Ma sa r yk Un iv e rsi t y

Faculty of Economics and Administration

Field of study: Finance

CAPITAL ASSET PRICING MODEL

VERSUS ARBITRAGE PRICING THEORY
Diploma Thesis

Thesis Supervisor: Author:

Ing. Dagmar Linnertová, Ph.D. Bana Musharbash

Brno, 2016
 MASARYK UNIVERSITY

Faculty of Economics and Administration

MASTER’S THESIS DESCRIPTION

Academic year: 2015/2016

Student: Bana Musharbash

Field of Study: Finance (eng.)

Title of the thesis/dissertation: A comparison between CAPM and APT

Title of the thesis in English: A comparison between CAPM and APT

Thesis objective, procedure and methods used: The thesis aim is to compare two models; CAPM and APT, in order
to find out which model is better for a prediction of stock returns on
the stock market.

Process of Work:

1. Introduction

2. Theoretical Methodology

3. Theoretical Framework

4. Conclusion, results and discussion

Methods:analysis, comparison, deduction

Extent of graphics-related work: According to thesis supervisor’s instructions

Extent of thesis without supplements: 60 – 80 pages

Literature: ANDREAS, S and M AUSTIN. An Empirical Comparison of Alternative

Models of Capital Asset Pricing in Germany. , 1992, roč. 16, č. 1.

ABEYSEKERA, S P and A MAHAJAN. International Arbitrage Pricing

Theory: An Empirical Investigation. SOUTHERN ECONOMIC JOUR-
NAL, CHAPEL HILL: UNIV NORTH CAROLINA, 1990, roč. 56, č. 3.
ISSN 0038-4038.

BLACK, F. International Capital Market Equilibrium with Investment

Barriers. Journal of Financial Economics, 1974, roč. 1, č. 4.

BLACK, F., M.C. JENSEN and M.S. SCHOLES. The Capital Asset Pri-
cing Model: Some Empirical Tests. In Studies in the Theory of Capital
Markets. : Praeger Publishers Inc., 1972. s. 79-121.

ABDYMOMUNOV, A and Morley J AMP. Time Variation of CAPM

Betas across Market Volatility Regimes. Applied Financial Econo-
mics, 2011, roč. 21, č. 19.

Thesis supervisor: Ing. Dagmar Linnertová, Ph.D.

Thesis supervisor’s department: Department of Finance

Thesis assignment date: 2015/04/14

The deadline for the submission of Master’s thesis and uploading it into IS can be found in the academic year calendar.

.................................. ..................................
prof. Ing. Antonín Slaný, CSc. dean
Head of department
In Brno, date: 2016/05/11
Abstract

This work is dedicated to the study of the Capital Asset Pricing Model and the Arbitrage
Pricing Theory model. The first part is the theoretical one; which describes the theoretical
background of each model and illustrates their mathematical derivations, then previous
empirical tests performed on the models as well as some of their alternative versions are
discussed.
The practical part describes the time-series regression analyses carried out for each model, the
results of which are analyzed and a comparison between the CAPM and the APT model is
made.

Key words

CAPM, APT, empirical test, time-series, regression analysis, beta coefficient, security market
line, risk factors, factor loading.

I
Statement of Authorship

I hereby declare that the Master thesis “Capital Asset Pricing Model Versus Arbitrage Pricing
Theory” and relevant research in its background is entirely my own work, supervised by Ing.
Dagmar Linnertová, Ph.D., and has not been taken out of the work from others. The used
literary resources and other specialist resources have been cited and acknowledged within the
text of the thesis and listed in the References according to the relevant legislation and
regulation.

In Brno____________ ________________

Bana Musharbash

II
Table of Contents
INTRODUCTION ................................................................................................................. 11
THEORETICAL BACKGROUND ....................................................................................... 14
Modern Portfolio Theory .................................................................................................. 14
The Capital Asset Pricing Model ...................................................................................... 20
Previous Empirical Studies of the Capital Asset Pricing Model....................................... 25
The Arbitrage Pricing Theory ........................................................................................... 28
Previous Empirical Studies of the Arbitrage Pricing Theory............................................ 32
The German Financial System and the German Financial Market ................................... 35
Changes to the German Financial System ........................................................................ 36
Impact of the Financial Crisis in Germany ....................................................................... 36
DAX Performance Index................................................................................................... 39
Empirical Tests and Findings ................................................................................................ 40
Methodology ..................................................................................................................... 40
Data Selection ................................................................................................................... 40
Statistical Examination of Tested Data ............................................................................. 41
Testing of the Standard Capital Asset Pricing Model............................................................ 44
Methodology of the Empirical Tests ..................................................................................... 45
Testing the Model ............................................................................................................. 46
Empirical Results ................................................................................................................... 47
Periodic CAPM ...................................................................................................................... 49
Pre- crisis Period ............................................................................................................... 49
Crisis Period ...................................................................................................................... 51
Post-Crisis Period .............................................................................................................. 52
Testing of the Arbitrage Pricing Theory ................................................................................ 54
Methodology of the Empirical Tests ..................................................................................... 55
Empirical Results ................................................................................................................... 56
Periodic APT.......................................................................................................................... 57
Pre-Crisis Period ............................................................................................................... 57
Crisis Period ...................................................................................................................... 58
Post-Crisis Period .............................................................................................................. 59
Summary ................................................................................................................................ 61
CONCLUSION ...................................................................................................................... 65

III
REFERENCES ....................................................................................................................... 67
APPENDICES ........................................................................................................................ 70
Appendix 1......................................................................................................................... 71

IV
List of Tables
Table 1: Companies currently listed on the DAX performance index 29.

Table 2: Statistical characteristics of the market index (DAX) 31.

Table 3: Regression results for the period March, 2001- December, 2015 for

certain securities 37.

Table 4: Pre-crisis period regression results 48.

Table 5: Crisis period regression results 49.

Table 6: Post-crisis period regression results 50.

Table 7: Summary of results for the entire testing period 51.

Table 8: Summary of results for pre-crisis period 52.

Table 9: Summary of results for crisis period 53.

Table 10: Summary of results for post-crisis period 53.

List of Figures
Figure 1: Probability distribution for two different investments with the same

expected return 4.

Figure 2: How diversification reduces risk 6.

Figure 3: Combination line for securities A and B for the case of zero correlation 7.

Figure 4: Choices of investors with different indifference curves 8.

Figure 5: Investment Opportunities 11.

Figure 6: The Capital Asset Pricing Model 14.

Figure 7: Arbitrage Pricing Line 21.

Figure 8: The Security Market Line (SML) 38.

Figure 9: Pre-Crisis Period SML 40.

Figure 10: Crisis Period SML 41.

Figure 11: Post-Crisis Period SML 42.

V
Intentionally left blank

VI
INTRODUCTION

Harry Markowitz developed the model of portfolio theory in 1952; his theory explained how
risk-averse investors can create optimal portfolios which maximize expected return for a given
level of risk, highlighting the fact that risk is an intrinsic part of higher reward. A decade later,
in the early 1960s, Jack Treynor (1962), William Sharpe (1964), John Linter (1965), and Jan
Mossin (1966) developed an asset pricing model built on Markowitz’ portfolio theory. Their
model; the Capital Asset Pricing Model (CAPM), remarked a breakthrough in the world of
finance and economics, it was developed at a time when the theoretical basics of decision-
making under uncertainty were just being introduced, and when what are now regarded as
basic empirical facts about return and risk in capital markets were still foreign.

The Capital Asset Pricing Model joined risk and return in a linear relationship. This
relationship used beta as a measure of risk and suggested that the only factor affecting the
rates of return on securities in capital markets is the return on the market portfolio; a portfolio
that includes all assets in the market.

The CAPM proved to be a very controversial model. It was criticized for the assumptions on
which it is based, which were said to be unrealistic and unattainable in the real world. The
CAPM repeatedly failed in empirical tests and was rejected by many scholars and researches.
However, theoretically it remains one of the most important asset pricing models regardless
of the many attempts to create alternative models based on more realistic assumptions or
models that address the shortcomings of the CAPM.

One such model that was created as an alternative to the CAPM is the Arbitrage Pricing
Theory (APT) model. Introduced by Stephen Ross in 1976, the APT relaxed some of the
assumptions on which the CAPM is based, and most importantly addressed the fact that
securities’ rates of return are affected by many common risk factors and not just the risk of
the market portfolio as the CAPM suggests.

The APT describes the “true” price of a security; therefore, it is used by arbitrageurs to profit
by taking advantage of mispriced securities in capital markets. A mispriced security will have
11
a different price than the one predicted by the APT model. Arbitrageurs identify those assets
in the market and form their investment decisions based on whether the securities are
overpriced or underpriced.

The CAPM has been described as a special case of the APT model, as a single-factor version
of the multifactor APT model. Both models have been tested and tried by many scholars and
economists independently and against each other. In this paper, the CAPM and the APT are
tested on the German market to observe how both models perform.

First, presented and described are the theoretical backgrounds of the CAPM and APT models,
the assumptions on which they are based, the mathematical derivations of the models, and
previous empirical tests done on both models.

Second, an introduction to the German financial system is presented. A brief history of the
German financial system is outlined along with the impact the 2007-2008 financial crisis had
had on the German economy and the German financial market.

Third, empirical tests done on both models with their results are described. The data selection
process is first mentioned, followed by statistical tests done on the data to make sure it is
suitable for the testing procedures.

Time-series regression analyses were carried out for the CAPM and APT model and the
empirical results are detailed. The time period used for testing the models was taken from
March, 2001 until December, 2015. The monthly returns for 29 out of the 30 stocks listed on
the Deutscher Aktienindex (DAX) index of the German financial market were used. The tests
for both models were done first for the entire testing period. The entire period was then split
into three sub-periods; pre-crisis period, crisis period, and post-crisis period, based on the time
the effect of the global financial period reached the German economy and its financial market.
The latter step was performed to gauge how well both models would be able to describe the
prevalent economic conditions. Finally, the empirical results are stated and analyzed.

12
In the last section of this paper, the concluding remarks can be found in detail, which were
drawn from the empirical tests done on both models and the nature of the empirical results
obtained.

The conclusion that can be made is that both models have their merits and their shortcomings.
The results varied for both models when tested for the entire period and for the sub-periods.
It is true that securities’ rates of return are affected by the return on the market portfolio, but
it is also true that there are many other common risk factors that these returns are also sensitive
to. Therefore, it is recommended for rational investors to use both models jointly, the CAPM
and the APT, for constructing efficient and diversified portfolios and for forming sound
investment decisions.

13
THEORETICAL BACKGROUND
Modern Portfolio Theory1

In the early fifties Harry Markowitz (1952) created a set of concepts known as the modern
portfolio theory. Markowitz aided the further evolution of the financial theory by introducing
a new way to measure asset risk, and developing methods for including this in risk-efficient
portfolios.

Returns over time, and the volatility of these returns, are the two most relevant values of any
asset. When rates of return are measured over a fairly short period of time, they conform
closely to the normal distribution. On the other hand, when rates of return are measured over
longer periods of time, their distribution tends to be lognormal (skewed to the right) (Brealey
et al. 2011b). However, a normal distribution is commonly assumed for rates of return. The
mean and the standard deviation are the two numbers needed to describe a normal distribution.
Financially, the mean is the expected value of the returns on an asset, while the standard
deviation measures the volatility of the returns and is therefore, a measure of the asset’s risk.
Investors pay very close attention to these two measures when making investment decisions.

