International Asset Pricing in Hong Kong Market - Literature review Example

Literature review Table of Contents Literature Review 3 Asset pricing models 3 Development of Asset Pricing Model 3 Standard and international CAPM 5Implication of the augmented model in the Hong Kong market 7 Usefulness of international asset pricing in Hong Kong market 7 Conclusion 11 Reference List 13 Literature Review The literature review comprises evaluation of the different asset pricing models and examines the best model for Hong Kong capital market. The literature considers the facts regarding Capital Asset Pricing Model (CAPM) and its augmented version. Views of numerous authors are depicted in this literature review regarding usefulness of asset pricing models in Hong Kong market. The literature elaborates on whether or not the international CAPM helps in understanding different aspects of the market. The asset pricing model generated by Fama and French (1992) was criticized by various authors and a new augmented CAPM was devised in order to take systematic risk into account while investing in stock market and completely ignore the unsystematic risk. This augmented CAPM is accurate for applying in the Hong Kong market and thus, its validity is checked through this literature (Hearn, n. d.). Asset pricing models Asset pricing models are defined as frameworks that are devised for identifying and measuring risk. The models also identify the rewards that are attached with risk bearing. The theories attached to the models helps in realizing reasons for expected returns on the government bonds to be less than that on the stocks. It also assists in developing idea behind two stocks with different expected returns. The change in expected returns over time is also explained through this model (Hearn, n. d.; Huang, Yang and Hu, 2000). The basic premises of asset pricing model are that the investor’s desires for higher expected returns. The investors do not like to take risk and hold diversified portfolios so that the risk is distributed in different sectors. The models also specify fair rate of return for particular asset. The information regarding rate of return is very crucial for taking any investment decision for corporations who evaluate projects and the formation of portfolios for investors. The theories related to models helps in characterizing the risk of a project or acquisition and also examine the discount rate associated with the risk. Development of Asset Pricing Model The asset pricing model was first developed by Sharpe (1964) and Lintner (1965). However, there had been lot of advancement in asset pricing for the past 35 years. The progress was important for understanding the issues encountered while implementing asset pricing models in any emerging market. So, this model should be followed and also modified over time, while investment situation changes due to several challenges. The first asset pricing theory is known as Capital Asset Pricing Model (CAPM) developed by great researchers, Sharpe (1964) and Lintner (1965). It states that there is a linear relation between expected return of stock; systematic risk and beta. Here, beta is described as a variable that explains the cross-sectional returns for stocks. Even before this particular development, CAPM was devised by Harry Markowitz. The model explained that an investor is risk averse to his/her choice of portfolio for particular period of time and will receive a particular return. The model was based on algebraic statement, which aims at predicting the relationship between return and risk of a particular portfolio. Later, Sharpe (1964) and Lintner (1965) modified the model and depicted that expected return on a stock is generated after considering risk premium and risk free interest rate. The analysis that are carried out in the past highlighted that beta is sole explanatory factor. It tends to describe the cross-sectional variation in the stocks. Thus, there are a number of variables in the asset pricing that aims at explaining the cross-sectional variations in stock returns as well as the market risk. The model is basically used for predicting the value of cost pertaining to equity and for evaluating the performance of portfolios developed in stock market. It also develops the linear relation between the risk and expected return of a stock and beta. Sharpe (1964) and Lintner (1965) also modified the assumptions of CAPM that was devised by Markowitz. The modified assumptions are as follows: 1. The security market is predicted to be perfectly competitive. a) The market comprises many small investors. b) These investors are regarded as the price takers. 2. The markets do not encounter friction or disturbance. a) The transactions that are taking place in security markets do not bear any tax or other transactional costs (Sharpe, 1964; Lintner, 1965). 3. The investors are very narrow-minded as well as risk averse. a) The investors count only one and the same holding period. 4. The investments are restricted for investing in the publicly traded assets. The assets bear unlimited lending and borrowing at risk-free rates. a) The assets like, human capital, do not form a part of opportunity set of the investment plan (Sharpe, 1964; Lintner, 1965). 