CIfAPI'ER 1V

REVLEW OF LITERAlURE

This chapter deals with the d~scuss~on on the earller stud~es relevi~nt

for the present topic of research. The stud~es are dlvlded ~ n t o live d~f le re~i l

groups

( I ) Studies on behaviour of share prlces a11(1 retllrtis

(2) Studies on r ~ s k return relat~onslup

(3) Studies on diversificat~on and portrolio r ~ s k

(4) Stud~es on Capital Asset prlclng model 5 : A'c 8 .

( 5 ) Studies on determinants of r~sk

Studies on Behaviour of Share Prices and Returns . *--.-/ ~ o o ~ ~ t e r l studied weekly price data on 45 stocks fro111 New Yl~rk.

stock Exchange testing the randon~ness by nieans a n~ean square successive

d~fference test and according to 111111 ~ I I C F I O C ~ IirIce iiplicar 10 I I I O \ ' ~ :II

random

Bourno H solaik2 tested whether European sLock prlces follow

random walk A sample of 234 securlhes fro111 e~ght Inajor European ~narkrt

' ~ o o n t e r , Paul, H . "Stock Pr~ces: Random Vs Systeinat~c Changes". lrldustnal Management Revtew. Vol 3 , No 2. 1962. pp 24-25

2 ~ o u r n o H Solaik, "Notes On The Validity of The Random Walk For European Stock Market", Journal of Finance, Dec., 1973. pp. 1153-1 168

102

were used In his study. The data base cons~sted of daily prices and cl~v~dencl

data for a per~od of five years from March 1966 to Apr~l 1971 He tested llie

data using serial correlation test and found that departure from the r a n d o ~ n ~ ~ r t s

of rate of return gets less s~gnificant wltli Incrcaslng tlti1e tnterval

Sharma and ~ennedy ' tested randorllness In the shares In thr stock

market of India in comparison to stock market 111 U S and Londolt The test

per~od covered 132 monthly observation for each ~ndex for eleven years f ro~n

1963 to 1973. The test methodology irt~llsetl nor1 parantetrlc tryt for

randomness by an analysis of runs of cortsecutl\e price c l l i ~~~ges o f t l~e S ~ I I I I ~

slgn and a parametrrc test for ~ndependence by it11 ex s~ t t~na t~on of rtruclurnl

densit~es of the data for any cyclical co~llpolle~lt or l>e r~od~c~ ty I t w;ts

observed that Bombay Stock Exchange ohey a randon1 walk a~td are equ~vale~tt

in this sense to the behaviour of stock prices In llte litarkel of adva~lcecl

~ndustrialised countries

~ u p t a ~ In his doctoral thesis analysed the randor11 hehav~our 01 s t o ~ k

prlces by uslng serlal correlat~on and run test He took Econoln~c T~lire.;

Index. Flnanclal Express Index and further 39 ~nd~vldual shares from January

1971 to March 1976 He concluded share prlces follow randomness

3 ~ h a r m a , J .L and Robert E. Kennedy. "A Comparative Analys~s of Stock Price Behaviour on Bombay. London and New York Stock Exchanges". Journal of Financial and Quanritarive A ~ ~ a b s r s . Sep , 1977. pp 39 1-4 1 I

4 ~ u p t a , 0 P. , Behaviour of Slzare Pnces 111 Irldta A Tesr of Mnrkrr Eflciency, National Publishing Base. 1984

Eugene ~ a r n a ~ studied two separate hypothesis

(I) Successive price changes are independent

( i i) The price changes confirm to some probability distributio~i

Daily share price data o f 30 stocks of Dow Jones Industrial average

from December 1957 to September 1962 were analysed hy the hell) o f

frequency distribution double log and probabtltty graphs, range analysis.

sequential variance. run test and serial correlation The sludy coi~cludc(l

strong and voli im~nous evldence 111 favour of rai~doini~e.is iii tllc sliilre price

hehav~our

~endal%analqsed the hcIiav~i,ur of uxckly llrlcc c l ~ n ~ ~ g c . ~ III 19 i l i i l~ccr

of Brit ish Industrial share prtces and two c o i ~ i i i ~ i ~ d ~ t y (co l t i~n slid WIICR~) ~ l )o t

p r ~ c e series After an extetisive analysis of srri i i l ccrrrrl;ltio~l Keildal Iok~ild

the stock price changes behave as i f tllcq had hreri pencrated I)y a suital~ly

designed roulette wheel

~ober ts ' conducted a simiilatioi~ test with a serles o f nuiiibcr crcinccl

by cu~ninulating random numbers He found tliar the later series ~)rinluces

' ~ugene F. Fama, "The Behaviour o f Stock Market Pr~ces", Tlre Journal of Business, Jan., 1965, pp 34-104

6 ~ e n d a l , M.G., "The Analysis o f Eco~ioinic Time Series Past Prices". Journal of The Royal Starisrrcal Soc~ety Series (General), Vol I 16. N o I . 1953. pp 11-25.