Probability Probability

Rate of Return Rate of Return

INVESTMENT 1 INVESTMENT 2
Figure 1 – Probability distribution for two different investments with the same expected return (Source:
author’s creation)

Figure 1 shows two investments with the same average expected return but different standard
deviations (risk). A rational investor who is risk-averse, that is; one who in a risk-return

1
This part relies to a great extent on Thomas E., Weston Fred J. Shastri Kuldeep [2005 // 1988] and Haugen
Robert A. [Haugen 2001a]
14
framework will always strive to achieve the highest possible return with the lowest possible
risk, will choose Investment 1 as its returns are less dispersed around the average expected
return and therefore; has less risk than Investment 2.

Investors refrain from investing their entire wealth in a single asset, but use diversification to
combine many different assets into portfolios. The expected rate of return on such a portfolio
is simply the weighted average of the expected returns on the assets in the portfolio:

E(Rp) = ΣxiE(Ri) (1)

Where:
E(Rp) : Expected return on the portfolio
xi : Weight of stock i in the portfolio
E(Ri) : Expected return on asset i

Calculating the risk of a portfolio is not as straightforward as calculating its expected return.
Simply multiplying the assets’ standard deviations by their respective weights and summing
them up would only work if the assets in the portfolio were perfectly correlated with each
other and that is rarely the case.

Markowitz (1952), in his studies, introduced the concept of diversification and explained how
when combining stocks into portfolios, the resulting standard deviation of the portfolio is less
than that of each asset on its own. The fact that prices of different stocks are not perfectly
correlated with each other is what makes diversification possible. Figure 2 below shows how
risk of a portfolio is reduced as the number of assets in the portfolio is increased.

15
 Unique risk

Market Risk

Number of Securities

Figure 2 – How diversification reduces risk (Source: Brealey, Myers, Allen [((Brealey et al. 2011a)])

We can see from Figure 2 that up to a certain number of securities, if more securities are added
to the portfolio, the risk of the portfolio decreases noticeably. After a certain point, the more
securities added to the portfolio the less is the decrease in the overall risk of the portfolio until
the risk ceases to decrease when more securities are added. Moreover, the only risk that can
be diversified away is the firm-specific (idiosyncratic) risk; the systematic (market) risk
cannot be diversified, and is the risk that investors are awarded for bearing.

Now that we know more about the types of risks and how they can be managed by
diversification, we can show how the risk of a portfolio can be calculated. For a portfolio of
two securities, the risk can be measured as follows:

σ(p) = √𝑥12 𝜎12 + 𝑥22 𝜎22 + 2(𝑥1 𝑥2 𝜎1,2 ) (2)

Where:
σ(p) : Standard deviation of the portfolio
𝑥12 : Weight of stock 1 in the portfolio
𝜎12 : Variance of stock 1
𝑥22 : Weight of stock 2 in the portfolio
𝜎22 : Variance of stock 2
𝜎1,2 : Covariance between stock 1 and stock 2

16
As we add more securities into the portfolio, more variables are added into Equation 2 above.
For example, a portfolio with three securities would include three weighted variance terms
and six weighted covariance terms as follows:

σ(p) = √𝑥12 𝜎12 + 𝑥22 𝜎22 + 𝑥32 𝜎32 + 2(𝑥1 𝑥2 𝜎1,2 ) + 2(𝑥1 𝑥3 𝜎1,3 ) + 2(𝑥2 𝑥3 𝜎2,3 ) (3)

The next step would be to know how to determine the correct weights of the securities in the
portfolio that would minimize risk and maximize expected return. Equation 1 and 2 can be
employed to calculate the expected return and standard deviation for different combinations
of assets and determine the optimal portfolio weights. Figure 3 below displays the different
combinations of two assets:

Expected portfolio return %

XA=150% XB=-50%
A
XA=100% XB=0%

MVP
XA=45% XB=55%

XA=0% XB=100%

B XA=-25% XB=125%

Standard deviation of portfolio return

Figure 3 – Combination line for securities A and B for the case of zero correlation (Source: Haugen Robert
A. [(Haugen 2001b)])

Figure 3 shows the combination line generated using equations 1 and 2 while plugging in
different weights (xA ,xB ) for the two stocks in the portfolio. The shape of the combination line
depends on the correlation between the two stocks. The bell-shape of the curve depicted in
Figure 3 is generated when the correlation between the two stocks is zero.

Investors may use Figure 3 to choose the suitable combination of stocks for their investment
preferences. A rational, risk-averse investor would seek the combination that would minimize
17
his exposure to risk while maximizing his expected return. Such a portfolio is called the
Minimum Variance Portfolio (MVP).

In order to find the minimum variance portfolio, many stocks must be analyzed at once and
many combinations of these stocks are to be constructed. The endless possibilities here will
be represented by an area in the risk-return structure rather than a single combination line.

Expected portfolio return %

II
III I

MVP

Standard deviation of portfolio return

Figure 4 – Choices of investors with different indifference curves (Source: Copeland, Weston & Shastri
(2005))

The area inside the curve ABMVPF in Figure 4 represents the feasible set of portfolios that
an investor can choose from. A rational investor would choose a portfolio that would
maximize his expected return for his preferred level of risk. For example, if we look at Figure
4 we can see that no rational investor would choose point F over point A since they both have
the same standard deviation (risk) but point A offers a higher expected return than portfolio F
does for the same level of risk. It should be noted here that no rational investor would choose
any portfolio on the curve ABMVPF that is below the minimum variance portfolio since they
can always attain higher expected return along the red segment of the curve for the same risk
as those on the negatively sloped segment of the curve. Now we can define the efficient
frontier and the efficient set. The efficient frontier is the red segment of the curve which
contains portfolios defined by Markowitz as efficient portfolios. “The efficient set is the set
18
of mean-variance choices from the investment opportunity set where for a given variance (or
standard deviation) no other investment opportunity offers a higher mean return.” (Copeland
et al. 2005)

The utility functions I, II and III in Figure 4 represent different investor preferences. A risk-
averse investor would have a utility function such as III and would choose to invest in the
minimum variance portfolio. A risk-neutral investor is willing to bear a little more risk for a
higher expected return and would therefore have a utility function such as II and would invest
in portfolio B. On the other hand, a risk-seeker would tolerate a high level of risk and would
have the III utility function and invest in portfolio A since it offers the highest expected return.

Now that it has been clarified how risk may be reduced by means of diversification, and how
investors may use the efficient frontier to make investment decisions by choosing efficient
portfolios, it is possible to derive the Capital Asset Pricing Model (CAPM) based on
Markowitz’ modern portfolio theory.

19
The Capital Asset Pricing Model2

Sharpe (1964) and Lintner (1965) created the Capital Asset Pricing Model (CAPM) which
then marked the birth of the asset pricing theory, and earned Sharpe a Nobel Prize in 1990.
Black (1972) added valuable input to the CAPM, eventually shaping it into the model being
taught and used now.

Five decades later, due to its power, simplicity, and intuitively pleasing predictions about
measuring risk and expected return, the CAPM is still used in a wide set of applications,
including the estimation of the cost of capital for firms (including Fortune 500 firms), and in
the performance evaluation of managed portfolios. The CAPM is often the only asset pricing
model taught in higher education courses and is considered the centerpiece of investment
courses.

All the above have given the CAPM a favorable position among scholars, however,
unfortunately empirical tests have given the model a disadvantage due to its poor empirical
record which deemed the way the model is used in applications invalid.

The CAPM has long intrigued economists, and has been tested and tried over and over again
ever since it has been created. These empirical tests have rejected the model more often than
not, and these empirical problems of the CAPM may reflect failures in the theories put forth,
which are due to many simplifying assumptions that have been said to be impossible in the
real world, which resulted in the implication that the CAPM is unrealistic and therefore unfit
to be used in measuring the risk and expected return of assets and managed portfolios in real
world stock markets. However, the true test of a model is not how reasonable the assumptions
behind it appear to be, but how well the model describes reality.

The CAPM is based on Markowitz (1959) “mean-variance model”, which assumes that
investors are risk averse who when choosing a portfolio at time t-1, the portfolio chosen
maximizes expected return, given variance (risk), and minimizes variance (risk), given
expected return for their investment period t, and produces a stochastic return at time t. The

2
This section relies to a great extent on Eugene F., Kenneth R. [2004] and Elton [2011a]
20
mean-variance model provides an algebraic condition on asset weights in mean-variance-
efficient portfolios. The CAPM takes this algebraic condition and turns it into a testable
prediction about the relation between risk and expected return which, if asset prices are set to
clear the market of all assets, identifies portfolios that must be efficient. When creating the
CAPM, Sharpe (1964) and Lintner (1965) added two key assumptions to Markowitz (1959)
mean-variance model in order to identify mean-variance-efficient portfolios. These two
assumptions are:
1. Complete agreement; given market clearing asset prices, investors agree on the
joint distribution of asset returns, from the period t-1 to t, from which the returns
used to test the CAPM are derived.
2. Unlimited borrowing and lending at the risk-free rate; which is the same rate for
all investors.

Figure 5 shows the investment opportunities available in the market, and describes the
efficient portfolio set which constitutes all mean-variance-efficient portfolios that can be
obtained by creating portfolios containing either risky assets only, or portfolios with risky
assets and risk-free assets, depending on the risk preference of the investor; from risk aversion
to risk seeking.

Figure 5 – (Source - The Capital Asset Pricing Model: Theory and Evidence (Fama, French 2004))
21
The horizontal axis represents portfolio risk, measured by the standard deviation of the
portfolio return denoted by (σ), the vertical axis represents the portfolio expected return
denoted by (E(R)). The curve abc shows the set of portfolios in which only risky assets are
included. The set of mean-variance-efficient portfolios will be found above point b, since these
are the portfolios that maximize the expected return for each given return variance.

When risk-free borrowing and lending is added, the efficient set becomes the straight line
shown in the graph which stretches from Rf ; which is the portfolio with zero variance and
risk-free rate of return, and goes through the point g; which is some risky portfolio.

The weights assigned to the riskless and the risky assets within the portfolio determine where
the portfolio will be located along the straight line. The same applies when only risky assets
are included in the portfolio, the weights assigned to the different risky assets will determine
where the portfolio will be located on the curve abc in Figure 5.

According to Tobin’s (1958) “separation theorem”, to obtain the set of mean-variance-

efficient portfolios which include risk-free borrowing and lending, a line is drawn from Rf in
Figure 5, up and to the left in order to go through the tangency portfolio T on the curve abc.

Before arriving at the gist of the CAPM, the following assumptions on which the CAPM is
based will help make the punch line clearer (Elton 2011b):
 There are no transaction costs (taxes, commissions, etc.) for buying or selling any
asset,
 all Assets are marketable (even human capital can be bought and sold on the market),
 assets are infinitely divisible; meaning that investors can short any asset, and hold any
fraction of an asset, regardless of the size of their wealth,
 investors can perform unlimited lending and borrowing at the riskless rate,
 the only two concerns of investors upon which they make decisions are the expected
values and the standard deviations (volatility) of the returns on their portfolios,
 all investors have the same investment period (i.e. plan to invest over the same time
horizon),

22
  investors share homogeneous (identical) expectations regarding the inputs to the
portfolio decision.(i.e. Same expected return, volatility, and correlations for every
asset in the market).
As can be seen from the above mentioned assumptions, there is a reason these are deemed
unsustainable, as such a frictionless environment does not exist in the real world.

