Downside Risk-Based Six-Factor Capital Asset Pricing Model (CAPM): A New Paradigm in Asset Pricing

Abstract

The importance of downside risk cannot be denied. In this study, we have replaced beta in the five-factor model of using downside beta and have added a momentum factor to suggest a new six-factor downside beta capital asset pricing model (CAPM). Two models are tested—a beta- and momentum-based six-factor model and a downside-beta- (proxy of downside risk) and momentum-based six-factor model. Beta and downside beta are highly correlated; therefore, portfolios are double-sorted to disentangle the correlation. Factor loadings, i.e., size, value, momentum, profitability, and investment, are constructed. The standard methodologies are applied. Data for sample stocks from different non-financial sectors listed in the Pakistan Stock Exchange (PSX) are taken from January 2000 to December 2018. The PSX-100 index and three-month T-bills are taken as proxies for market and risk-free returns. The study uses three subsamples for robustness—period of very high volatility, period of stability, and period of stability and growth with volatility. The results show that the value factor is redundant in both models. The momentum factor is rejected in the beta-based six-factor model only. The beta-based six-factor model shows very low R2 in periods of highly volatility. The R2 is high for the other periods. In contrast, the downside beta six-factor model captures the downside trend of the market in an effective manner with a relatively high R2. The risk–return relationship is stronger for the downside beta model. These reasons lead us to believe that, overall, the downside beta six-factor model is a better option for investors as compared to the beta-based six-factor model in the area of asset pricing models.

How does the six-factor model do in explaining the relationship between return and risk on the Indonesia stock exchange?

“…Research results from Roy and Shinji (2018) prove that six-factor can explain stock returns very well. Other studies that are in line with their research, namely Maiti (2018) and Ayub et al (2020) also proves that six-factor is able to explain returns from stocks very well. So that, the seventh hypothesis generated from this study is:…”

“…Another study that is in line with their research, Maiti (2018) which found out that the six-factor is designed to capture the variables of size, value, profitability, investment, and human capital that affect the average portfolio return and this model is proven to be able to perform better than FTFF (Three-Factor when book-to-market-value is replaced by leverage) and FFFF (FF Three-Factor). Research from Ayub et al (2020) also proves that six-factor are able to explain returns from stocks very well.…”

Momentum Investment Strategy Using a Hidden Markov Model

“…While the traditional momentum strategy theorized by Jegadeesh and Titman [4] has been widely used in many studies, the effectiveness of the momentum strategy in the Korean stock market has not been determined. This study indicates that the momentum investment strategy using HMM is useful in the Korean stock market.…”

“…Charhart added a momentum factor to the Fama-French three-factor model and showed linear correlations between the momentum factor and stock returns [3]. A recent study by Ayub et al also incorporated a momentum factor to propose a new six-factor downside beta capital asset pricing model (CAPM) for asset pricing [4].…”

Investment decision by using Capital Asset Method Pricing Model (CAPM) (Case studies on five automotive companies listed in stock exchange)

“…SML is a depiction of a line of the CAPM model, where the SML illustrates the trade off between risk with the expected return for individual securities can be identified as the beta (ß) of such shares. Beta (ß) determine the magnitude of the additional expected return for individual securities with the argument that portfolio in diversification are perfectly and the relevant risk only systematic risk measured by beta (Ayub, et al 2020).…”