5. All investors are rational beings. They aim at optimizing the mean-variance before investing. a) Investors are using Markowitz portfolio method for selecting their investment plan. 6. Perfect information is collected by investors in order to get a clear idea regarding security market and risk associated. a) The investors have good access to the information that is provided. b) The investors are expected to analyse information in the same way (Sharpe, 1964; Lintner, 1965). After development of the asset pricing concept, Fama and French (1993 cited in Kjerstadius, 2013 ) proposed a number of changes to the previous researches carried out by Sharpe (1964) and Lintner (1965), which included the variables and asset returns in the model. They added two risk factors, which are not related to the stock market factor. These factors are used for implementing CAPM in fully characterized economy, where stocks are very risky in nature (Bundoo1, n.d.). Standard and international CAPM The application of CAPM is vast; it is specially used for calculating the cost of capital of a company and also for managing investor’s portfolio. The model appeals the intuitive and powerful prediction that helps in measuring the relation between risk and expected return. According to perfect integration hypothesis, use of CAPM has been extended to international markets. Internationally, it is observed that similar assets bear same prices regardless of trading location (Kjerstadius, 2013; Wu, 2008; Huang, Yang and Hu, 2000). The evidences from the world market suggest that stock markets are not perfectly integrated. The results derived from unconditional tests in the international markets are undetermined and conditional tests signify that the models are perfect in the international market. This conditional test has identified severe challenges for explaining portfolio holdings and relates them to the time variations (Kjerstadius, 2013; Wu, 2008) Standard CAPM: The general CAPM is regarded as Standard CAPM. It is assumed that mean-variance is efficient in the market portfolio globally. The standard CAPM is derived as following: R = Rf +b (Rm – Rf) Where, R = expected return of the risky asset Rf = expected return of the risk free asset B = beta = the risk associated with the asset relevant to the whole market Rm = expected return of the market portfolio (Kjerstadius, 2013; Wu, 2008) International asset pricing: The standard CAPM does not take into account fluctuations on the global market. It only refers to the risk and return that are associated in the domestic and international context. Black (1974) had presented an international asset pricing model that is applicable only to the segmented markets. He developed a model for two countries after encountering a number of barriers with regard to investment globally, which was in form of taxes on assets in one country by the foreigners. However, the model was modified by Stulz (1981) and Cooper and Kaplanis (2000). They aimed at identifying the rules of capital budgeting that are dependent on the level of taxes, which discourage foreign investors from investing internationally. Investments in stock markets are associated with risks, which can be minimized by employing financial tools for determining expected return. CAPM is one such tool that simultaneously assesses the risk and return of a stock. The model evaluates rate of return for the assets by employing both the expected returns of market and a risk-free asset (Kjerstadius, 2013; Huang, Yang and Hu, 2000). Although the assumptions of CAPM are predicted, the CAPM is useful in estimating expected returns. However, the impractical assumptions of CAPM had expanded the model, which includes additional factors. International CAPM employs similar types of inputs as that of standard CAPM. The former takes into account a number of other variables too. These variables can influence the return on assets after considering fluctuations in global exchange rate. Hence, it can be depicted than international CAPM is useful than standard CAPM (Cooper and Kaplanis, 2000). International CAPM improves the unrealistic assumptions of CAPM. The most important modification of international CAPM is that international capital markets are integrated. It is recognized that if the assumption fails to elaborate on the ingredients of international market, then the market is segmented. Consequently, there will be pricing discrepancies among different assets, which will have similar risk profiles denominated in different currencies. This stimulates investors in segmented markets to make higher allotments for specific assets in certain countries, thereby leading to inefficient asset pricing. International CAPM takes into account unlimited borrowing and lending at risk-free rates (Cooper and Kaplanis, 2000; Huang, Yang and Hu, 2000). The main implication of the international CAPM is that world market is not efficient if the investors do not hold international assets. So, there is a need for improving CAPM by adding a new factor in order to reflect proportion of domestic risk that is not diversifiable internationally as it is segmented. Hence, market integration