' ~ e n r ~ V . Roberts. "Stock Market Patterns and Financial Analys~s", Journal of Finance, Vo1.14, N o 1. 1959. pp 1-10

104

patterns similar to the pattern o f share price serles. He furtlier showed tliat

the first order difference o f t h~s artlf ic~ally generated series looked very

much l ~ k e first order difference o f stock prlce series

Granger and ~orgensten' ~n t l ie~r study applied spectral ~iietl i<xls lo

a number o f price serles o f New York Stock excllariges 111 gerieral they

found that short run rnovelnents o f stock prlces follow s~niple r a ~ i d o ~ n walk,

however long run movements do not adequately explain tlie satne

Rao and ~ u k h e r j e e ~ used spectral analys~s on weekly price? o i juc t

one company du r~ng 1950-1970 and found evidence contrary to ra~idoni walk

hypothes~s.

~ a l w a r " exa~n~n rd 122 coliiiii<,n stock listed III Bo~nbay Stock

Exchange for the per~od 1963 to 1982 based on montllly c l c ~ s ~ ~ l g prices H e

adopted two non paralnetrlc tests narnely Spearlria~i's rank correlat~ori atid ruli

test for the purpose o f analysls and came out with s~gnl l ica~it results 111

favour o f random walk hypothes~s

live W J Granger and Oskar Morgensten, "Spectral Analys~? 01 New York Stock Market Prices", Kyklas, Vol 16. 1963. pp 1-27

' ~ a o N Krishnan and Mukherjee. K . "Random Walk Hypothes~s. An Empirical Study", A n h a ~ l i t ~ . Vol 14. Nos 1 & 2, pp 53-59.

10~nlguresh B. Yalwar. "Bombay Stock Exchange. Rate of Retur~l And Efficiency", Ind~an Eco~lomic Journal. Apr-Jim. 1988, p 69

105

~ u p t a ' ' studied va r~o i~s aspects o f the returll oli eqillty shares 111

India. Tlie study was for 606 shares for a period o f I 6 years spa11 f r o l l ~

1960-1976. The major findings were (a) Investors tame horr~zon crucially

Influence the degree o f ~narket rlsk faced by hirn (h) Dlvldend y~e ld was

found to be more dominant part of overall return and capital galn colnponellt

IS low compared lo dividend component (c ) there was no strong evltler~cc

to establish the effect o f company s17e on equlty share liolders r e t ~ ~ r ~ ~ s ( d )

returri o f new co~iipanies share were niurc volatile ant1 1 1 x 1 a I ~ ~ g l ~ u r

speculat~ve elenlent (e) rando~~iness was loulitl In the behavioi~r of equity

returns ( f ) i r rat~onal~ty was found In Illdlan ~ n p ~ t a l lriarket heuausc of t l ~ c

preponderance o f speculative ~l~f luence over trlvcstlilcrh ~n f l t t c~~c t .

~ ~ x l t ' s l * study covered 42 colnparlles drawn fro111 14 d~ l le ren l

Industries The analys~s o f shares was done ~ ~ i d ~ v ~ t l u a l l y the per~od of the

study was 20 years fro111 1961 to 1982 He found out that d~v~dends EPS alld

size have powerful influence on share prices.

Prasanna ~ h a n d r a " cons~dered 110 f i r m In all rndustr~es except

banking and insurance and 56 firms o f cotton lext~le ~~ ldus t r y D ~ l l e r e l ~ t

" ~ u p t a . L C , Rare of relunzs oft eqlrrrres Tlie Indrnrl Experre~lce Oxford University Press 1981. D e l h ~

" ~ i x i t , R.K , Behavrour of Sllnre Prrce crrrd Irrvesrr~~enrs rrl Irrdrn. Deep and Deep Publicatron, New Del111, 1986

I3prasanna Chandra, Vnlunrrorr of Equrrres Shnres r t l Irldra, Sultan Chand & Sons, Daryaganj, New Dellii. 1977

I Oh

measures o f return growth risk leverage and con1p;iny slze varlahles were

chosen and tested. The findings were (a) d~v~dend llas i~ very strong

relat~onship with stock prlce (b) growth varlable has a posit~ve hut weak

influence (c) reta~ned earnlng were not s~gnificant (d) rlsk varlables also put

poor performance (e) leverage turned out lo be redundant and posltlve

relat~onsh~p with share prices

STUDLES ON RISK KETURN KEI,A1'IONSIIII'

Fred Ardlttl 's studyi4 presentrrl a !nodel ~ d e r ~ t ~ f y ~ n g dl l feren~ r 1 4

varlables and thew effect on requlred ratc of rcturrl l i e llatl i l~vldccl r-~sk

varlables into two cateporles (a) those that are (l~rectly ;issoc~eted w l t l ~ t l ~c

probab~lrty d~str~hut lon of return of a firln's stock such ;IT S ~ L ~ I I ~ ;III~ t l i ~ r ~ l

niolnent o f the d~str lhut~on and the coefficient of correlat~on hctweell returll

from a slngle stock and all ava~lable stocks (h) Those varlat~lcs wh~ch are

Interwined with firm's financ~al policies. the d~vldend earlllllg and deht eqrllty

ratlo.

Arditti's Theoretical Justification

According to economlc theory, assumlng that a typical Investor 17 rlsk

averse the ~narg~nal u t ~ l ~ t y o f wealth decreases wit11 lncreasrnp wealth, tile

coeftic~ent o f second moment lnust be negatlve and tlllrd moment be posltlve

I 4 ~ r e d D. Ardittl, "Risk and Requlred Return on Equ~ty" . Jounlnl (?/ F~nance. March. 1967. pp 19-36.

