The Testing for Capital Asset Pricing Model for the Chinese Stock Exchange - Case Study Example

THE TESTING FOR CAPM FOR THE CHINESE STOCK EXCHANGE ABSTRACT The main purpose of this research is to test the validity of using Capital Asset Pricing model in the Chinese Stock Market. This type of asset pricing theory has been tested in may various stock markets worldwide and the Chinese stock market being one of the security markets that is growing steadily its more sensible to test on it having been an identified gap to research on. The relevance of using CAPM by investors in evaluating the valuation of financial assets in the Chinese stock for purposes of identifying a portfolio with the appropriate portfolio beta and expected return of the portfolio that is worth risking funds for investment is very crucial to the investors. The validation of CAPM is based on daily stock prices and interest rates in the Chinese stock market for the year 2015.This validation is very important because it will help determining the cost of equity, portfolio diversification, discount rates advantage, determining the relationship between the expected risk and expected return and evaluating whether the assets have been efficiently priced. In this research I have used the regression analysis model in analyzing my data for purposes of interpretations and giving recommendations. INTRODUCTION The capital asset pricing model is a model that was invented I the early 1960’s so that it determines and describes the existing relationship between risk and expected returns on an individual stock asset or a portfolio that is listed at a sock market. This model is used by the finance managers in making finance decisions such as setting the risk of stock, computing the expected returns as well as the cost of capital that can be associated with a particular security (Giovanis, 2010). LITERATURE REVIEW Capital asset pricing model was developed in the 1960’s basing on the then existing Markowitz model of 1952 that was majorly used for pricing the financial assets. For an individual security, a security market line plays a major role in identifying the relation between the expected return of the security and systematic risk which is known as beta in order to guide on the pricing of the security (Ehrhardt, 2008). The Markowitz model was improved by the introduction of two assumptions for the CAPM model to be developed. The two assumptions include the mean- variance model on any portfolio that ensured investor selects portfolios where there is spread risk and the other assumption was the borrowing and lending at a risk free rate. Following the above discussion the CAPM model can be clearly represented on the graph below to satisfy the principle of expected returns of particular securities being in a linear relationship with the beta, risk free rate and the expected market premium (Brooks, 2011). Asset return Risk free rate Risk free rate of return CAPM equation is as below Expected return=risk-free rate of interest +beta (risk premium) Risk free rate This refers to the expected return of any asset that is risk free .Risk free assets are the only assets that investors know of their return with certainty. Beta This is the systematic risk on any financial asset. This is the risk of the market that takes into consideration of the interest rates and economic conditions.. Beta =covariance of asset with market portfolio Variance of market portfolio Risk premium This is the difference between the expected return and the risk free rate. In a market portfolio all the assets are considered in the determination of the market risk premium. Chinese Stock market history The previous tests ad researches that were carried out on the Chinese stock market indicated that there existed a negative free rate market (Funke, 2002). At the same time when these tests were carried out the stock market was still very young for an amicable test to be carried out (Ehrhardt, 2008). The then market regulations were not perfect resulting to the investors receiving imperfect information for their decision making as the Chinese stock market was at its preliminary stage. Additionally the unsystematic risk in the stock market can be diversified through the diversification of the portfolio (Giovanis, 2010). This research gap was very essential to be researched since the testing of CAPM is important in decision making, strategy or problem solving since now the Chinese stock market has greatly grown, there is perfect information for the investors from the market and the market regulations are reliable.. Testing of Capital asset pricing model on the Chinese stock market is very essential for the investors who intend to put their funds on the securities of the companies that are listed on the capital market. Proper testing of CAPM will help the investors in determining whether the assets have been accurately priced to avoid their exploitation (Brooks, 2011). This testing will significantly help in influencing the financial investment decision making, strategizing on their investments for the better returns and problem solving on challenges that may be facing the Chinese stock market Approach in testing CAPM validity This research used the regression model methodology on testing the validity of CAPM on the Chinese stock market. The average beta of the market was used for the regression analysis and the same time the individual annual expected returns of every security was combined entirely as a portfolio long as it was listed on the Chinese stock market to find the mean and variances for the regression purposes that helped in identifying the errors ,risk and returns (Black, 2011). CAPM as a forecasting model for use by the investors for purposes of guiding their investment decisions will play a major role in helping them evaluate the risky financial assets being traded on the Chinese stock market. . The testing of CAPM has got very many importances for the investors as explained below: 1. Cost of equity An investor can apply the capital asset pricing model in calculating the cost of equity much easier than the dividend growth model. This is simply because the CAPM takes into account of the company’s level of systematic risk relating to the specific stock market. Investors prefer using the capital asset pricing model to compute the cost of equity since it factors the systematic risk and many factors that relate to the asset thus improving its credibility ad reliance by the investors when determining the relevant costs associated to the source of funds for purchasing the securities from the Chinese stock market (Sharifzadeh, 2010). 