Investors, having identical expectations regarding the investment universe; from the same
expected returns, and same expected volatility of these returns, to the same correlation
between assets, and using the same input list when constructing their portfolios, all will arrive
to the same efficient frontier. Since the CAPM also assumes the same riskless rate for all
investors, they will hence draw identical tangent capital allocation lines (CAL) to their
efficient frontiers and will arrive at the same risky portfolio P. The weights assigned to the
risky assets within the portfolios will also be identical; which will be calculated by dividing
the market value of each asset by the total market value of all assets in the portfolio. The
aggregate of all the individual investor portfolios will equal the entire wealth of the economy;
as the lending and borrowing will cancel out, and this aggregate is called the Market Portfolio,
M, and M too will have the same weights. Therefore, the CAPM arrives to the conclusion that
all investors choose the same risky portfolio, and that must be the market portfolio, that is, the
value weighted portfolio of all assets in the investable universe. Therefore, the capital
allocation line (CAL) based on each investor’s optimal risky portfolio will ultimately be the
capital market line (CML).

To conclude, the CAPM assumptions entail that for the asset market to clear, the market
portfolio M must lie on the minimum variance frontier (i.e. it is a mean-variance-efficient
portfolio).

The algebraic relation to sum up all the above for any risky asset (i), when there is risk-free
borrowing and lending in the market, will be:

E(Ri) = E(Rf) + βiM [E(RM) – E(Rf)] (4)

23
In this equation βiM is the market beta of asset i which is calculated by diving the covariance
of its return with the market return by the variance of the market return:

𝑐𝑜𝑣(𝑅𝑖 ,𝑅𝑀 )
𝛽𝑖𝑀 = (5)
𝜎²(𝑅𝑀 )

The market beta of the asset i, is the slope of the regression of its return on the market return,
and therefore, measures the sensitivity of the asset’s return to changes in the market return.

A definition of the market beta, more in line with the CAPM, would be as the risk of the
market portfolio M, and βiM is proportional to the risk each dollar invested in asset i, adds to
the overall risk of the market portfolio, M.

With this definition of risk and the algebraic relation connecting it to return (CAPM) we can
finally represent it graphically using two points; the risk-free return, with its beta being equal
to zero, and the market portfolio M, with its beta being equal to 1. Notice how beta has
replaced standard deviation, and the line previously called the Capital Market Line (CML) is
now referred to as the Security Market Line (SML), as follows:

E(Ri)
SML

M
E(RM)

E(RM) - Rf

Rf

0 1 β

Figure 6 – The Capital Asset Pricing Model (Source: Haugen [2001])

24
In equilibrium, all stocks must lie on the SML since according to the CAPM the risk premium
earned for bearing systematic risk should be proportional to the stock’s beta. Assets that lie
above the SML are considered to be underpriced and offer greater return than predicted by the
CAPM, investors will rush to buy these assets to the point where their prices are pushed up
and their returns lowered enough for them to lie on the SML. On the other hand, assets that
lie below the SML are considered overpriced since they offer lower return than predicted by
the CAPM given their level of risk, investors will sell these assets to drive their prices down
and increase their returns until they lie on the SML.

Finally, the CAPM provides investors with two investing advices to be followed. First,
diversification proportionally to the market portfolio is key to maximizing the expected return
on an investor’s portfolio given each investor’s preferred level of risk. Second, include both
risky assets and risk-free assets in the portfolio in the appropriate weights to achieve the
desired level of portfolio risk.

Previous Empirical Studies of the Capital Asset Pricing Model

Black, Jensen, and Scholes were the first researches to publish empirical research supportive
of the CAPM in 1972 (Haugen 2001b). They were the first to use the cross-section analysis
technique in their methodology and concentrated on the properties of the security market line
of the model. Their data included all stocks listed on the New York Stock Exchange, and their
testing period was from 1926 – 1965. They started by estimating the stock betas by regressing
the monthly returns of the stocks from the first four years of the testing period on the monthly
returns of the market index. Next, they grouped the stocks into 10 portfolios using the
estimated stock betas3 as the grouping criterion and computed the monthly returns on these
portfolios starting from the fifth year and so forth until the end of the testing period. Finally,
they approximated the security market line by estimating the portfolio betas and relating them
to the average returns on the portfolios. Their results showed a linear relationship between the
portfolio betas and average returns that was positive with a significant slope. That was a very
promising and supportive conclusion for the CAPM.

3
10% of stocks with highest betas formed one portfolio, 10% of next highest betas formed next portfolio etc.
25
In 1974, Fama and MacBeth (Haugen 2001b) published another study on the CAPM. They
followed a similar approach to that used by Black, Jensen, and Scholes in their research;
however, with one distinct difference. Fama and Macbeth tried to predict future rates of return
using estimates from previous periods. Their results were again supportive of the CAPM and
reached a conclusion similar to that of Black, Jensen, and Scholes.

Nevertheless, this was not always the case. The CAPM was criticized and rejected on several
occasions. Richard Roll (Copeland et al. 2005) wrote several papers in the late 1970’s
criticizing the CAPM and its assumptions. Roll argues that the model cannot be tested since
the model specifies that the market portfolio should be efficient and for that to be true it should
include all assets on the market including the international market, hence making the model
impossible to test.

In 1992, Fama and French (Haugen 2001b) performed a study that was an extension of the
Fama and MacBeth study from 1974. They took company size into consideration along with
returns and found anomalies that could not be explained by the CAPM. The fact that they
found that on average, small companies tend to earn higher rates of return than larger
companies, was inconsistent with the CAPM which only includes risk as a factor affecting
returns.

Other studies have found that returns are affected by more factors than just risk. One such
study was that performed by Reinganum (1983). Reinganum studied the January effect which
states that risk premiums tend to be higher in that month of the year. French, beforehand, in
1980 stated that risk premiums tend to be on average lower on Mondays. Studies have also
shown that ratios such as earnings/price ratio and book-to-market ratio have a positive
influence on risk premiums (Michailidis et al. 2006).

Javier Estrada (2002) tested the downside CAPM (D-CAPM) against the CAPM in emerging
markets (Ems). The D-CAPM uses the semivariance of returns as a measure of risk instead of
beta as in the standard CAPM. The semivariance of returns is an alternative measure of risk
for diversified investors, also known as downside beta. Estrada’s results favoured the
downside beta and the D-CAPM to beta and the CAPM

26
A more recent study was done by Ronald J. Balvers and Dayong Huang (2009). They tested
asset pricing in a monetary economy where lower transaction costs are assigned to liquid
assets. They derived real money growth as an additional factor that affects securities’ rates of
return, thus extending the CAPM and the consumption CAPM. They found that a value
premium arises since value firms are sensitive to liquidity shocks while growth firms are not.
They also concluded that the real money growth factor was not driven out by any other factor;
however, further explanatory power was added by conditioning consumption-wealth ratio
(CAY) factors of Lettau and Ludvigson.

Despite all the criticism it has received, the CAPM is still widely used in many applications
and is still taught as the most prominent asset pricing model in Finance and Economics.

27
The Arbitrage Pricing Theory4

The Arbitrage Pricing Theory (APT), formulate by Ross (1976), is a more general alternative
to the CAPM. Unlike the CAPM, which predicts that the rates of return on securities are a
linear function of a single specified factor which is the rate of return on the market portfolio,
the APT predicts that security rates of return are a linear function of several k factors that are
not explicitly specified.

Ri = E(Ri) + bi1F1 + bi2F2 + … + bikFk + εI (6)

Where:
Ri: the random rate of return on the ith asset,
E(Ri): the expected rate of return on the ith asset,
bik: the sensitivity of the ith asset’s returns to the kth factor,
Fk: the mean zero kth factor common to the return of all assets under consideration,
εI: a random zero mean noise term for the ith asset.

The APT is based on some of the same basic assumptions as the CAPM. For example, the
APT is derived under perfectly competitive and frictionless capital markets. Individuals must
have homogeneous expectations regarding the k-factor model governing the securities’ rates
of return. Furthermore, the theory emphasizes the importance of having a much larger number
of assets being considered than the number of k factors included in the model. Finally, the
noise term, εI, is the unsystematic risk component for the ith asset, which must be independent
of all factors and random errors of other assets.

The most important feature of the APT is the arbitrage portfolios. These are portfolios that, in
equilibrium, are constructed from the assets under consideration using no wealth and must
earn no return on average since they have no risk. Since no change in the total invested wealth
must be made when constructing arbitrage portfolios, the investor would sell some assets and
use the proceeds to buy other assets. And the zero change in total wealth is written as:

∑𝑛𝑖=1 𝑤𝑖 = 0 (7)

4
This section relies to a great extent on [Copeland et al. 2005 // 1988]
28
The portfolio return gained from adding n assets to the arbitrage portfolio can be represented
as follows:

𝑅𝑝 = ∑𝑛𝑖=1 𝑤𝑖 𝐸(𝑅𝑖) + ∑𝑛𝑖=1 𝑤𝑖 𝐹1𝑏𝑖1 + … + ∑𝑛𝑖=1 𝑤𝑖 𝐹𝑘𝑏𝑖𝑘 + ∑𝑛𝑖=1 𝑤𝑖 𝜀𝐼 (8)

In order for the arbitrage portfolio to be completely riskless, diversifiable (idiosyncratic) risk
as well as undiversifiable (systematic) risk must be eliminated. The following conditions must
be met to achieve riskless arbitrage portfolios:
1. selecting small percentage changes in investment ratios, wi,
2. diversifying across a large number of assets,
3. choosing changes, w, so that for each factor, k, the weighted sum of the systematic risk
component, bk, is zero.

Due to the independence of the error terms, the law of large numbers guarantees that their
weighted sum will approach zero as their number increases. This means that the last term of
equation 8 will be eliminated by proper diversification.

Selecting arbitrage portfolios with zero betas in each factor; by eliminating all systematic risk
through choosing the weighted average of the systematic risk components for each factor to
be zero, causes the return on the arbitrage portfolio to become a constant and not a random
variable:

Rp = ∑𝑛𝑖=1 𝑤𝑖 E(Ri) (9)

If the market is to be in equilibrium, the risk of the arbitrage portfolio must be zero and it must
earn zero return, otherwise, it would be possible to earn an infinite rate of return with no
capital requirements and no risk. Hence, if the arbitrageur is in equilibrium, the return on the
arbitrage portfolio will be:

Rp = ∑𝑛𝑖=1 𝑤𝑖 E(Ri) = 0 ( 10 )

29
Any vector that is orthogonal to the constant vector, that is:

∑𝑛𝑖=1 𝑤𝑖 × 𝜀 = 0 ( 11 )

And to each of the coefficient vectors,

∑𝑛𝑖=1 𝑤𝑖 × 𝑏𝑖𝑘 = 0 ( 12 )

Must also be orthogonal to the vector of expected returns,

∑𝑛𝑖=1 𝑤𝑖 × E(Ri) = 0 ( 13 )

Therefore, the expected return vector must be a linear combination of the constant vector and
the coefficient vectors. With the presence of k + 1 coefficient, it is as such:

E(Ri) = λ0 + λ1bi1 + λ2bi2 + … + λkbik ( 14 )

In the case of the presence of a riskless asset in the market with a riskless return, b0k = 0, and
Rf = λ0, equation 14 can be rewritten in the excess return form as:

E(Ri) – Rf = λ1bi1 + λ2bi2 + … + λkbik ( 15 )

Assuming there is only one stochastic factor, k, affecting stock returns, the APT looks very
similar to the CAPM, as CAPM can be considered as a special case of the APT model. Figure
7 below illustrates this relationship. In equilibrium, all assets must lie on the arbitrage pricing
line. The point A is the price of risk in equilibrium for the kth factor.