The economic itnplication o f this negattve sign 1s-greater the variablllty o f the

return on Investment the lower the expected uttllty o f the Investment On the

other hand any rlsk prernlutil decreases wttli wealth. Whlch ~tnpltes

coefficient o f third moment must be positlve lrivestors w ~ l l tllerefore accept

a lower expected return from an invest~l~ent wlth a higher poslttve skewness

o f return and same varlance Skewness IS a tiieasure o f asytiimetry factor.

consequently the investor who 1s rtsk averter dtsllkes negative skewt~ess and

l~kes poslttve skewness and securtttes Iiavttig negntlve or just s l~g l~ t l y pos~ t~vc

covariance are mostly welcotrled by the Investors stnce they tetld to reduce

the overall variance o f the portfolio

Then he had considered tile other rrsk variables that are assocrated

with firm's financial policy. The greater the proportton o f debt In the firtil's

capltal structure the more is the financial and harlkruptcy r~sk . conseque~itly.

as the firm's debt equlty ratto increases. tlie rtsk borne h y tlie share li<~lcler

increase and the expected utility o f the tnvesttnent decreases

The effect o f firms d~vtdend policy under dlvtdends do count theory

holds that increase in divtdend pay out IS accoliipanietl hy a decrease III (11s

required rate o f return Since tlie vartabtl~ty o f dlvldend is less than tlie

variability o f stock price any substitution o f d~vidends for capital galtis 111 the

over-all return received by the share holders wi l l reduce the variabtl~ty CIC

return. The other school of thought is that dtvidends have no effect on tlie

108

capitalisation rate. Therefore, the ult~rnate rnodel suggested for empirical

verrficalion 1s

P = a o + alxl + a2x2 + a3xj + a4x4 + asx5

Where,

P = required rate o f return

xl, x2. x3, x4, x5 denoted varrance, skewness, correlatiori between stocks

return and all other market portfolio, debt equrty ratlo a ~ l d

dividend earnir~g respectively The signs o f the coefficiei~ls

are expected to be

a, > 0, a2 > 0, a3 > 0, a4 > 0. as = '1

A sa~nple o f 458 firms f r o ~ n seven industrial classification for a

period 1946 to 1963 was studied. The dependent variable, rate o f r e t u r ~ ~ or1

equ~ties was regressed on indepe~~dent var~ables, vartance o f return, skewness

coefficient, market correlation coeffic~ent. drvrdend earnrng ratto and leverage

ratlo. The results were.

a) Variance o f returns is s~gnrficantly and posrt~vely related to ratc o f

returns

b) Skewness coeflicient is significant but wrth a negatlve slgn whrch irnpl~es

market prefers positive skewness in returns to a negatlve skewness

C) Market correlatiori coefficient not s~gn~f icant

d) Dividendlearning ratlo is sign~ficant In some regressron and weak 111

others. I t has a negative srgn ind~cat~ng t l ~e div~dend preference o f the

~narket.

I09

e) Leverage proved to be not only weakly s ~ g n ~ f i c a ~ ~ t but appeared w ~ t l ~

negative sign wh~ch was found to be difficult to expla~n.

R S . Bower and D S ~ o w e r " exa~n~ned a salnple consist~ng of 100

stocks for 5 cross section years The explanatory variable were earnlllp

growth rate, div~dend pay out ratlo. marketabil~ty of shares. nlarket corrrlat~ot,

coeffic~ent. price variabtl~ty and firm effects The dependent var~able In the

regression was price earning multiples The results were a) PIE ratlo IS

positively associated with growth variable hut the associat~on IS weak: b)

There is a posit~ve but weak relat~onship between dlv~dend pay out ratlo and

PIE ratlo; c) Other variables l ~ k e market correlat~on and prlce variab~l~ty also

have a positive relationship w ~ t h PIE ratio, d) Tlle ~nosl s ~ g n ~ f i c a ~ ~ t vnriable

explaln~ng the PIE ratlo was the firm effect var~ahle

W.F. Sharpe and G M cooper i6 in thelr study of all conilnon stock

traded In New York Exchange coverlng a per~od of 32 years determ~ned the

r ~ s k classes by estimating the beta of each stock at the beg~nn~ng of each year

and each constructed portfolio of 10% of renlalnlng stocks w ~ t l ~ lowest beta

and so on unt~l the tenth portfolio conslstlng of the highest beta The r ~ s k

return relationship was then examined for each portfolio It was found that

I 5 ~ o w e r , R.S. and Bower, D.S , "Risk and Valuat~on of Co~n~nr ,n Stock", J o u n ~ a l of Political Econon~y, June, 1969, pp 349-62

I6sharpe, W.F. and Cooper, G M.. "R~sk Return Classes of New York Stock Exchange Common Stock, 1931-67". Fina~lcral A~lalysr J o u n ~ a l . March-April, 1972, pp 46-56.