2. Portfolio diversifications CAPM only considers the systematic risk of the securities and ignores the unsystematic risk enabling the investors to easily evaluate the securities in the capital market in order to be able to come up with the most suitable diversified portfolio for the most minimum risk and the highest expected return from the investment. Investors will prefer to invest on portfolios than individual securities, this is because in a portfolio the investor has an opportunity to diversify the risk so that incase in the near future the value of some securities decrease in value the other securities are there to suppress the loss. 3. Discount rates advantage Capital Asset Pricing Model is believed to be more superior than the weighted average cost of capital in coming up with the best discount rates to the investors for the purposes of investment. CAPM discounts rates favor the investors thus encouraging investments on the securities of the companies that have been listed on the capital market compared to the discount rates provided by the weighted average cost of capital. Investors prefer using the capital asset pricing model for the purposes of testing the Chinese stock market since it enables the investors to receive better discount rates than the weighted average cost of capital (Vollmer, 2010). 4. Expected return relationship with the systematic risk The capital asset pricing model is widely used by the investors to calculate the systematic risk and the expected return of the securities in the Chinese stock market. The expected return and risk of any security or market help the investor in making most of the investment decision.Investors will settle on a security or portfolio with the minimum possible risk and high expected return for purposes of maximizing profits and maximizing utilization of the wealth for better financial investments. 5. Determine whether the assets have efficiently priced The capital asset pricing model is known to be the most efficient method of re-computing the pricing of the securities on the Chinese stock market for purposes of confirming whether the securities have been efficiently priced (Damodaran, 2010). This computation helps the investors to determine whether the listed companies are trying to exploit its customers by actually overpricing the prices in order to make supernormal profits. If the assets are overpriced the investor will be required to buy securities or portfolios that have been efficiently priced or postpone their investments. PRINCIPLES OF CAPITAL ASSET PRICING MODEL APPLICATION Efficient implementation for the use of capital asset pricing model assumes that various principles and conditions that are existing in the capital market that it’s being used. For instance, in our Chinese stock market we assumed that the following assumptions and conditions prevailed when we applied the capital asset pricing model to test the efficiency of the stock market. 1. Investors hold diversified portfolios The investors in any capital market are assumed to invest across the wide range of the investment assets contained in the Chinese stock market. Since the investors use the systematic risk of the selected portfolio to determine the expected return of the portfolio for purposes of making investment decisions. 2. Existence of a perfect capital market Capital Asset pricing mode assumes that the capital market for instance the Chinese stock market is that the valuing of the securities that have been listed is correct ad the expected returns can be represented on the security market line. The Chinese stock market is assumed not to have taxes and transaction costs for any trade, the investors are able to get perfect information freely, the investors at the same time have homogeneous expectations, all investors are assumed to be risk-averse and rational, all investors are aspiring to maximize profits from their portfolio investments and utilize the wealth for purposes of growth of the investments 3. Investors can borrow and lend at the risk-free rate of return The investors have the freedom to buy the securities from the companies that have been listed on the Chinese stock market on credit and sell them to other investors on credit so as to promote trading with the capital market. 4. Single-period transaction principle The transaction of trading by the investors is allowed within a particular period when the company has been listed and has some outstanding assets for the investors to buy and the investors can only sell their securities when the right time to sell them comes. 5. The assets are divisible and easy to liquidate All securities that are traded in the Chinese stock market are assumed to be highly divisible in that they can be split into small quantities in order t be easily liquidated (Giovanis, 2010). Any diluted security can be easily sold since it will not require the investor to use huge amount of capital in order to buy the securities. 