can be effective in lowering the risk premium and thereafter, cost of capital. When the market is perfectly integrated, the model converges with the global CAPM (Hearn, Piesse and Strange, 2008; Cooper and Kaplanis, 2000). Implication of the augmented model in the Hong Kong market There are several studies elaborating on effectiveness of the CAPM. The studies have highlighted that usefulness of the CAPM in developing and developed countries is subject to significant ambiguity. It is observed that additional factors have been added to the explanation of cross-sectional average returns. These factors include book to market equity ratio, company size, cash flow to price ratio, price earnings ratio and sales growth. The CAPM model is tested for the OECD countries and the result obtained is not definite. Shum and Tang (2006) had tested the risk factors for determining the returns available in Asian stock markets. They used the companies listed on Singapore, Hong Kong and Taiwan Stock Exchanges as sample. The outcome obtained highlights the results that were pointed out by Fama and French (1993 cited in Hearn, Piesse and Strange, 2008; Cooper and Kaplanis, 2000). The result indicated that contemporary market factors of the augmented model included size and book-to-market ratios. The study stated that there was no serious improvement in the model and it gave the same outcome as the traditional CAPM. Drew and Veerarachavan (2003) had applied Fama and French model on South Korea, Hong Kong, Malaysia and Philippines. The research was carried out to identify size and value effects on the cross-sectional market. Nonetheless, it is noted that the traditional CAPM model was more efficient than the augmented CAPM. This can be realized after considering the fact that there is no serious improvement in findings derived by the various researchers. Hong Kong market is a highly integrated market and the following section highlights effectiveness of the international asset pricing in Hong Kong market. Asset pricing is very important in this case as Hong Kong has an integrated market (Drew and Veerarachavan, 2003). Usefulness of international asset pricing in Hong Kong market Market integration is complex in nature and it involves a gradual process, which takes into consideration a number of explicit and implicit barriers (Bruner, et al., 2002). Models of market integration assumed that there are barriers for certain investments, which affect equilibrium returns. As a result, the model does not portray any flexibility for investigating the complications of market integration. International asset pricing helps in meeting the gap that exists in international CAPM for integrated markets. This underlines the complex mechanism prevalent in national stock market, which is an integrated market. It gauges the impact of changes on the cost of capital and anticipated profit from the world portfolio (Paramati, Gupta and Roca, n.d.). In absence of an asset pricing model, assets cannot be appropriately priced in fully integrated markets. Even so, determination of asset prices in segmented market becomes difficult as there is no asset pricing model. There were many global financial issues that cannot be dealt without incorporating any assumption that relates to whether markets are internationally segmented or integrated. The widespread use of asset pricing models worldwide is relevant for every stock market and thus, can be applied to Hong Kong market. The proxies are generated in order to understand the market portfolio for the home country market (Paramati, Gupta and Roca, n.d.; Fama and French, 1992). This has created a foundation for analyzing prices of the assets, which can be rationalized only by predicting that markets are segmented internationally. The reverse situation is noticed when the market is integrated as in case of Hong Kong. It is observed that when the markets are fully integrated, cash flow is valued with the same method regardless of the nation. Hong Kong has a fully integrated market and follows an optimal mean-variance framework for diversifying their stocks internationally (Paramati, Gupta and Roca, n.d.; Paramati, Gupta and Roca, n.d.). Presently, there is no convincing evidence that highlights the fact that the segmented national stock market concept is incorrect. It can be possible that the markets are segmented. The main reason behind inclusion of the market segmentation concept is that there are models offering insufficient information about the asset pricing prevalent worldwide. In these parts of world, the markets can be fully integrated and have flexible exchange rates. So, after ascertaining whether the markets are integrated or segmented, the asset pricing models are applied to get an accurate result. The existing international asset pricing models originate from one of the two assumptions: world can be modelled in such a way that it has only one commodity along with countries bearing different inflation rates. The second assumption is that the terms of trade have perfect correlation with prevailing exchange rates of country. However, these assumptions are not satisfactory (Paramati, Gupta and Roca, n.d.). The reason behind the unsatisfactory