110

there was consistent relationship between risk as ~iieasured by beta and return

The least rtsky portfolto was w~th the lowest beta of 0 58 and the lowest

average return of 11.58% Tlie 111ost rtsky portfolto had a beta of 1 42 atld

had the highest return of 22.67%. Thus tlie study confir~ned tlie trade off

between rtsk and return. The results of tlie study were as follows:

Table: Average Return and Beta: 10 Investmetit Strategies 1931-1951

Source:W F Sharpe and G M . Cooper. "Risk Return Classer of New York Stock Exchange Colnlnon Stocks, 1931-1967". F i~~o rc in i Ano!)'si.\ Jountal, March-April 1972, pp 46- 52

Strategy 10 9 8 7 6 5 4 3 2 1

~acob 's" study deals w ~ t h 593 New York Stock Exch;~nge stocks for

which complete data from 1946 to 1965 was available Regresston analyst?

were performed for 1946-55 and 1956-65 perlods for botll ~nonthly and annual

security return.

"lacob Nancy, "The Measurement of Systetnatic R ~ s k For Secl~r~ties and Portfolios - Some Empirical Results", Journal of Financial and Quantitative Analysis, Vol.VI, March. 1971. pp.815-834

Average Return

22 67 20 45 20.26 21.77 18.49 19 13 18 88 14 99 14.63 11 .S8

Beta

1 42 1 18 1 14 1 24 I 06 0 98 1 00 0 76 0 65 0 58

I I I

The results show a significant positive relationship between realized

return and risk durlng each of the 10 years period Altlio~~gli the relat~orisll~p

shown are positive they are weaker than those pred~cted by the CAPM for.

each period r l IS less and ro is greater than theoretical value The results o f

Jacob's study given below where in the relat~onsh~p of mean securlty return

and beta values is shown.

Results of Jacob's Study

r = ro + rlBJ + In,

Test Based on 593 Securities

a) Coefficient unlts are tnonthly data, per cent per month annual data, per cent per year.

b) Standard Error.

S0urce:Jacob Nancy "The Measurement of Systemat~c Risk for Secur~t~es and Portfolios - Some Ernpir~cal Results", Journnl of Flrlarlclal a ~ d Quattnrarrve A~lalysfs Vol.VI March 1971 Table 3 pp 827-828

112

The Miller - Scholest8 study deals with annual return of 631 stocks

during 1854-1961 The tests were conducted to study ( I ) nlean return Vs

Beta (2) mean return vs unsystematic r ~ s k (sE,)~ and (3) mean return vs hot11

Beta and unsystematic r ~ s k . The results were as iollows

Results of M~ller and Scholes Study..

R, = ro + vtBj + r 2 ( S ~ J 2 + MI

Annual rates of returns 1954-1963

Test Based on 631 Securities

Regression Results 1 Theoretical Values

16.30 (0.40) (02 5)

12.70 31.0 0.33 8.5 (0 60) (0 6) (02 6)

(a) Units of coefficients per cent per year.

(b) Standard Error

Source:Miller H.Merton and Scholes Myron "Rates of Return in Relat~on to Risk. A Re-examination of Recent F ~ n d i n ~ s " Published In Stud~es 111

the Theory of Capital Marketed by ~ i c h a e i ~ o n s o n New York Praeger (1972) Table IB p.53

' 8 ~ i l l e r H. Merton and Scholes Myron, S , "Rates of Returns in Relation to Risk - A Reexamination of Recent Findings". Publ~shed in Srudres rn Theory of Capital Markets edited by Michael Jonson, New York. Praeger 1972. pp.47-78.

I13

The results for the first test showed a significant poslttve relationslllli

between mean return and beta. A one unit increase in beta IS assoc~ated w1t11

a 7.1 per cent Increase In mean return. The result of second test do 1101

agree with CAPM's prediction. That is, high unsystematic r ~ s k IS apparently

assoclated with h~gher reallsed return M~ller and Scholes show that t h ~ s

correlat~on may be largely spurious for example a substantla1 positlvr

correlation exlsts between beta and ( s E ~ ) ~ Thus systeniatlc r ~ s k will appeilr

to be significant in tests from wh~ch beta has been olnltted eve11 tliougl~ 11 111;ly

not be important to prlcing of securities This sort of stat~st~cal correl;itt<)l~

need not imply a causal link between the variables Test to (3) tncludes both

beta and (sE,)~ In the regression equation. Both are found to be s~gn~ficantly

positively related to mean return. The conclusion of ( s E ~ ) ~ has solrie what

weakened the relationship of return and beta However a one un~t Illcrease

in Beta is assoclated with 4 2% Increase In mean return. The results show

that stocks with high systematic risk tend to have higher rate <1t rcturn

Friend and ~ l u ~ n e ' ~ have conducted rlsk return studies, wliicl~

exa~nines relationship between long run rates of return and varlou3 risk

measures by constructing portfolios of NYSE conllnon stocks at the b e g ~ t i ~ ~ ~ ~ i g

of three different hold~ng periods. The periods began at the end of 1929, 1948

and 1956. A11 the stock for which monthly return data could be obta~ned

19~r iend Irwin and Blume Marshall, E , "Rlsk and The Long Run Rate of Return on NYSE Common Stocks". Workrrtg Paper No 1872, W h n n o ~ ~ School of Commerce and Frnance. Rochey L. Whlte Center of F~nanclal Research.