30
Using the slope-intercept definition of a straight line, the linear arbitrage pricing relationship
can be written as:

E(Ri) = Rf + λbik ( 16 )

E(Ri)

E(Ri) = Rf + λbik

Arbitrage Pricing Line

A
δk

Rf

bik
bk = 1

Figure 7 – Arbitrage Pricing Line. (Source: Copeland, et al [2005: 222] )

We can also define bik in a similar way as in the CAPM:

𝑐𝑜𝑣 (𝑅𝑖 ,𝐹𝑘 )

bik = ( 17 )
𝑣𝑎𝑟 (𝐹𝑘 )

Where:
cov(Ri, Fk): the covariance between the ith asset’s return and the linear transformation of the
kth factor,
var(Fk): the variance of the linear transformation of the kth factor.

There are several reasons why the arbitrage pricing theory is considered superior to the capital
asset pricing model (Copeland et al. 2005: 222). First, the APT makes no assumptions about
the empirical distribution of asset returns. Second, the APT makes no strong assumptions
about individuals’ utility functions. Third, the APT allows the equilibrium returns of assets to
be dependent on many factors and not just one as in the CAPM. Fourth, the APT yields a
statement about the relative pricing of any subset of assets; hence one need not measure the

31
entire universe of assets in order to test the theory. Fifth, there is no special role for the market
portfolio in the APT, whereas the CAPM requires that the market portfolio be efficient.
Finally, the APT is easily extended to a multi-period framework.

The CAPM is a one-dimensional model and can take into account the effect of only one factor,
the market portfolio, on the rates of return on assets, while the APT is a multidimensional
model that can account for the effect of more than one factor on the securities’ rates of return.

Previous Empirical Studies of the Arbitrage Pricing Theory

Many significant researches have been carried out on the APT ever since it was introduced by
Ross in 1976, and just like the CAPM, the APT has its supporters and also those who criticize
it.

Ingersoll is one of the supporters of the APT model; stating in 1984 in his study that the APT
derives a simple linear pricing relationship that manifests the factors affecting security rates
of return without imposing some of the CAPM’s questionable assumptions.

In 1985, Bruce N. Lehmann and David M. Modest published a study examining the different
strategies for constructing basis portfolios that are highly correlated with the factors affecting
security rates of return. They concluded that as the number of securities included in the basis
portfolios is increased their performance is significantly improved. They also concluded that
using different forms of factor analysis when constructing the basis portfolios was superior to
using the principal components procedures presented in the literature.

Chen, Roll, and Ross (1986), tested the validity of the APT in US stock markets. They used
macroeconomic variables specific for the US economy as the factors affecting securities’
returns. They showed that the macroeconomic variables they used as factors were very helpful
in explaining the stocks’ returns, particularly the following factors; industrial production,
variations in risk premiums, and the shifts in the yield curve.
The relation between risk and return for agricultural assets was examined by Louise M.
Arthur, Colin A. Carter, and Fay Abizadeh (1998) who concluded that the APT was better at
explaining returns for these assets than the CAPM.
32
Puneet Handa and Scott C. Linn (1993) tested the APT in the case of incomplete information
on the parameters generating asset returns. Their results showed a linear relationship between
expected asset returns and their factor betas; however, they also concluded that when there is
more information available, predicted prices were higher while factor betas were relatively
lower. On the other hand, less available information underestimated prices and overestimated
factor betas. Moreover, when the sample size was increased in the factor analysis procedure,
it led to the detection of additional priced factors that do not really exist.

Lee Sarver and George C. Philippatos (1993) examined the nature of spot foreign exchange
risk premiums using the APT. They tested whether the deviations in the pure returns on
currencies depend on measuring systematic risk. They came to the result that expected
exchange returns can be explained by a single-factor APT model.

Regarding the effect of non-stationarity of security returns on the results of APT, Gregory
Koutmos and Panayiotis Theodossiou (1993) tested the effect of conditional
heteroskedasticity in the APT with observed factors. They showed that grouping assets into
portfolios does not diminish the presence of conditional heteroskedasticity, that conditional
heteroskedasticity leads to inefficient estimates of factor betas, and if ignored leads to
erroneous pricing of factors.

Séverine Cauchie, Martin Hoesli, and Dušan Isako (2002) conducted a study on the
determinants of stock returns using an APT framework in the Swiss stock market which is
particular due to the fact that it includes a large number of firms that are susceptible to foreign
economic conditions. They used statistical and macroeconomic implementations of the APT
on 19 industrial sector indices. They concluded that statistically determined factors were better
at explaining determinants of stock returns than macroeconomic variables.

Altay E. (2003) used the factor analysis technique on a group of main economic indicators
from the German and the Turkish economies in order to determine factors that affect security
returns in an APT framework. Altay used the same economic indicators for both countries and
found four factors affecting the German market while he found only 3 for the Turkish market.
The German market had two factors relating to unexpected economic changes; unexpected

33
interest rate factor and unexpected inflation factor. On the other hand, none of the factors of
the Turkish market related to unexpected economic changes.

Raj Dhankar & Rohini Singh (2005) carried out a study to determine the factors that influence
stock returns in India. They analyzed the Indian stock market using monthly and weekly
returns for the period of 1991-2002, their results showed that multi-factor APT provides a
better indication of assets’ risk and estimates of required rates of return than the CAPM does
which uses beta as the single measure of risk.

A study was conducted by Turgut Türsoy, Nil Günsel, and Husam Rjoub (Türsoy et al. 2008)
in which they tested the APT on the Istanbul Stock Exchange (ISE). They used monthly data
for the period February, 2001 till September, 2005. They tested 13 macroeconomic variables
against 11 industry portfolios to analyze the effect of these variables on securities’ rates of
return. Their results concluded that the APT failed to explain the relationship between the
tested macroeconomic variables and the stocks’ returns.

A more recent study was done by M.H.Ebrahimi Sarvolia, A.saleh Ardestani, J.Hajibozorgi,
and H.Ahmadinia, (2010) regarding portfolio management in investment companies listed on
Tehran stock exchange (TSE). They used the CAPM, the APT model, systematic risk
indicators, and unsystematic risk indicators in their testing. They examined 12 firms, selected
from Tehran stock exchange, for the period March, 2005 till March, 2009. The results
suggested that systematic risk, unsystematic risk, CAPM, and APT model should be used
simultaneously to evaluate investment companies’ performance.

Finally, the last study to be mentioned is very similar, regarding the methodology of the
testing, to the one carried out in this paper. Erie Febrian and Aldrin Herwany (2010),
investigated the ability of the CAPM and the APT to explain the risk premiums of portfolios
of stocks traded on the Jakarta Stock Exchange (JKSE). They carried out the testing on three
separate periods; pre-crisis period (1992-1997), crisis period (1997-2001), and post-crisis
period (2001-2007). The results supported the APT, as they suggested that Beta is not the only
factor that can explain the portfolios’ additional returns. Their results showed that excess
return averages were consistently negative, and that risk premiums varied over the observation
periods.

34
The German Financial System and the German Financial Market

The German financial system has always been and still is governed by banks, and is therefore
known to be a bank-based financial system. German households prefer to retain most of their
wealth in the form of bank deposits rather than investing it in the stock market, and companies
seek financing through bank loans rather than turning to the market in the form of initial public
offerings (IPOs). Hence, compared to US stock markets, the German stock market is relatively
underdeveloped which can be observed by the small number of companies listed on the
market, the low capitalisation, and slow activity seen on the market.

The German regulatory system was responsible for the central role of banks. The Banking Act
(Kreditwesengesetz) of 1961 had not put restrictions on the extent of financial services banks
could offer and thus followed a universal banking principle. The only regulation enforced on
banks was through the setting of liquidity and capital standards while direct intervention
through the use of interest rate regulation was limited from the beginning. Moreover,
competition from non-banks was very small due to the wide definition of banks set by the
Banking Act which most financial activities fell under.

Unlike the banking sector, the financial market faced very low regulation from formal
supervisory authorities. Low transparency, accountability, protection of minority
shareholders, and no binding rules against insider trading were some of the characteristics of
the regulatory framework. The self-regulating bodies of the German exchanges were
comprised mainly of big banks which had also dominated the capital markets and used their
power to stabilise the regional structure. The three-pillar structure of the banking system
consisting of private banks, savings banks, and cooperative banks lead to roughly 50 percent
of the banking sector to be of non-profit organisations. That and the regional focus of banks
came in very handy during the financial crisis.

Compared internationally, the profitability of the German banking sector is low; however, this
is outweighed by the fact that German banks offer better financial inclusion, cheaper and better
financial services, and lower-cost funding to SMEs.

35
Changes to the German Financial System5

During the 1970s, attempts were made at the European Exchange Commission (EEC) to
synchronize the banking and security market regulations, the fruit of said attempts began to
appear in the late 1970s; however, with very low grip. By early 1990s the impact of these
regulations strongly amplified and kept increasing up until today where financial market
regulation is fully controlled by EU legislation.

The changes made to the regulatory structure favoured the development of financial markets
through increased investor protection, criminalizing insider trading, and setting the general
framework for a market for corporate control.

Impact of the Financial Crisis in Germany

The “export-led mercantilist” growth model of Germany was the primary reason the country
was highly affected by the financial crisis. Economists and politicians enforced wage
moderation in the hope that it would increase investment demand. On the contrary, the unions’
action led to stagnating wages in the years prior to the crisis due to the establishment of a low
wage sector caused by the comprehensive labour market reforms carried out. The resulting
low domestic consumption growth coupled with the public sector’s attempts to consolidate its
accounts caused the total growth of domestic demand to amount to only 0.85 percentage points
for the period starting from the early 2000s until 2008. External demand was the main driver
of economic growth which averaged 1.44 percent and Germany built up large financial claims
with the rest of the world. Due to this model, the effect of the financial crisis was transmitted
to Germany through two main channels; the trade channel and the financial market channel.

Germany, compared to other EU countries, is much more vulnerable to economic downturns

in its foreign markets, due to the fact that Germany is highly integrated in and dependant on
international trade. Moreover, the nature of the goods the German export industries is
specialized in is highly volatile; such as investment and intermediate goods
.