6. Investors are price takers According to CAPM, all investors are seen as price takers since they cannot influences the prices of the securities in the Chinese stock market (Brooks, 2011). The prices of securities are set by the companies that have been listed hence the investors can either buy the securities or sell the securities at the prices that have been set by the listed companies or they stop trading the securities. DATA, VARIABLES AND EMPIRICAL MODELS The validation of CAPM is based on daily stock prices and interest rates in the Chinese stock market for the year 2015.The prices are from different companies representing various sectors within the Chinese economy for the whole year of 2015.The expected return is the dependent variable in this case while the risk is the independent variable. price interest rate 601398 4.39 4.35 601988 3.37 5 601318 35 6.5 601628 22.95 4.35 600028 4.95 7.5 600036 18.11 4.35 601328 5.69 4.35 600519 310.1 3 600000 16.58 4.35 600016 9.2 4 601166 16.23 4.35 601998 6.32 4.35 600104 23.68 5 600030 17.2 7 600018 5.27 3 600015 10.97 2 600048 9.38 4.35 600011 7.16 3.5 600050 5.89 5 600887 17.88 4 601006 7.02 4.35 601111 7.59 3 600010 2.94 2.9 600688 5.96 4.35 600795 3.05 4.35 601600 4.26 6.7 600009 26.51 8 600362 20.72 4.35 600309 20.57 6 600100 14.12 4.35 600177 14.34 3.2 600583 7.25 3 601333 4.47 4.35 601872 5.61 7.9 600642 6.08 4.35 600037 17.17 3 600320 5.11 4.35 600717 10.53 3 601588 4.28 4.35 600331 6.27 5 600601 5.07 4.35 600269 4.95 3 600026 7.41 4 Regression Statistics Multiple R 0.122886 R Square 0.015101 Adjusted R Square -0.00892 Standard Error 0.382211 Observations 43 ANOVA   df SS MS F Significance F Regression 1 12.00999254 12.00999 0.628629 0.432423 Residual 41 78.33074493 1.910506 Total 42 79.53174419         Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept 0.854149 0.226050454 20.0906 7.78E-23 4.084971 4.998008 4.084971 4.998008 X Variable 1 0.365553 0.004610558 0.792861 0.432423 0.012967 0.005656 0.012967 0.005656 y=0.85+0.37x Standard error=0.3822 r=85% of the interests keeps on varying. Empirical models and interpretations From the data analysis that carried out o the Chinese stock market using the regression analysis having applied the 95% confidence level on the sample size and the data collection. The standard error on the analysis is assumed to be 0.38 of which is insignificant to make the results of the analysis unreliable. Risk levels The systematic risk in the Chinese stock market is 23% and the payoff rate is as well very low. The coefficient of the risk is 0.85 indicating that the investors pay attention on the time value of the asset and at the same time they are highly cautious on the high risk and high returns of the financial assets. This means that the Chinese stock market is still not stable and that is why the investors are high cautious since the market trends are unpredictable (Giovanis, 2010). The beta value of 0.365553 that there is a positive relationship between the stock market systematic risk and the expected return risk (Vollmer, 2010).The t- value of 0.79 is insignificant to the results indicating that the sample data collected was ideal for the analysis. Linearity test On the nonlinearity test,p-value is 7.8 which is not statistically equal to zero but higher than zero hence it means that the relationship between the systematic risk and the expected return on the Chinese stock market is linear thus supports the provision in capital asset pricing model of existence of a flat relationship between the portfolio risk and portfolio expected return. Risk averseness of the investors On the test of whether the investors are risk averse, the p-value of the Chinese stock market is 0.48 which is larger than 0.05 which means that statistically it’s larger than 0.The meaning of this result is that the investors are highly risk averse. The investors will expect to receive higher returns where there is higher risk for investment in the available financial assets in the Chinese stock market. The definition of the capital asset pricing model will remain the same that beta will be the only variable that explains the existing differences in expected returns in the various securities of companies listed in the Chinese stock market. CONCLUSION This paper was expected to validate the relevance of using capital asset pricing model to value the securities in the Chinese stock market and the study covered the period of January 2015 to December 2015 having considered 48 stocks listed on the Chinese stock market. According to the findings of this research, it was proven that there is an existence of a linear relationship between the risk and expected return on the Chinese stock market, the higher the risk in any portfolio the higher the expected return of the portfolio and the nonsystematic risk of any asset has no effect on the expected return even if there is a diversification of the portfolio. In conclusion, the CAPM model invention of the 1960’s is still being used by majority of investors who have intentions of investing their extra funds in the stock market of China. The CAPM model has helped the investors mostly in analyzing the expected return from the stock markets as well as their systematic risk (Grandville, 2003). However this type of model is unable to predict the expected return and risk on portfolios within the Chinese stock market accurately due to the other factors that affect the expected return of the market other than the systematic risk. All in all CAPM still remains a significant model for use in the risk analysis ad expected return relationship of portfolios and single assets for the investors even though it faces some limitations in applying its principles and theory fully into practice when it comes to analysis of the stock markets since the principles are not fully met due to externalities in the market (Sharifzadeh, 2010). Bibliography Black, K. (2011) Business Statistics: For Contemporary Decision Making - Page 296, London. Brooks, L. (2011) Business & Professional Ethics - Page 694. Damodaran, A. (2010) Applied Corporate Finance - Page 552, New York: Cingage Learning. Ehrhardt, M. (2008) Corporate Finance: A Focused Approach - Page 554, london: Cingage Learning. Funke, N. (2002) Macroeconomic News and Stock Returns, London. Giovanis, E. (2010) Application of Capital Asset Pricing (Capm) and Arbitrage Pricing, New york. Grandville, O.d.L. 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