performance is that they do not take into account the changes stochastically that appear in terms of trade (Levy and Sarnat, 1970). These assumptions do not include the time value as well as do not perfectly correlate with the exchange rates. The facts obtained from the changes in exchange rate indicate that at each point of time, the opportunity set of consumption for every investor is dependent on the nation wherein he/she resides (Yiu-wah Hoa, Strangeb and Piesse, 2006). The opportunity set for consumption of any investor can be defined as set of goods that are available for his/her consumption (Solnik, 1974). In order to understand the effect of market integration of Hong Kong stock market, a completely segmented country is chosen. In this particular segmented country, the local and foreign investors cannot invest in foreign securities. Now, if the standard CAPM is applied in this market, then the risk that investors will encounter will be the contribution of asset to variance, signifying the diversified portfolio within that country. The risk is the variance of that country’s portfolio and has no connection with that of the world. The distinction between the integrated and segmented world can be highlighted here. In an integrated country like, Hong Kong, the covariance between portfolio risk and rate of return is obtained from the world portfolio (Levy and Sarnat, 1970). The covariance is, however, rewarded by the world price that is associated with average risk aversion in world. In any segmented country, its risk portfolio and rate of return indicates its variance. Here, the variance is rewarded with help of the country specific prices, which are linked with the weighted average risk aversion in that particular country. Research conducted on emerging markets have highlighted the importance of integrated market and has portrayed that every markets worldwide are not integrated in capital markets of the world economy. The research results had also depicted that the markets are not segmented either. It can be stated that Hong Kong has an integrated market, but there are parts that are not integrated yet and cannot be segregated as per the segmentation concept (Syriopoulos and Roumpis, 2009; Levy and Sarnat, 1970) The diversification studies carried out by different researchers have documented that the investors are motivated to diversify their investments in international stock markets as there arises low correlations among international asset returns (Hearn, Piesse and Strange, 2008). During the past few years, correlations of asset returns have created a developed market, which has aimed at increasing market integration worldwide. If these correlations increase in portfolio markets, then the portfolio diversifications are forced to reduce. In Hong Kong, the investors are benefitted from diversification of the portfolios. The comparison between the Asian stock market and the Indian stock market is identified for exploring interdependence of the markets by way of employing co-integration methods (Huang, Yang and Hu, 2000). The study also included the time varying nature, which is expressed in terms of conditional correlation among the markets. The study indicated that the correlations significantly increased during the financial crisis and rate of return on stocks are closer to the initial position before the crisis had been triggered. The study had detected the presence of relationship among the stock markets of different countries in short run, but could not find any relation in the long run. Finally, they suggested that the absence of long-run relationship between these markets may provide potential diversification benefits for the investors (Huang, Yang and Hu, 2000). This short run and long run relationship between the world stock markets was examined by Huang, Yang and Hu, (2000). Their analysis confirmed the evidences pertaining to short-term relationship, but had failed to demonstrate long-term relation between markets. Elyasiani, Perera and Puri (1998) also carried out research for studying the dynamic and dependent behaviour between different trading partners in Asian continent, which included India, Hong Kong, Singapore, South Korea, Japan and Taiwan. He also studied the association of this market with that of the US. The result of their study pointed out interdependence between stock markets in the Asian countries and that in Pacific basin (Lahrech and Sylwester, 2011). Claus and Lucey (2012) had analyzed integration in stock markets between ten countries in the Asia Pacific region. The outcome obtained from the study revealed that the observed stock markets displayed the extent of integration, but could not recognize any segmentation between the economies. Additionally, it indicated that the membership of a conventional economic organization do not influence the extent of integration (Huang, Yang and Hu, 2000). Chelley-Steeley (2004) had studied the pace of integration among the developed nations and identified that the stock market of Hong Kong can be considered as an emerging and developed one. The rate of returns can be calculated by employing CAPM model of asset pricing model. The analysis, however, recognized that integration