114

atleast for years preced~ng the test per~od were dtvided illto 10 portlolios tlir

securities were assigned on the basis o f their betas dur~ng the proceeding

four years - the 10 per cent o f secur~ties with lowest beta to the first

portfol~o, the group with next lowest beta to the second port fol~o and so on

After the start o f the test per~ods the secur~t~es were reass~gned

annually That is each stock's estimated beta was recomputed at the end o f

each successive year, the stocks were ranked again on the basis o f t l le~r betas

and new portfolios were formed. This procedure kept the portfolio betas

reasonably stable over time. The performance of these portfol~os is

summarized ~n the following table. The table give the a r~ t l ~ l l ~e t i c meal1

monthly returns and average beta values for each o f 10 portSolios and for

each test per~od.

For 1929-69 period the result ind~cate a strong posit~ve assoclatloll

between return and beta For 1948-69 period while higher beta portfolios llarl

h~gher return than portfolios with lower beta there was l ~ t t l e d~fference 111

return among portfolios with betas greater than one

The 1956-69 period results do not show a clear relationship betweer1

beta and return On the basis o f these tests they concli~de that stocks w ~ t l ~

above average risk have higher returns than those with below average r ~ s k INI!

that there is l itt le pay off for assuming additional r ~ s k w t th~n the groups CIS

stocks with above average betas.

115

Black Jense and ~choles ' s~ ' study is a careful attelnpt lo reduce

measurement errors that would bias the regresslon results for each year from

1931 to 1965 the author grouped all NYSE stocks Into 10 portfolios The

number of secur~ties in each portfolio increased over the 35 year perlod f ron~

a low of 58 secur~ties per portfolio in 1931 lo a h~gh of 110 111 1965

Results of Friend Blunle Study

Monthly arlth~netic lnean returns

Source:Friend 1. and Blume M.E. "Rlsk and Long Run Rate of Return OF NYSE Common stocks U'orkirtg Paper No 1872 Wl~anori School of Commerce and Ftrtartce Rodney L. White Center for Financ~al Research Table 4 p. 10.

20~ lack F. Jense and Scholes, "The Cap~tal Asset Prlc~ng Model - Some Empirical Tests, Published in Srudles in The Theon' of Caplral Market. Ed. by Michael Jonson, New York, Praeger, 1972, pp 79-121

I I6

Month by month returns for the portfolios were conil>uted fro111

January 1931 to December 1965 The results for colnplete per~cd are glveli

below:-

Results of Black Janse and Scholes Study

R, = rot,B, + h,

1931-1965

Test based on 10 portfol~os

Averaging 75 stocks per portfolio.

a) Units of Co-effic~ents per cent per month

Regression Results I Theoretical Results

b) Standard Error.

r,

Source:Black Jense & Sclioles "Capital Asset Pr~clng Model - Son~e Empirical Tests" Published in Studies In the Theory ojCnprtnl Mnrhizr Ed. by M~chael Jonson New York. Praeger 1972 Table 4, p 48

rl I r2 I r, = RF I r, = RM - RF

The results indicate that over the co~nplete 35 years per~od average

return increased by approxi~nately 1.08 per cent per non nth Ibr a one un11

increase in beta. The risk return trade off was estimated for a nini~ber of wh-

periods. The slope of regression lines tend in ~nost periods to nnderstate tile

theoretical value but are generally of the correct slgn Also the sub-per~od

relationship appeared to be linear This paper provides substantial support for

0 5 1 9 1 1.08 1 0.90 1 0 16 I 1 42

117

the hypothesis that realised returns are a linear functlon of systelnatlc risk

values. Moreover it shows that the relationship is significantly posltlve over

a long period of t i ~ i ~ e .

Fama and ~ a c b e t h " extended the Black Jensen Sclloles' test 10

Include two addit~onal factors The first rs an average B~~ for all ind~vldual

securities in portfolio p designated B~~ The second is a s~milar average of

the residual standard deviations (SEI) for all stocks in portfol~o. p, des~gnated

SE, The first term tests for non- linearity In r ~ s k return relat~onsll~p and llle

second for impact of residual vartatlon. The equatlon of the fitted l ~ n e for

Macbeth study is given by:

where according to CAPM we should expect Vz and V3 are zero

The results of the Fama and MacBeth tests show that wh~ le est~niated

values of V2 and Vg are not equal to zero for each ~nterval examined, llte~r

average values tend to be insignificantly different fro111 zero Fama MacBetl~

also confirm the Black Jensen Scholes results that realised values of Vo are

not equal to Rf as predicted by CAPM.

2 ' ~ a t n a , E.F. and Macbath, J.D., " R ~ s k Return and Equllihr~uln - Empirical Test", Journal of Polirical Economy, Vo1.81, 1973.,pp.607-636.

118

sharma2' has made a study under Indian context to identtfy tlie

factors affecting the relative prlces of equity shares. He has developed

relative prices of equities as dependent and div~dend pay-out, growth.

capitalisation rate earning variab~lity and leverage as independent var~ahle

The regression equatron has the following form

log Y I = Bo + B, log X , + B2 log X2 ... + B, log Xi + 11,

The important results are sunnnarized in the following table connotes

that growth, d~vidend payment and slze have emerged wltli stat~stlcally

s~gnificant posltive signs as hypothes~sed He attrrbutes volat~l~ty in niarkel

price of the securities as the reckless speculat~on wli~ch I S tlnlque Icature of

Indlan Capital Market.

