbitrage opportunities.     

Extending the capital asset pricing model: the reward beta approach

This paper offers an alternative method for estimating expected returns. The proposed reward beta approach performs well empirically and is based on asset pricing theory. The empirical section compares this approach with the capital asset pricing model (CAPM) and the Fama–French three‐factor model. In out‐of‐sample testing, both the CAPM and the three‐factor model are rejected. In contrast, the reward beta approach easily passes the same test. In robustness checks, the reward beta approach consistently outperforms both the CAPM and the three‐factor model.     

Testing conditional asset pricing models: An emerging market perspective

The CAPM as the benchmark asset pricing model generally performs poorly in both developed and emerging markets. We investigate whether allowing the model parameters to vary improves the performance of the CAPM and the Fama–French model. Conditional asset pricing models scaled by conditioning variables such as Trading Volume and Dividend Yield generally result in small pricing errors. However, a graphical analysis reveals that the predictions of conditional models are generally upward biased. We demonstrate that the bias in prediction may be the consequence of ignoring frequent large variation in asset returns caused by volatile institutional, political and macroeconomic conditions. This is characterised by excess kurtosis. An unconditional Fama–French model augmented with a cubic market factor performs the best among some competing models when local risk factors are employed. Moreover, the conditional models with global risk factors scaled by global conditioning variables perform better than the unconditional models with global risk factors.     

The relationship between earnings' yield,market value and return for NYSE common stocks: Further evidence

The empirical relationship between earnings' yield, firm size and returns on the common stock of NYSE firms is examined in this paper. The results confirm that the common stock of high E/P firms earn, on average, higher risk-adjusted returns than the common stock of low E/P firms and that this effect is clearly significant even if experimental control is exercised over differences in firm size. On the other hand, while the common stock of small NYSE firms appear to have earned substantially higher returns than the common stock of large NYSE firms, the size effect virtually disappears when returns are controlled for differences in risk and E/P ratios. The evidence presented here indicates that the E/P effect, however, is not entirely independent of firm size and that the effect of both variables on expected returns is considerably more complicated than previously documented in the literature.     

Liquidity and asset pricing: Evidence from the Hong Kong stock market

This study investigates the role of liquidity in pricing stock returns in the Hong Kong stock market. Our results show that liquidity is an important factor for pricing returns in Hong Kong after taking well-documented asset pricing factors into consideration. The results are robust to adding portfolio residuals and higher moment factor in the factor models. The results are also robust to seasonality, and conditional-market tests. We also compare alternative factor models and find that the liquidity four-factor model (market excess return, size, book-to-market ratio, and liquidity) is the best model to explain stock returns in the Hong Kong stock market, while the momentum factor is not found to be priced.     

Ambiguity and asset pricing: An empirical investigation for an emerging market

This study explores the impact of ambiguity on returns of both individual stocks and stock portfolios in an emerging market setting. First, an ambiguity index is derived and then the sensitivity of stock returns to ambiguity is analyzed while controlling for the other risk factors commonly cited in the literature. Results show that stocks with a high (low) sensitivity to ambiguity generate higher (lower) excess returns. These results are intuitive in the sense that investors seem to ask for lower returns from those stocks that serve as a natural hedge against ambiguity. Our findings are also in line with the earlier studies that provide similar evidence from the US stock markets.     

Sovereign asset values and implications for the credit market

Using the contingent claim approach and market data on sovereign credit default swaps we assess the drivers of a country's risk perception. Deriving market-based asset values for a set of advanced economies we gain insights into the capital markets' perspectives on sovereign creditworthiness. We find the market-based asset values to be positively influenced by debt and to be an early risk indicator for economic developments. In a cross-section analysis we identify drivers of the economic risk of countries. Clustering the countries according to their debt to asset value ratios provides further insights into the market perceptions of sovereign credit risk. For example we find that the asset values of countries with higher ratios react to changes in the global equity market. Countries with a lower ratio react more to the political stability within the country.     

Exposure to the world and trading-bloc risks: A multivariate capital asset pricing model

This paper employs a capital asset pricing model that incorporates both world and trading-bloc factors to show that the recent trend of trade regionalism has led to segmentation of world stock markets. The model is developed within a multivariate GARCH framework. The conditional time-varying betas are derived to examine the dynamics of risk exposures to the world and trading-bloc factors. The results show risk exposure behaviour that is not revealed using static risk estimates.     

Shortability and asset pricing model: Evidence from the Hong Kong stock market

This study explores how the violation of free short selling assumption affects the performance of CAPM and the Fama-French three-factor model, as existing studies show that short-sales constraints affect asset pricing of the stocks. Using data from the Hong Kong Stock Market which has unique regulations on short selling, we conduct both time-series and cross-sectional regression analyses to evaluate the performance of the two models under the short-sales-constraints and the no-constraints market environment. The two models perform much worse in the former environment than in the latter, indicating a significant impact of the short sales constraints on the explanatory power of the models. We then augment the two models with a shortability-mimicking factor. Our results show that the factor has a significant power in explaining both time-series and cross-sectional variation in the size-B/M portfolio returns. The addition of the factor to the two models considerably increases their overall performance.     

Nonlinear asset pricing in Chinese stock market: A deep learning approach

The redesign of asset pricing models failed to integrate the frequent financial phenomenon that stock markets exhibit a non-linear long- and short-term memory structure. The difficulty lies in developing a nonlinear pricing structure capable of depicting the memory influence of the pricing variable. This paper presents a Long- and Short-Term Memory Neural Network Model (LSTM) to capture the non-linear pricing structure among five elements in the Chinese stock market, including market portfolio return, market capitalisation, book-to-market ratio, earnings factor, and investment factor. The long–short-term memory structure implies that the autocorrelation function of the stock return series decays slowly and has a long-term characteristic. The LSTM model surpasses the standard Fama–French five-factor model in terms of out-of-sample goodness-of-fit and long–short strategy performance. The empirical findings indicate that the LSTM nonlinear model properly represents the nonlinear relationships between the five components.     

Tests of conditional asset pricing models in the Brazilian stock market

In this paper, we test a version of the conditional CAPM with respect to a local market portfolio, proxied by the Brazilian stock index during the period 1976–1992. We also test a conditional APT model by using the difference between the 30-day rate (Cdb) and the overnight rate as a second factor in addition to the market portfolio in order to capture the large inflation risk present during this period. The conditional CAPM and APT models are estimated by the Generalized Method of Moments (GMM) and tested on a set of size portfolios created from individual securities exchanged on the Brazilian markets. The inclusion of this second factor proves to be important for the appropriate pricing of the portfolios.     

Testing asset pricing models with changing expectations and an unobservable market portfolio

When the assumption of constant risk premiums is relaxed, financial valuation models may be tested, and risk measures estimated without specifying a market index or state variables. This is accomplished by examining the behavior of conditional expected returns. The approach is developed using a single risk premium asset pricing model as an example and then extended to models with multiple risk premiums. The methodology is illustrated using daily return data on the common stocks of the Dow Jones 30. The tests indicate that these returns are consistent with a single, time-varying risk premium.     

The equilibrium price of futures contracts: A result drawn from capital asset pricing model

A recent study shows that separation theorems in the stock and forward market literatures may not hold in an integrated financial market; therefore, the securities market may influence futures trading. This article investigates the securities market influence on the futures price. The result shows that although the futures price incorporates the investor's expectation about the future spot price, it generally is not a best estimate of the spot price. In addition, it is shown that the speculative activity can destabilize the cash market for some commodities, if initially, the underlying cash price is highly volatile.