5
This section relies to a great extent on Detzer et al. 2014
36
The Trade Channel: The effect of the financial crisis on Germany manifested itself by the
decline in the growth of the country’s GDP after the third quarter of 2008 when there was a
collapse in world trade and decreasing net exports highly affected growth. The sharp decline
in investment demand meant that internal absorption of the crisis had began. By the first
quarter of 2010, Germany’s rapid recovery started due to high export demand by emerging
markets, followed by domestic demand in the second quarter of that year.

The financial market channel: Over the past few decades Germany had substantially
increased its international financial integration which caused it to be particularly susceptible
to the financial market channel. By 2007, Germany had a tenfold increase in foreign assets
since 1991, where the level of foreign assets reached €5 trillion (from 58% to 207% of GDP),
half of which were held by German banks. Germany was also vulnerable to external shocks
due to the high correlation between foreign and domestic assets prices. When the crisis effect
reached Germany, foreign financial assets fell by €16 billion, the major stock price indices
collapsed following the collapse of US stock markets, and domestic financial investments
experienced great losses.

Overall, the financial crisis affected Germany most through its banking sector. Many banks
experienced grave losses since they were exposed to the US real estate bubble through their
asset holdings. By the end of 2008, many major banks resorted to government assistance to
refrain from announcing bankruptcy, and so either received emergency loans or were
nationalised depending on the amount of their losses.

The German government intervened heavily to prevent the crisis from spreading to the
financial sector. The government provided guarantees, recapitalised banks, and allowed them
to transfer their toxic assets to state owned banks, the cost of these measures amounted to
€198 billion. Although capital injections have not been fully repaid yet and the bad banks still
hold a significant portion of toxic assets, the government’s actions helped prevent the spread
of a banking sector crisis and stabilised the financial sector.

The question of whether Germany faced a credit crunch remains. Credit growth persisted up
until November 2008 but became negative in January 2009, and it was not until December
2010 that yearly growth rates became positive again. Banking behaviour towards lending

37
became stricter, on the other hand, there are multiple reasons for the decline in credit volume
during that period that are not bank related. During periods of economic uncertainty or
recessions, firms tend to borrow less external funding and households postpone larger
investments, which results in a credit decline due to less demand. Although banks did reduce
their lending due to the deterioration of their borrowers’ creditworthiness, Germany had
witnessed worse periods of weak credit growth such as in 2003. The banking system did not
impose overly restrictive credit policies, managed to control the crisis to a certain extent, and
performed quite well under the prevailing circumstances at the time.

38
DAX Performance Index

Below is a table of the companies currently listed on the DAX index, as of March 21st, 20166

Table 1 – Companies currently listed on the DAX performance index

Company Industry Group Ticker Symbol Index Weighting (%)

Adidas Clothing ADS 2.54
Allianz Insurance ALV 7.97
BASF Chemicals BAS 7.39
Bayer Pharmaceuticals and Chemicals BAYN 9.13
Beiersdorf Consumer goods and Chemicals BEI 0.98
BMW Manufacturing BMW 3.17
Commerzbank Banking CBK 1.05
Continental Manufacturing CON 2.56
Daimler Manufacturing DAI 8.11
Deutsche Bank Banking DBK 2.85
Deutsche Bӧrse Securities DB1 1.67
Deutsche Lufthansa Transport Aviation LHA 0.82
Deutsche Post Logistics DPW 2.83
Deutsche Telecom Communications DTE 6.07
E.ON Energy EOAN 2.03
Fresenius Medical FRE 3.00
Fresenius Medical Care Medical FME 1.94
HeidelbergCement Building HEI 1.24
Henkel Consumer goods, Chemicals HEN3 2.03
Infineon Technologies Semiconductors IFX 1.68
K+S Chemicals SDF -
Linde Industrial Gases LIN 2.66
Merck Pharmaceuticals MRK 1.15
Munich Re Insurance MUV2 3.66
RWE Energy RWE 0.64
SAP Software SAP 8.15
Siemens Industrial, Electronics SIE 9.06
ThyssenKrupp Industrial, Manufacturing TKA 0.93
Volkswagen Group Manufacturing VOW3 2.58

6
Source: Bloomberg
39
Empirical Tests and Findings

Methodology

The methodology and testing procedure will be described in this section. The data selection
process is first described, followed by describing the testing procedure used and the
modifications made to the model to make it testable. Finally, the empirical results are stated
and analyzed.

Data Selection

The CAPM was tested using data from the Frankfurt Stock Exchange, extracted using the
Bloomberg financial software. The stocks used were taken from the DAX (Deutscher
Aktienindex) index, which is a blue chip stock market index consisting of the 30 major
German companies trading on the Frankfurt Stock Exchange.

Tests were run on 29 out of the 30 listed stocks due to the limited amount of information
available for one of the stocks. The experimental period was from March, 2001 up until the
end of December, 2015.

Monthly closing stock prices were used and amounted to 178 observations. The DAX market
index was used as a proxy for the market portfolio. The risk-free required return was taken as
the monthly closing prices for the German government 10-year bond.

First, testing was performed for the entire period to have an overall result to show the
explanatory power of the model in the long run. Next, the period was divided into three smaller
periods as follows:
1. March, 2001 – December, 2006: This is the pre-crisis period where Germany
experienced credit growth, growth in international trade and also in GDP
2. January, 2007 – December, 2010: The crisis period. Although the effect of the crisis
reached its peak in the 3rd quarter of 2008, warning signs had started in 2007 and that
is why 2007 was included in this period. Recovery began in the 1st quarter of 2010.

40
 3. January, 2011 – December, 2015: The post-crisis period. By 2011, GDP had recovered
from the crisis, and Germany’s economy had become even better than the pre-crisis
period.

Statistical Examination of Tested Data

Before starting to test the model, some statistical tests have been run to ensure that the input
data is suitable for time-series analysis.

The table below shows some of the statistical characteristics of the market portfolio, the risk-
free asset and the stocks included in the testing.

Table 2 –Statistical characteristics of the market index (DAX) and the securities listed on the index
(Source: Author’s Calculations)

Skewene Kurtosis
Mean Median Max Min Std. Dev. ss
- -
DAX 0.003081 0.013130 0.193738 0.293327 0.064457 1.004984 3.204294
- - -
Rf 0.011363 0.016220 0.709676 0.600057 0.129154 0.197868 9.849751
- -
ADS 0.009357 0.007384 0.191014 0.314384 0.077799 0.752867 1.968402
- - -
ALV 0.003873 0.014153 0.433154 0.506473 0.107715 0.975811 5.295569
- -
BAS 0.005961 0.008157 0.226035 0.258195 0.074313 0.436115 1.443439
- -
BAYN 0.004748 0.012889 0.269244 0.328250 0.083371 1.000535 3.004456
- -
BEI 0.003949 0.006563 0.143200 0.189722 0.058829 0.303497 0.184321
- -
BMW 0.005353 0.005659 0.233752 0.305055 0.083694 0.317732 1.126284
- - - -
CBK 0.016227 0.009778 0.365279 0.658420 0.145190 0.862757 4.106569
- - 10.15783
CON 0.014132 0.025903 0.444561 0.731287 0.124186 1.899060 4
- -
DAI 0.002103 0.003898 0.352552 0.383090 0.100401 0.384918 1.995561
- -
DB1 0.008210 0.010629 0.221052 0.251934 0.083538 0.430708 0.839210
- - - -
DBK 0.006983 0.004141 0.377144 0.520327 0.106072 0.614814 3.773487
41
 - -
DPW 0.000582 0.012404 0.266358 0.535716 0.089762 1.470476 7.315552
- - -
DTE 0.002587 0.006607 0.314343 0.406448 0.081679 0.879926 4.884295
- - -
EOAN 0.004128 0.010011 0.223222 0.274802 0.074582 0.706420 1.726443
-
FME 0.005481 0.009416 0.371436 0.281106 0.078072 0.280551 5.797447
- -
FRE 0.009534 0.014607 0.510562 0.421008 0.091612 0.237990 7.967165
- -
HEI 0.002401 0.015385 0.328366 0.443879 0.110256 0.574805 1.845163
- -
HEN3 0.008128 0.012878 0.148932 0.229474 0.061888 0.644777 1.218607
- - -
IFX 0.004887 0.015728 0.840481 0.740998 0.181483 0.191314 5.674522
- - -
LHA 0.002424 0.004511 0.204187 0.500775 0.098545 1.009911 3.201509
- -
LIN 0.005572 0.011514 0.164481 0.210366 0.065973 0.501855 0.663436
- -
MRK 0.007295 0.005954 0.204357 0.319874 0.078530 0.437604 1.241085
- - - - 14.78502
MUV2 0.003355 0.000394 0.533427 0.554153 0.093787 0.817733 9
- - - -
RWE 0.007079 0.007963 0.220579 0.346922 0.083375 0.887020 2.777837
- -
SAP 0.003154 0.006902 0.518136 0.527348 0.101941 0.293180 8.180125
- -
SDF 0.009617 0.013649 0.265464 0.531989 0.110046 1.406605 5.477737
- -
SIE 0.000586 0.008387 0.340458 0.347275 0.093156 0.537030 2.851459
- - -
TKA 0.000453 0.011042 0.261723 0.486568 0.109889 0.782502 2.053366
- -
VOW3 0.007412 0.009521 0.305660 0.596114 0.120889 1.399568 5.405819

The standard deviation is a measure of the volatility of the stocks; it measures the dispersion
of the actual returns of the stocks from their expected normal returns. The standard deviation
values observed are relatively low, which is expected since the stocks included in the DAX
market index are stable blue chips that are not volatile.

Almost all stocks have negative skeweness; therefore the data is negatively skewed and left
side asymmetry is observed; however, the deviation from zero is not significant and so we can

42
assume that the data is normally distributed as perfect symmetry cannot be realistically
expected.

Kurtosis indicates the shape of the distribution, higher values of kurtosis (higher than 3 - the
value for normal distribution) such as the values observed for the returns tested indicate that
the distribution of the returns is leptokurtic; that is, the distribution is more peaked than the
normal distribution.

43
Testing of the Standard Capital Asset Pricing Model

The most common version of the CAPM can be expressed as follows:

E(Ri) = Rf + βi [E(RM) - Rf] ( 18 )

𝑐𝑜𝑣(𝑅𝑖 ,𝑅𝑀 )
𝛽𝑖 = ( 19 )
𝜎 2 (𝑅𝑀 )

A second version of the CAPM expresses the returns in terms of their excess over the risk free
rate of return and can be written as follows:

E(Zi) = βiE(ZM) ( 20 )

𝑐𝑜𝑣(𝑍𝑖 ,𝑍𝑀 )
𝛽𝑖 = ( 21 )
𝜎 2 (𝑍𝑀 )

Where,
E(Zi) = E(Ri) – Rf
E(ZM) = E(RM) – Rf

The next step will be to employ the fair-game model of the efficient market hypothesis which
states that on average, studying a large number of samples, the expected return on an asset
will equal its actual return, in order to prepare the CAPM for testing by transforming it from
expectations (ex ante) into a model that uses actual observed data (ex post).