Results of Sharrnn's Study

+ Significant at 10% level

Constant

0.175

(0 794)

* S~gnificant at I % level

GMP = Growth rate of market prlce of share DPY - Dividend pay-out ratio

VCE = Variability in earnings VMP = Variability in market price LEV - Leverage S1Z = Size

GMP 0.892+

(1 542)

22~harrna Rattan, K . "Factors Affecting Relative Pr~ces of Eqt~lty Shares an Emp~rical Analyses", The Chanered Accoutlranr. Augusl. 198'9. p.114.

DPY

13.757~

(8.1 10)

VCE

0.061

(0 260)

VMP

0.246*

(6 445)

LEV

0 137

(2 546)

SIZ

0 246

(6 445)

R2

0 58

119

G.C. Maheswari and K.R. ~ a n j a r a ~ ~ in their study trled to ex ; l i~~ i i i r

whether there is any relationship between syste~natic risk and ret l~rn, return

and price and prlce and risk, with a sample securit~es o f 112 In nu~nber T l l r

securltles were ranked in ascend~ng order using the three paratnrters

systematic risk, return and prices hy e~nploying rank c r i r r e l a t~o~~ coc f f i c~e~ i t

relat~onsh~p was established among the pairs The rcst~lts showed III b e a r i ~ l ~

market, (a) Systeinatic risk and actual return are nrgat~vely correlated (1))

Actual returns and Market price of a security are insigiilficantly c<~rrelatecl

~ i i fe r r ing that Indian Stock Market is not eftic~erit r noug l~ to price it'.:

securities according to their risk return characteristics

~ h a n d a r i ~ ~ and others have made a study on rlsk return c i I newly

listed secur~ties belonging to 1822 firms o f NYSE Bq the corlstructioll 01

cross-sectional analysis, time series analys~s the researchers consistently

observed that the newly listed stock under perform dur~ng post I ~ ? t ~ n g per~od

I t has been attributed that this anoinalous finding IIIBY, 111 part, he exl) la~~ied

away i f the risk during t h ~ s period is lower than at other tiine However hy

studying the rislclness o f newly l~sted stocks over long intervals. the

23~aheswar i , G C and Vanjara, K R , "Risk Return Relationsll~p. A Study of Selected Equity Shares", Stock Marker Eflcrerlcy and Puce Behaviour, The Indian Experience ed by O.P. Gupta, A n ~ n o l Publication. Delhi, 1989.

24~handar i Arvind, Theonary Grammatikos. An i l K Maklll la and George Papaioannou, "Risk and Return on Newly Listed Stocks - The Post Listing Experience", The Journal of F~nancial Research, Vo l XII , N o 2. Suinmer. 1989, pp.93-103.

120

researcher have mixed transitory risk changes The evidence shows that the

riskiness of newly listed stocks undergo a seasonlrlg process Instead of

lower rlsk after listing, rlsluness 1s in fact greater In later periods

~ a ~ n a ~ ' in his study to clarify the conflicts aroused in interpreting the

Lintner and Sliarpe's model wh~ch are aimed at identifying the appropriate

~iieasure of risk of a capital asset and equilibriu~n relationship between risk

and return. The study observed that the apparent conflict between the two 1s

caused by Sharpe's concentration on a special stochastic process for descrihii~g

returns that is not necessarily implied by his asset pricing tnodel Wlirn

applied to the more general stochastic process that I~ntner treats Sharpe's

model leads to Lintner's conclus~on.

M.C. ens en^^ developed a model for evaluating the perfor~nance ol

portfolio of risky assets Incorporating the theoret~cal results of Sharl~e i111cl

Lintner on the pricing of cap~tal asset under uncertainty

E~np~rical results show the estimates of systernatlc r ~ s k seen1 to lie

~rrelevant to. length of interval i e , the estimated systernatlc r~sk are

independent of Investors I~or~zon per~od. The measures of syste~nat~c rlsk lor

2 S ~ a ~ n a F. Eugene. "Risk Return Equil~br~us,~ - So111e C l a r ~ l y ~ ~ i g Comments", The Journal ofFinance, March, 1968, pp 29-39.

2 6 ~ i c h a e l C. Jensen, "Risk, The Pricing Of Capital Assets And The Evaluation Of Investment Portfolio", Jourtzal of Busl~less, University of Chicago, Vo1.42, No.2, April, 1919, pp.167-185

the mutual fund seem to be statlonary over time observed h~storical patterii ( 1 1

systematic risk and return for mutual funds in sample are consistent w ~ t h tlie

hypothesis of CAPM is valid As far as 115 nltitual funds take11 111 tlie stud)

are concerned, price of security coinpletely capture tlie effects of all

currently ava~lable information.

While extending his coinlnents on Arditti's contr~butio~i of iunalys~ilg

risk factors ranc cis^' has irlade an evaluation study oil explor~ng tlie answer

to the questions that do investor prefer securit~es that are pos~tively skewed.

