Testing conditional asset pricing models: An emerging market perspective

Abstract

a b s t r a c tThe 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.

Multi-Asset Portfolio Optimization and Out-of-Sample Performance: An Evaluation of Black-Litterman, Mean Variance and Naïve Diversification Approaches

“…We use tow geographic MSCI stock indices covering both developed and emerging markets: MSCI World and MSCI Emerging Markets, both denominated in US dollar. Emerging markets usually provide higher stock returns than developed markets which are related to additional risk factors such as illiquidity or institutional and political conditions (Iqbal et al, 2010). Chiou et al (2009) show that international diversification is beneficial for US investors by reducing portfolio volatility and improving risk-adjusted returns.…”

On the estimation of the cost of equity in Latin America

“…Further work may consider conditional versions of CAPM (Bonomo, 2001, Iqbal et al, 2009 or downside beta/semi-variance portfolio models (Galagedera, 2007) to estimate the cost of equity and assess their explanatory power compared to our regression results.…”

“…The study makes a contribution to the empirical literature on stock pricing and corporate valuation in emerging markets (see Godfrey, S., and R. Espinosa, 1996, Rouwenhorst 1999, Wong 2000, Fama and French 1998, Bonomo and Garcia, 2001, Bruner et al, 2002, Mishra and O´Brien, 2005, Pereiro 2006, Gozzi, Levine, and Schmukler, 2008, Iqbal et al, 2009 or Barclay et al, 2010 among others) in at least 3 ways: 1) it sets out and econometrically runs a modified version of CAPM to allow for the instability in the estimation of betas, the presence of sovereign risk as government risk-free rates in most of these countries are not default risk-free, illiquidity and the stochastic nature of risk-free interest rates, 2) it provides two robustness tests to check whether well diversified global and multilateral currency portfolios on the one hand, and portfolios constructed according to the stock size and book-to-market ratios, add information to the adjusted version of CAPM on the other, and 3) it informs business and financial managers on how (or how not) to value stocks in a large and representative sample of emerging Latin American markets.…”

Development of Portfolio Theory: Pricing Deformations and Autonomous Self-regulation of the Financial Market

“…We decided to modify the proposed Estrada model (Estrada, 2007). To do this we used the conclusions conditional asset-pricing model (Iqbal et al, 2010). In our model, we have added two new factors in the standard model.…”