Mathematically, this step can be expressed as follows;

εi,t+1 = Ri,t+1 – E(Ri,t+1) ( 22 )

E(εi,t+1) = E[Ri,t+1 – E(Ri,t+1)] = 0 ( 23 )

44
Where:

εi,t+1 = The difference between actual and expected return

Ri,t+1 = Actual return
E(Ri,t+1) = Expected return

The second equation, equation (23), simply assumes that the probability distributions of
returns do not change significantly over time; hence, the expected value of the difference
between actual and expected returns is zero.

Finally, the CAPM that will be tested in this paper is:

Zi = βiZM ( 24 )

Methodology of the Empirical Tests

The classical regression equation presented by Black, Jensen, and Scholes [Jensen et al. 1972],
which is based on time series analysis, was employed in testing the CAPM in this paper.

Rit – Rf = αi + βi(RMt – Rf) + eit i = 1,2,....,N ( 25 )

Where:
Rit = an expected return rate on asset i at time t,
Rf = return on the risk-free asset
αi = the measurement of asset i risk that is uncorrelated to the market portfolio M,
βi = the measurement of asset i risk that is correlated to the market portfolio M,
RMt = an expected rate of return on the market portfolio M at time t,
eit = the value of the random error for asset i at time t,
N = number of securities in the market portfolio

The asset’s risk premium, which is the extra reward earned for bearing the undiversifiable
(systematic) risk of the asset, is the difference between the asset’s return and the return on the

45
risk-free asset. While the market risk premium, is the return on a portfolio required by an
investor that is above the risk-free rate of return.

Since the data collected were the closing prices of the stocks, they were converted to returns
using the following equation:

𝑃𝑡
𝑅𝑖 = 𝑙𝑛 𝑃 = 𝑙𝑛𝑃𝑡 − 𝑙𝑛𝑃𝑡−1 ( 26 )
𝑡−1

Where:
𝑃𝑡 = price of the asset at time t
𝑃𝑡−1 = price of the asset at time t-1

Testing the Model

Equation (25) can be rewritten as follows:

Zi = αi + βiZM + εi ( 27 )

Where:
Zi = Ri – Rf : risk premium earned for investing in the risky security
ZM = RM – Rf: market risk premium

First, excess returns were calculated for the market portfolio and for every stock included in
the market index. Second, every stock’s excess return was regressed on the market excess
return individually to obtain the β for each stock. The final step was to determine the alpha
(α) and beta (β) coefficients using the least squares method and thus the regression equations
were obtained.

The Security Market Line (SML) was then calculated by regressing each stock’s average
excess return on its corresponding beta (β).

The previous steps were carried out first for the entire period, and then for the three individual
periods (pre-crisis, crisis, and post-crisis) in order to test whether the model was able to
capture the prevailing economic conditions and reflect them in the results.

46
Empirical Results

Theoretically, if the CAPM holds, alphas calculated by the model must equal the return on the
riskless asset, since the model predicts that the risky asset’s return depends only on the
systematic risk.

Table 3 – Regression results for the period March, 2001 – December, 2015 for certain securities 7(Source:
Author’s Calculations)

Adjusted
Stock Coefficient Std. Error t-statistic R-squared R-squared
0.0048107 1.4245154
Alpha 0.006852943 18 37 0.8181749 0.8171418
ADS 0.0341161 28.141840 07 1
Beta 0.960090891 37 88
0.0032745 0.8747517
Alpha 0.002864431 64 4 0.9134897 0.9129981
BAS 0.0232222 43.109631 22 86
Beta 1.001100621 03 69
0.0038405 0.3630352
Alpha 0.001394262 69 55 0.8882822 0.8876474
BAYN 0.0272361 37.408530 13 52
Beta 1.018863808 35 96
0.0052375 0.3251562
Alpha 0.001703025 59 65 0.7852406 0.7840203
BEI 0.0371431 25.367731 19 95
Beta 0.942237752 61 95
0.0041730 0.4307361
Alpha 0.001797493 73 57 0.8737538 0.8730364
BMW 0.0295941 34.901309 02 94
Beta 1.032874588 5 22
0.0056775 0.5683622
Alpha 0.003226903 47 08 0.7569986 0.7556179
FME 0.0402634 23.415289 36 46
Beta 0.942779632 2 21
0.0058855 1.1879076
Alpha 0.006991534 87 63 0.7514231 0.7500107
FRE 0.0417387 23.065785 17 48
Beta 0.962737567 73 04
HEN3 0.0042648 1.2711318 0.8549384 0.8541142
Alpha 0.005421155 25 04 76 63

7
The table representing the regression results for all stocks is found in the appendix.
47
 0.0302448 32.206805
Beta 0.974089387 31 25
0.0035813 0.8006638
Alpha 0.002867441 3 52 0.8931128 0.8925055
LIN 0.0253976 38.348354 4 27
Beta 0.97395967 91 4
0.0055366 0.8237248
Alpha 0.004560698 76 6 0.7783021 0.7770425
MRK 0.0392644 24.857056 49 02
Beta 0.975997544 05 96

The regression results have shown alpha values that are not quite equal to zero but are very
close to zero. On the other hand, the coefficients of determination have values high enough to
conclude that it is possible to apply the CAPM to the German market. Low standard errors
coupled with high t-statistic values validate the conclusion made.

The CAPM equation for every stock included in the DAX market index that was obtained
from the regression analysis is as follows:

Ri = 0.000869 + 0.012561*βi ( 28 )

0.03

0.025

0.02

0.015
Securities
0.01
SML
0.005
Ri

0
0 0.5 1 1.5
-0.005

-0.01

-0.015
Beta

Figure 8 – The Security Market Line (SML) (Source: Author’s Creation)

48
The security market line (SML) is depicted in Figure 8 above using equation (28) derived in
the regression analysis performed. The securities form a cluster due to the high correlation
between their returns; this is expected since there are only 30 securities in the DAX market
index, which is a small sample compared to other indices. We can also notice that the
securities are mispriced since they do not lie on the SML, this fact means that investors can
benefit from riskless arbitrage opportunities present due to the mismatch between expected
and real prices. A rational investor would sell short securities lying under the SML as they are
overpriced and their prices will fall, while buying securities lying above the SML as they are
underpriced and their prices will rise. The CAPM can be used in that manner by investors who
are trying to predict asset price movements.

Periodic CAPM

In order to gauge how well the CAPM reflects the prevailing economic conditions, the entire
testing period was split into three periods; pre-crisis, crisis, and post-crisis, based on when the
crisis effect reached the German market. Regression analyses were carried out again for each
period and the CAPM equation was derived for every period and analyzed as follows.

Pre- crisis Period

The pre-crisis period was taken from March, 2001 – December, 2006. First, the excess returns
for each stock were regressed on the market excess return to calculate the beta for each stock.
Second, the average excess returns for each stock were regressed on their corresponding betas
to derive the SML equation.

The CAPM equation for this period was:

Ri = 0.016683 - 0.012408*βi ( 29 )

49
 1.8

1.6

1.4

1.2 Securities
SML
1
Linear (SML)
Ri

0.8

0.6

0.4

0.2

0
-0.1 0.1 0.3 0.5 0.7 0.9
Beta
Figure 9 – Pre-Crisis Period SML (Source: Author’s Creation)

The CAPM specifies that the intercept should equal the return on the riskless asset and the
beta coefficient should equal the excess return on the market portfolio, but this is not the case
here. The intercept is 0.016683 with a t-value of 4.5; meaning that it is significantly different
from the risk-free proxy value for this period, that is -0.002654. The beta coefficient has the
“wrong” sign and is not equal to the excess return on the market portfolio for the period, which
was in this case equal to 0.003521. One of the reasonable explanations for these values is the
fact that the German market is bank-based and the stock market is controlled by banks and
not by the market forces of supply and demand, thus the beta values for the securities are very
close to zero, as they are not moving with the market in the economical and theoretical sense.
Once again, the securities lie in a cluster; that is due to the fact that their returns are highly
correlated.

50
Crisis Period

As mentioned before, the crisis hit the German economy in the 3rd quarter of 2008 when GDP
growth started declining. Recovery began in the 1st quarter of 2010 and continued throughout
the year. The time-frame taken for this period is from January, 2007 – December, 2010. The
year 2007 was included as that is the year Germany’s foreign asset position started weakening
and hence, the onset of warning signs that the crisis was reaching the German economy.

The CAPM equation derived for this period is:

Ri = 0.008602 - 0.005046*βi ( 30 )

0.04

0.03

0.02

0.01

Securities
0
Ri

SML
0 0.5 1 1.5 2 2.5 3
Linear (SML)
-0.01

-0.02

-0.03

-0.04
Beta

Figure 10 – Crisis Period SML (Source: Author’s Creation)

Despite the fact that the SML is slightly flatter in this period, it remains negatively sloped;
however, in this period particularly it does not come as a surprise that the beta coefficient is
negative due to the crash in the market indices witnessed in the German market as they
followed suit the crash in the major US market indices. The intercept, at 0.008602, is closer

51
to zero. The excess returns are more dispersed than in the previous period and some are
negative, which is due to the crisis causing the decline in GDP witnessed during this period
and the losses in domestic financial investment.

Post-Crisis Period

The German economy had a fast recovery from the crisis; growth rates on a yearly basis were
positive again by December, 2010 and a return to pre-crisis levels was reached by spring of
2011.

The CAPM equation derived for the period January, 2011 – December, 2015 is:

Ri = - 0.000294 + 0.030543*βi ( 31 )

0.06

0.05

0.04

0.03
Securities
Ri

SML
0.02
Linear (SML)

0.01

0
0 0.2 0.4 0.6 0.8 1 1.2 1.4

-0.01
Beta

Figure 11 – Post-Crisis Period SML (Source: Author’s Creation)

The SML is positively sloped with an intercept of zero. Excess returns are all positive again
and positively correlated with the market index. This fast recovery was due to the rapid
resumption of external demand for exports by emerging markets. The German banking system

52
also obviated aggravating the crisis by avoiding overly restrictive credit-policies which,
together with the actions of the German government, helped the fast recuperation back to pre-
crisis levels.

53
Testing of the Arbitrage Pricing Theory

Over the years the APT have been tested many times using different methods to specify the
relevant factors that affect stock returns that are to be included in the model. One of these
methods is factor analysis; a statistical method that uses multivariate statistical models which
generate factors affecting returns, however, without these factors being identified.
Another method is selecting macroeconomic variables that the researcher deem relevant
depending on the economic influences that affect security returns.

In this paper, the approach used is that of Fama and French (1993) that involves specifying a
set of portfolios affecting the return-generating process. These portfolios are (Elton 2011b):
1. the return on a market portfolio (the DAX market index was used as a proxy)
2. the difference in return on a portfolio of small stocks and a portfolio of large stocks
(small minus large),
3. the difference in return between a portfolio of high book-to-market stocks and a
portfolio of low book-to-market stocks (high minus low),
4. the difference between the monthly long-term government bond return and the one-
month Treasury bill return (long minus short).

It must be noted here that due to the nature of the German market and the availability of data,
the 10-year government bond was used as a proxy for the long-term government bond, while
the 2-year government bond was used as a proxy for the Treasury bills.