By cons~dering the qi~arterly rate of 1 I3 large ~iiutual fund coiiipan~es dur~iig

1960-68. The study has resorted to the stepwise regression to 111clude two

liiiportant distributional var~ables, viz . standard deviat~on and skewness It

has observed that while standard deviat~on as a measure of risk found to have

pos~ t~ve and high for it's coeffic~ent, the coeffic~enl skewness IS f o u ~ ~ d 1101

sign~ficant. This Indicates that investors do not take cognizance of skewness

in mahng their decision. This finding d~scounts Ardittl's skewness f i nd~~ igs

The study attributed the wrong findings in Arditti's study to annual data and

small size of the sample as well as period of study

27~rancis Jack Clark, "Skewness and Investing Decis~on", Journnl of Flnancral and Quantitative Analysis, March, 1975, pp 163-172

I22

Studies on Diversification and Portfolio Risk

Evan and ~ r c h e r " have made an early attempt to e ~ n p ~ r ~ c a l l y ve r~ t y

the portfolio algorithms suggested by Sharpe (1963). Where~n the variatton

of portfolio return is segregated i n to systematic variat~on and unsystematic

variation. The purpose of the study is to examine the rate at w l i i c l~ the

variat~on o f returns for randomly selected portfolio is reduced as a ~~IIIC~IOII

o f the number o f secur~ties ~~ ic luded In the port fol~o I t l l~ rows cor~s~tlerehle

l ~ g h t as to the optimal number o f securities to be included in a port fol~o 470

securltles listed In Standard and Poor ~ndex for the year 1958 were studled

Portfolros were constructed taking I Lo 40 securities at random and portfolios

were examined for the hypothes~sed relationsh~p - decreasing po r t f o l~<~

standard deviation to an asymptote (at some pos~tive level) as d ~ v e r ~ ~ f i c a t ~ ( ~ t l

Increases. The relationship appeared to take the form of a rap~dly decreas~rlp

asylnplost~c funct~on With the asymptote approx~~nating levels of systenlatlc

varlatlon. The results also ralse doubts concerning the econolnlc just1ficat11111

of increas~ng por t fo l~o size beyond 10

shapez9 has made an attempt to present ~l lustrat~vely the

inter-relationsh~p between risk market sensitivity and the d~vers i f i cn t~o~l He

''~ohn L Evans and Stephen H Archer, "D~ve rs~ f i ca t i o~ l and Reduction of D~spesson AII Empirical Analysis", The Jour t~a l of F t t~n~rcr , December, 1968. pp.761-767.

2 9 ~ i l l i a m F . Sharpe, "Risk Market Sensitiv~ty and D~versi l icat~nn". F inanc~al Analyst Journal, Jan-Feb 1972. pp.74-79

123

has atte~npted to construct portfol~os so that two portfolios with coniparable

diversification will likely to have comparable amounts of non rnarket risk

The study employed market sensitivity index estimating the divers~ficat~orl

effect. The illustration shows that as diversification increases, the a~ i~oun t of

non market nsk decreases but not proportionally

On study~ng systelnatic and unsystematlc co~iiponents Ahralia~ii

~ e j a ~ ' made an attempt lo theoret~cally establ~sli the systefriatlc and

unsystelnatlc conlporients of financ~al rlsk generally used In market ni(~del ol

portfoho evaluation. Whlle unsystelnatic component is observed to be

component that is perfectly correlated with each other and unsystematlc r ~ s k

berng uncorrelated, with earlier one. The study establishes that the so-called

market model that can beat be interpreted as alternative presentations rather

than set of assulnption comprising a model The study comes out w ~ t l ~ the

necessary formulation to establish the equ~librium of one per~od y~eld of all

assets which are deco~npused into systematic and unsyste~nat~c components

and establishes that whlle practical application of generalized systematic

return depends on the use of same effective surrogates of Beta, it's theoretical

llnportance stands independently.

3 0 ~ b r a h a ~ n Beja, "On Systematic and Unsystematic Components of Financial Risk", The Journal of Ffnance, March 1972, pp.37-45.

124

Wagner and ~ a u ~ ' , in their study aimed to show how diversificatio~l

can be utilised to offset the riskiness of individual securities so that portfol~o

containing large number of higher risk securities may be less risky than

portfolio containing small number of low risk securities and earn a

substantially high rate of return Cons~der~ng the securities ~ncluded in the

S & P stock rating list for a period of 1960-71 the study constructed the

portfolio across different qual~ty rating, the researchers hold that a superlor

investment strategy is one that can Identify and reduce those risk whicll bears

no compensation. The reduction can be accomplished simply and effect~vely

by means of diversification.

~ e v ~ ~ ~ tried to apply some investment bellav~our to examine

e~npirically to what extent divers~fication of Investment IS worthy The

emplr~cal results support the theoretical findings that d~vers~ficat~on allnost

always pays, but the larger the Investment horizon slnaller is the Inerlt of

diversification. Portfolios which are d~versified by ~ndustry groups tend to he

better than portfolios which are diversified randomly However beyond

certain size the benefit from an increase in the number of securtlles ~ncluded

In the portfolio is found very small.

3 1 ~ a g n e r , H.W and Lau, S C , "The Effect of Divers~ficat~un of Risk", Financial Analyst Journal, Nov- Dec. 1971, pp 48-53.

3 2 ~ e v y Haim, "Does Diversification Always Pay?", Times Stud~es Otz Management Sclence, Vol.11, 1979, pp.63-7 1.