among the Asian countries is faster than that witnessed in the other developed markets. Hence, the result obtained, after applying asset pricing model to Hong Kong market, pointed out that the rate of returns are more valid than other nations. This supports the statement that fully integrated market reflects the rate of return appropriately by way of highlighting on the risk factor (Huang, Yang and Hu, 2000). Bruner (2008 cited in Lahrech and Sylwester, 2011) have identified that segmented emerging stock markets have weak performance compared to the integrated markets globally. In order to summarize the discussion pertaining to the integrated market and asset pricing models, it can be said that the statement of Stulz (1981) is justified. He claimed that the models of international asset pricing are not appropriate in reflecting performance of the segmented stock markets globally. From the above discussions, it can be concluded that the CAPM is apt for integrated markets, rather than segmented markets (Korajczyk, 1996). There are a series of researches that have shed light upon the effect of asset pricing models on the financial crisis that had taken place in Asia in 2007 (Hearn, Piesse and Strange, 2008). As a result, there was co-movement between different members of stock markets within the Asian markets, which included the stock market of Hong Kong. Huyghebaert and Wang (2010) had assessed the extent to which stock market of Hong Kong had the ability to integrate, in comparison with the other seven main stock exchanges in developed countries like, Shanghai, Japan, Singapore, South Korea, Shenzhen and Taiwan. The Hong Kong stock markets had responded to the shocks of financial crisis that originated from East Asian markets (Korajczyk, 1996; Hearn, Piesse and Strange, 2008). After the financial crisis had come to an end, trends of recovery in Hong Kong had influenced rest of the East Asian countries to recuperate from the global shock and to maintain a stable stock market. This is only possible if the countries apply relevant asset pricing models for predicting the returns and eliminating the risk to the greatest extent. It is, hence, suggested that the augmented CAPM is the best model for calculating the result, given that this improved framework takes into account the systematic risk and completely avoids the unsystematic risk (Kearney and Lucey, 2004; Hearn, Piesse and Strange, 2008). The international asset pricing model had replaced the national systematic risk and considered the systematic risk that is prevalent globally. It is noticed that relationship existing between “expected excess return on market portfolio is linear” (Lucey and Muckley, 2011; Hearn, Piesse and Strange, 2008). This is acceptable only when the investor invest in a diversified portfolio. Although the findings obtained by Shum and Tang (2006 cited in Lucey and Muckley, 2011) support the use of contemporaneous market factors, the augmented model that includes size and book-to-market ratios reports no significant improvement over the traditional CAPM. Conclusion The literature review highlights the application of CAPM in a thorough manner and highlights on its modified versions that are developed for characterising the market conditions. The literature review presents the mentioned models by emphasizing on their performance in Hong Kong market. The market integration concept by way of comprehending the stock market in Hong Kong is also highlighted. The study stated that the asset pricing models are more successful in integrated market than in segmented markets (Taylor and Tonks, 1989). The augmented CAPM takes into account the changes in exchange rate and also the systematic risks. It can be stated that augmented CAPM is the apt tool for calculating the rate of return of any stock. Hence, this can be used to calculate the rates of returns of Hong Kong market. Though there has been criticism against augmented CAPM, yet authors have stressed on the fact that CAPM is also increasingly employed due to its efficiency in calculating rate of return of any stock. Welch (2008 cited in Hearn, Piesse and Strange, 2008) had found out that about 75.0% of the finance professors have recommended the use of CAPM for estimating the cost of capital and rate of return of a particular stock. Graham and Harvey (2001 cited in Hearn, Piesse and Strange, 2008) had suggested that 73.5% of respondents implement CAPM for calculating risk and return of portfolios. The asset pricing model developed by Sharpe and Lintner foregrounds the basic framework, which enables calculation of the rate of return of stocks in any stock market. Even so, several authors have modified this framework in order to incorporate new variable, but were not able to set forth any improvement. Reference List Black, F., 1974. International Capital Market Equilibrium with Investment Barriers. 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Euro Journal Publishing Inc., 1450(8), pp. 1-8. Yiu-wah Hoa, R., Strangeb, R. and Piesse, J., 2006. On the conditional pricing effects of beta, size, and book-to-market equity in the Hong Kong market. International Financial Markets, Institutions & Markets, 16, pp. 199-214. Read More