The functional form of the model, which will be tested in this paper, is as follows (Reilly,
Brown 2009: 241:243):

(Rit – Rft) = αi + bi1(RMt – Rft) + bi2SMBt + bi3HMLt + bi4LMSt + eit ( 32 )

Elements of risk associated with firm size are captured by SMB, while elements of risk
associated with growth (low book-to-market ratio) and value (high book-to-market ratio)
firms is captured by HML. The LMS captures elements of risk associated with the long-term
and short-term dimensions of relative return variability.

54
Methodology of the Empirical Tests

Once again, the DAX market index was used as a proxy for the market portfolio. Excess
returns were calculated for the market portfolio and for the individual stocks in the market
index.

To calculate the SMB (small minus big) factor, first, for each month, stocks were arranged
according to their monthly market capitalizations and split into two equally-weighted
portfolios. The return on the portfolio of “big” stocks – calculated as the average excess return
of all stocks included in the portfolio – was then subtracted from the return on the portfolio of
“small” stocks – which was also the mean of the excess returns of all stocks in the portfolio.

The HML (high minus low) factor was calculated in the same fashion used to calculate the
SMB factor, stocks were arranged according to their book-to-market ratio – calculated as the
inverse of the price-to-book ratio – and split into two equally-weighted portfolios. For each
month, the return on the portfolio of “growth” stocks (mean of excess returns of all stocks in
the portfolio) was then subtracted from the return on the portfolio of “value” stocks (mean of
excess returns of all stocks in the portfolio).

The last factor included, the LMS (long minus short), was calculated monthly by subtracting
the excess returns on the 2-year government bond from the excess returns on the 10-year
government bond.

Each stock’s excess returns were then regressed on each of the factor portfolio’s returns to
obtain the monthly factor values for the entire period.

Now that we have the monthly values for each factor and the average excess returns of each
stock, the last step is to calculate the factor loadings (bij’s) in order to obtain the equation for
the APT model.

The factor loadings were derived by the use of multiple regression, where the dependent value
was the average excess returns of the stocks, and the independent values were the factor
portfolios values.
55
Empirical Results

The following results are for the entire testing period from March, 2001 – December, 2015,
the data tested includes the monthly returns for the DAX market index and 29 of the 30 stocks
listed on the index.

The APT suggests that the intercept of the time series of excess returns must equal zero. The
following equation resulted from the regression analysis carried out for the entire testing
period:

Rit – Rft = 0.013839 + 0.001632SMBt + 0.002497HMLt + 0.217352LMSt ( 33 )

The intercept is very close to zero, as the APT would suggest. The factor loadings are all
positive when the APT is tested for the entire period.

The adjusted R-squared value was 20.19%, meaning that the model was able to explain
20.19% of the variation in the returns of the securities. This is a slightly higher value than the
adjusted R-squared value of 17.98% observed for the CAPM.

The sensitivity of returns to firm size is 0.001632, the fact that the factor loading has a positive
sign means that small capitalization stocks outperform large capitalization stocks, which is
actually the case in the German market.

The HML factor loading is 0.002497 which is the degree of sensitivity of security returns to
value versus growth firms. It can be noticed that value stocks (stocks with high book-to-market
ratio) outperform growth stocks (stocks with low book-to-market ratio) since the sign of the
factor loading is positive and that is observed in the German market as well.

Finally, the sensitivity of stock returns to dimensions of long-term and short-term variability
of return is 0.217352 which is the highest value for a factor loading observed for the entire
period; this says that stock returns in the German market are more sensitive to the investment
period considered.

56
Next, we will examine the APT for the three different sub periods, pre-crisis, crisis, and post-
crisis to see how well it performs in terms of explaining the variation in the returns of stocks
under the prevalent economic conditions in each sub period.

Periodic APT

Pre-Crisis Period

For the pre-crisis period from March, 2001 – December, 2006 regression analysis was run on
the data in the same manner used for testing the entire period.

First, the data was arranged according to their market capitalization and then their book-to-
market ratios to construct the factor portfolios and their values were then derived via time-
series analysis. Next, the factor loading were determined by regressing the average excess
returns of the stocks on the three factor portfolios via multiple regression.

The following equation for the pre-crisis period was obtained:

Rit – Rft = 0.016731 + 0.002203SMBt + 0.003115HMLt - 0.000149LMSt ( 34 )

The intercept and first two factor loadings, those relating to firm size and book-to-market
ratio, have values higher than those obtained for the entire period, this means that for the pre-
crisis period stock returns were more sensitive to the firm size, where small capitalization
stocks outperformed large capitalization stocks in the market. Moreover, value stocks of firms
with high book-to-market ratios outperformed growth stocks of firms with low book-to-
market ratios. On the other hand, the factor loading for LMS is much lower and has a negative
sign.

The adjusted R-squared value for this period is 20.65% this is slightly lower than the adjusted
R-squared value for the CAPM which was 24.45%. Yet, the R-squared value for the APT
(29.15%) is higher than the R-squared value for the CAPM (27.05%), but that is attributed to

57
the extra factors included in the APT model. The inference that can be made here is that the
explanatory power of the CAPM was better than that of the APT for this period.

Table 4 – Pre-crisis period regression results (Source: Author’s calculations)

Standard
Coefficient T-statistic P-value
Error
α 0.016731 0.002117 7.905024 2.919315
SMB 0.002203 0.002616 0.842133 0.407698
HML 0.003116 0.004026 0.773825 0.446291
LMS -0.000149 0.008273 -0.018013 0.985771

Crisis Period

The APT equation for the period January, 2007 – December, 2010 is:

Rit – Rft = 0.015896 + 0.000683SMBt + 0.008101HMLt - 0.021293LMSt ( 35 )

It is interesting to see here the significant drop in the values of the factor loading (bij’s). The
turbulent economic conditions and the crashes in the DAX and CDAX market indices
witnessed during the crisis period are apparent in the regression results, as the stock returns
have become desensitized to such factors as firm size and the growth stage at which the firm
is, since the entire German economy was suffering and the main aim of the government and
the banking system at that period was to prevent a credit crunch from spreading throughout
the entire economy. The factor loading for LMS is once again negative, but it has a higher
value than the one observed in the pre-crisis period.

The adjusted R-squared value of the model for the crisis period was 11.38% which is very low
compared to the values observed before. The adjusted R-squared value for the CAPM for the
same period was 1.03%. The APT was far better able to explain the variation in stock returns
in this period and that is due to the fact that the APT employs more factors in calculating the
expected return than the CAPM does.

58
However, this is not concrete evidence that allows us to prefer one model over the other, or
proclaim that one model is better than the other since the sample taken is relatively small and
the number of observations in each period is not enough to be conclusive.

Table 5 – Crisis period regression results (Source: Author’s calculations)

Standard
Coefficient T-statistic P-value
Error
α 0.015896 0.001837 8.653378 5.453505
SMB 0.000683 0.001806 0.377997 0.708623
HML 0.008102 0.003569 2.270341 0.032063
LMS -0.021293 0.010919 -1.949987 0.062477

Post-Crisis Period

The post-crisis period January, 2011 – December, 2015 had the following APT equation:

Rit – Rft = 0.008318 - 0.001567SMBt + 0.003623HMLt + 0.222541LMSt ( 36 )

Both the APT and the CAPM produced intercepts very close to zero in the post-crisis period,
which is reflective of the reality in the German market, as the return on the riskless asset is
now very close to zero and even negative in some time periods.

The factor loading corresponding to the firm size SMB is negative in this period, which may
indicate that high capitalization stocks are now performing better than low capitalization
stocks. This could be due to the fact that during the crisis, larger firms were supported heavily
by the German government; they were provided with guarantees and loans that they were able
to pay back with no additional costs, therefore helping propel them into recovery and they
recuperated so well that they started to perform better than small capitalization firms, those
that were outperforming them in previous periods.

59
The factor loading for LMS is positive in this period and significantly higher than previous
periods. A reasonable explanation is that during turbulent periods, such as in an economic
crisis, investors prefer short-term investments to longer-term investments as they cannot
predict how the circumstances might change and affect their investments. On the other hand,
in periods of economic stability, investors prefer long-term investments to short-term
investments as they are better able to predict the future.

The adjusted R-squared value for this period is 33.56%, the highest value obtained for APT
so far. While the adjusted R-squared value for CAPM for the same time period was 46.34%,
these values suggest that both models were better able to explain the variation in stock returns
in periods of economic stability than in periods of economic instability.

Table 6 – Post-crisis period regression results (Source: Author’s calculations)

Standard
Coefficient T-statistic P-value
Error
α 0.008318 0.002010 4.137273 0.000348
SMB -0.001567 0.001608 -0.974859 0.338969
HML 0.003624 0.001612 2.248265 0.033621
LMS 0.222541 0.144234 1.542914 0.135416

60
Summary

The following is a summary of the findings. A comparison is made regarding the performance
of both asset pricing models for the entire period and for each sub period.

The following table depicts the results obtained from both models for the entire testing period.

Table 7 – Summary of results for the entire testing period (Source: Author’s calculations)

CAPM APT
R2 0.209095 R2 0.287425
Adjusted Adjusted
0.179802 0.201915
R2 R2
Coefficien Std Coefficien Std
t-stat t-stat
t Error t Error
Intercep
Intercept 0.00344 2.47950 0.00273 5.06097
0.008544 0.013839
6 6 t 4 9

SMB 0.00195 0.83440

Beta 0.001631
5 1
Coefficien 0.00334 HML 0.00223 1.11534
-0.00894 -2.67172 0.002496
7 8 9
t 0.15807 1.37501
LMS 0.217352
2 6

The R2 and Adjusted R2 numbers show that the APT explained the variations in the stocks’
rates of return better than the CAPM did. That can be attributed to the fact that the APT
employs more factors in calculating the securities’ expected returns than the single-factor
CAPM, which confirms that stocks’ rates of return are influenced by more than one factor and
not just the return on the market portfolio as the CAPM suggests.

The intercepts from both models are very low, close to zero, and different from the average
risk-free rate of return prevalent during that period, however, their t-values are high indicating
that they are significantly different from zero.

The beta coefficient from the CAPM, which is -0.8%, indicates that the securities’
responsiveness to movements in the German market is low. But, this conclusion is based on a

61
small number of securities and cannot be regarded representative for the entire German
market. Moreover, as it is always the case in studies done before, there are measurement errors
when estimating the betas for the securities, the market portfolio, and ultimately the beta
coefficient for the entire model.

The coefficients of the factors from the APT model also indicate low responsiveness of
securities to the first two factor portfolios, the SMB and HML. On the other hand, the factor
loading for the LMS factor portfolio is much higher at 21.7%.

The tables below summarize the key results for all three sub periods; pre-crisis, crisis, and
post-crisis.

Table 8 – Summary of results for pre-crisis period (Source: Author’s calculations)

Sub
Perio CAPM APT
d
R2 0.270574 R2 0.291538
Adjusted Adjuste
0.244523 0.206522
R2 d R2
Coefficien Std Coefficien Std
t-stat t-stat
t Error t Error
Pre-
Intercep
Intercept 0.00370 4.49839 0.00211 7.90502
Crisis 0.016683 0.016731
9 9 t 7 4

SMB 0.00261 0.84213

Beta 0.002203
6 3
Coefficien HML 0.00402 0.77382
-0.012408 0.00385 -3.22279 0.003116
6 5
t 0.00827
LMS -0.00015 -0.01801
3

62
Table 9 - Summary of results for crisis period (Source: Author’s calculations)

Sub
Perio CAPM APT
d
R2 0.044416 R2 0.208736
Adjusted Adjusted
0.010288 0.113784
R2 R2
Std Coefficien Std
Coefficient t-stat t-stat
Error t Error
Crisis 0.00499 1.7231 0.00183 8.65337
Intercept 0.008602 Intercept 0.015896
2 55 7 8
SMB 0.00180 0.37799
Beta 0.000683
6 7
- -
Coefficien 0.00442 HML 0.00356 2.27034
0.00504595 1.1408 0.008102
3 9 1
t 3 2
LMS 0.01091
-0.02129 -1.94999
9

Table 10 - Summary of results for post-crisis period (Source: Author’s calculations)

Sub
Perio CAPM APT
d
R2 0.481941 R2 0.406749
Adjusted Adjuste
2 0.463439 0.335559
R d R2
Coefficien Std Coefficien Std
t-stat t-stat
t Error t Error
Post- Intercep
Intercept 0.00594 0.00201 4.13727
-0.000293 -0.04942 0.008317
Crisis 7 t 0 2
-
SMB 0.00160
Beta -0.001567 0.97485
7
9
Coefficien 0.00598 5.10371
0.030543 HML 0.00161 2.24826
4 8 0.003623
t 1 5
LMS 0.14423 1.54291
0.222541
4 4

The R2 value is a descriptive statistic that shows the amount of variation in the dependent
variable, being the securities’ rates of return here, which is explained by the independent
variables, the risk of the market portfolio and the factor portfolios in this case. However, the
R2 value increases as the number of variables introduced into the model increases, regardless
of whether they actually add any explanatory power to the model or not. The adjusted R2

63
variable, on the other hand, does adjust the statistic based on the number of independent
variables and whether they have added explanatory power or not. Therefore, the adjusted R 2
value is more relevant when comparing the explanatory power of the two models. For the sub-
periods, generally, from this value, we can see that the CAPM was better able to explain the
variation in the rates of return of the stocks listed on the DAX index.

Seeing that for the entire period the APT was superior to the CAPM, but when the entire
period was broken into sub-periods the CAPM advanced the APT, an inference can be made
that for longer periods of time, it is preferable to use the APT model to analyze the market and
predict stock returns, while for shorter periods of time, the CAPM can be more useful. One
reasonable explanation can be that for shorter periods of time, securities’ rates of return are
more susceptible to changes in the return on the market portfolio and respond faster to the
current prevailing market conditions. For longer periods of time, the effect of other factors;
such as firm size and book-to-market ratios, are affecting stocks’ returns to a greater extent
and cause further changes in these returns.

Finally, it cannot be concluded which asset pricing model is superior or recommended to be

used over the other; after all, the CAPM is regarded as a special case of the APT. Therefore,
this study suggests that both asset pricing models are useful and should be used jointly to
predict securities’ rates of return in order to make investment decisions and form efficient,
well-diversified portfolios by the rational investor.

64
CONCLUSION

The objective of this paper was to go into depth into the Capital Asset Pricing Model and the
Arbitrage Pricing Theory model; two of the most important asset pricing models which are
regarded as two very influential theories in the world of finance.

The empirical tests carried out on both models aimed at evaluating the performance of each
model both in the short and long run. Time-series regression analysis of the monthly returns
of 29 stocks listed on the DAX index of the German market was done over the period March,
2001 – December, 2015. The time-series analysis was first performed for both models for the
entire testing period to evaluate their performance in calculating securities’ expected returns
and explaining the variation in the returns over the long-run. The testing period was then split
into three sub-periods; pre-crisis period, crisis period, and post crisis period, and the time-
series regression was run again for each period to asses each model’s ability to reflect the
prevailing economic and market conditions and gage their performance over shorter periods
of time.

The first regression analyses were of the CAPM. The intercept and beta coefficients obtained
were analyzed. Although they did not accurately represent the predominant economic
conditions for each corresponding period, they were, however, statistically significant and
varied similarly to the variation observed in reality. Security market lines (SMLs) were then
plotted using the CAPM equations that resulted from the regression analyses performed. The
assets did not lie on the SMLs which indicated that the securities in the German market are
mispriced, a situation that arbitrageurs can take advantage of to earn riskless profits.

Next, the APT model was tested using the method of specifying a set of portfolios that affect
the return-generating process as the common risk factors in the model. The factor loadings
were then calculated using regression analysis. The results formed equations showing the
linear relationship between return and the common risk factors affecting returns.

The explanatory power of both models were analyzed and compared using the Adjusted R 2
values from the regression results. The values indicated that the CAPM showed more

65
explanatory power during the sub-periods than the APT model did. On the other hand, for the
entire testing period, the APT model was superior in its explanatory power to the CAPM.

The tests did not give conclusive results that favoured one model to the other. Both models
varied in their performance from one period to the next. Moreover, the tests showed that
securities’ rates of return are influenced by many risk factors, some of which are systematic
while others are idiosyncratic, as well as the return on the market portfolio. Therefore, to
conclude, rational investors, regardless of their risk-preferences, are recommended to use both
models, the CAPM and the APT model, adjacently when making investment decisions so as
to construct well-diversified and efficient portfolios that maximize their expected returns for
their preferred level of risk.

66
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APPENDICES

Appendix 1: Regression results for the period March, 2001 – December, 2015

70
Appendix 1

Regression results for the period March, 2001 – December, 2015

Adjusted R-
Stock Coefficient Std. error t-statistic R-squared
squared
0.00043086 0.09653916
Alpha 0.00446313
7 6
Rf 0.79085871 0.78967040
- -
2 9
Beta 0.81653608 0.03165115 25.7979915
9 6
0.00685294 0.00481071 1.42451543
Alpha
ADS 3 8 7 0.81817490
0.81714181
0.96009089 0.03411613 28.1418408 7
Beta
1 7 8
- -
0.00492350
Alpha 0.00802095 1.62911553
ALV 2 0.84313792 0.84224666
4 2
4 2
0.03491596 30.7571907
Beta 1.07391697
4 9
0.00286443 0.00327456
Alpha 0.87475174
BAS 1 4 0.91348972 0.91299818
1.00110062 0.02322220 43.1096316 2 6
Beta
1 3 9
0.00139426 0.00384056 0.36303525
Alpha
BAYN 2 9 5 0.88828221 0.88764745
1.01886380 0.02723613 37.4085309 3 2
Beta
8 5 6
0.00170302 0.00523755 0.32515626
Alpha
BEI 5 9 5 0.78524061 0.78402039
0.94223775 0.03714316 25.3677319 9 5
Beta
2 1 5
0.00179749 0.00417307 0.43073615
Alpha
BMW 3 3 7 0.87375380 0.87303649
1.03287458 34.9013092 2 4
Beta 0.02959415
8 2
- -
0.00834352
Alpha 0.02011228 2.41052492
CBK 9 0.64194022
5 5 0.64396316
4
1.05569647 0.05916974 17.8418291
Beta
8 5 7
0.01000120 0.00705451
Alpha 1.41770373
CON 8 2 0.72316706
0.72159415
1.07271331 0.05002843 21.4420731 4
Beta
5 3 9
71
 - -
Alpha 0.00210996 0.00451426 0.46739927
DAI 0.86571192 0.86494892
2 9
7 6
1.07835259 0.03201374 33.6840507
Beta
7 5 4
0.00653993 1.29620143
Alpha 0.00504546
DB1 3 8 0.78324573
0.78201418
0.90234422 0.03578085 25.2186324 9
Beta
7 5 6
- -
0.00552716
Alpha 0.01060042 1.91787741
DBK 3 0.79910947 0.79796805
1 8
8 4
1.03712695 0.03919694 26.4593853
Beta
5 1 3
- -
0.00504825
Alpha 0.00263112 0.52119543
DPW 8 0.81866965 0.81763937
9 6
7 1
1.00917599 0.03580069 28.1887254
Beta
4 6 7
- -
0.00539176
Alpha 0.00509946 0.94578812
DTE 5 0.78196979 0.78073099
7 8
9 1
0.96066916 25.1242436
Beta 0.03823674
6 1
-
0.00445471
Alpha 0.00581151 -1.30457531
EOAN 7 0.82283770 0.82183110
4
6 2
0.90322890 0.03159148 28.5908968
Beta
2 5 6
0.00322690 0.00567754 0.56836220
Alpha
FME 3 7 8 0.75699863 0.75561794
0.94277963 23.4152892 6 6
Beta 0.04026342
2 1
0.00699153 0.00588558 1.18790766
Alpha
FRE 4 7 3 0.75142311 0.75001074
0.96273756 0.04173877 23.0657850 7 8
Beta
7 3 4
-
-9.38211E-
Alpha 0.00671332 0.01397536
HEI 05 0.69764845 0.69593054
4
4 7
0.95941349 0.04760880 20.1520185
Beta
9 4 9
0.00542115 0.00426482 1.27113180
Alpha
HEN3 5 5 4 0.85493847 0.85411426
0.97408938 0.03024483 32.2068052 6 3
Beta
7 1 5
72
 - -
0.01097367
Alpha 0.00966881 0.88109139
IFX 9 0.53962156 0.53700577
4 4
5 9
1.11775245 0.07782195 14.3629449
Beta
8 5 7
- -
0.00524361
Alpha 0.00596475 1.13752624
LHA 9 0.81393606 0.81287888
4 2
9 8
1.03181396 0.03718613
Beta 27.747278
2 3
0.00286744 0.80066385
Alpha 0.00358133
LIN 1 2 0.89250552
0.89311284
0.02539769 7
Beta 0.97395967 38.3483544
1
0.00456069 0.00553667
Alpha 0.82372486
MRK 8 6 0.77830214 0.77704250
0.97599754 0.03926440 24.8570569 9 2
Beta
4 5 6
- -
Alpha 0.00720357 0.00503521 1.43063982
MUV2 0.83172270 0.83076658
1 7
6 5
1.05317444 0.03570815 29.4939440
Beta
2 9 9
- -
0.00512854
Alpha 0.00913418 1.78104876
RWE 2 0.78756265 0.78635562
3 7
2 2
0.92902469 0.03637004 25.5436794
Beta
4 2 1
-
- 0.00528712
Alpha 0.02348720
SAP 0.00012418 2 0.80593935 0.80483674
1
8 1
1.01369670 0.03749464 27.0357725
Beta
1 5 6
-
- 0.00528712
Alpha 0.02348720
SDF 0.00012418 2 0.80593935 0.80483674
1
8 1
1.01369670 0.03749464 27.0357725
Beta
1 5 6
- -
0.00396410
Alpha 0.00280990 0.70883658
SIE 5 0.88244261 0.88177467
3 2
1 1
1.02180889 0.02811221 36.3475048
Beta
5 6 2
- -
TKA 0.00577673 0.76983662
Alpha 0.00344653 0.59662323 0.76852888
1 7
2 5
73
 0.99396149 0.04096680 24.2626096
Beta
9 1 9
0.00492174 0.00733255 0.67121791
Alpha
VOW 4 8 3 0.65904580 0.65710856
3 0.95911683 0.05200024 18.4444671 3 3
Beta
8 7 3

74