125

has brought out an emp~rical evidence to show the risk

aversion in the stock market by cons~denng the behav~our of cap~tal ~iiarket

w ~ t h respect to the annual returns from 3 years openend mutual funds over

a period of 1954-1963. The evidence show that for effic~ent portfol~o larger

value of expected return are associated with larger value of sta~idard devtat~on

than do those with less var~able returns supporting the r ~ s k aversloll

hypothesis of CAPM.

Handa and others34 exa~n~ned the behav~our of heta as a funct~o~i of

return measurement interval and tested whether the slze effect tests are

sensitive to beta est~mation. The e~np~r ica l results denionstrate that lirtii slre

has incremental explanatory power, i e , size effect IS sensit~ve to tllc rcturn

measurement interval used to esti~nate systematic risk Betas of secur~ties

riskier than market increases with return interval whereas betas of securit~es

less risky than market decreases with return ~nterval The regression of

returns of 20 market value portfolio constructed froni all stocks llsted o n

CRSP monthly tape of NYSE for a period of 1964.1982 on 111orithly and

annual betas and the firm size to examine the i~nplrcat~on of the size effect

tests suggest that only annual betas explained return variation incre~rieritally

and the coeffic~ent of firm size variable IS insignificant

33~harpe , W.F., "Risk Aversion in Stock Market - Some Emp~r~ca l Evidence", The Journal of Finance, Sept. 1965, pp.416-422.

3 4 ~ a n d a , P., Kothari, S P. and Wasley Charte. "The Relat~onsh~p Between Return Interval And Betas - l~nplication For The S ~ z e Effect", Journal of Finance Econorn~cs, Vo1.23, 1989, pp.79-100.

126

Can future riskiness of an investment selection be accurately

estimated from past riskiness. Can an investor who bases his stock selection

on forecasting overall market direction rely on the persistence of market

related volatility. These questions have become the bass to conduct an

empirical examination by ~ e v ~ ~ ~ . Considering the weekly returns for 500

colnlnon stocks of NYSE over a perrod of 520 weeks endlng I970 the study

estimated separate betas and tested for their stationarity by uslng product

movement and rank correlation coefficient The evidence ~ndlcate that t l i~s

measure is remarkably stationary for large portfolios and unpred~ctable for

~ridividual securities Further the predictability improves as the forecast

per~od lengthens

~ r u ~ n e l l ' s ~ ~ study trles to characterlse the concept of negatlve

interdependence which prompts a risk averter to diversify, and show that 11

is not appropriate to call negative correlation as 11 is lriore restrictive

Sometimes negative independence imply positive correlation

In a note on diversification Gorden ~ ~ e ~ ' s h o w that investors in sollie

situat~ons appear to display risk averslon to opportunity loss. In fact r ~ s k

3 s ~ e y , A.R., "On the Short Term Slatlonarity of Beta Coefficient", Financial Analysts Journal, Nov-Dec., 1971, pp.55-62.

36~e lby L. Brumell, "When Does Diversification Between Two Investment Pay?", Journal of Financial and Quantitative Anal~~sis. June 1974. pp.473-482.

3 7 ~ o r d e n Pye, "A Note On Diversification", Tlze Jounzal of Finanoal and Quantitative Analysis, Jan. 1974, pp. 131- 136.

127

aversion to opportunity loss implres diversification in some cases in which

r ~ s k averse expected utility maximisation does not for risk averse util~ty

maximiser it is necessary to assume independence or negattve correlatioti

between securities. It 1s also necessary to assume that they were both

stochastic Neither of these assumption is necessary for an investor who 1s r ~ s k

averse to opportunity loss to diversify between two securltles.

John ~ ~ n t n e r ~ ' tried to determine the expllcit e q u i l ~ b r ~ u ~ n price of

risky assets traded in competitive market under ~dealised condlt~on to sllow

the power and l~mitation of divers~ficatlon to reduce r ~ s k and Improve

investment performance by analys~ng large openend mutual funds D~rec t

evidence of the power of diversificat~on to reduce or e l i ~ n ~ n a t e all hut the r ~ s k

resulting from market swings in economic activity is prov~ded by sta~~clarcl

error of the estimates of each of these funds about it's regression In the yleld

of standard and poor index

Studies o n Capital Asset Pricing Model:

The pioneering study to predict the be l~av~our of capital market in the

absence of a body of positive micro economic theory tlet~ling w~t l l c o ~ ~ t l i t i o ~ i

of risk is that of ~ h a r ~ e . ~ ~ The study has identified two lypes of niarket

3 B ~ i n t n e r , J . , "The Valuation of Risk Assets and The Selection of Risky Investments in Stock Portfolios and Capital Budgets". Revfew of Economrc and Starisrics, Feb. 1965, pp. 13-17.

39~harpe F. William. "Capital Asset Price - A Theory of Market Equilibrium Under Condition of Risk", The Journal of Flnance, Vol XIX. No.3 , Sept. 1964, pp.425-442.

128

prices, the price of time the pure interest rate and the prlce of r ~ s k , rise

premium. While bringing an improvement to mean varlance approach of

Markowitz, the author has developed an investor preference h~nctions for

optional investment policy. The prlces for capital assets are expected to be in

equilibrium when a simple linear relationship exists between expected return

and standard deviation of returns for efficient co~nbinatio~l of risky assets

Sliarpe argue that diversification enable the investor to escape all bur [lie risk

resulting from swings in economic activ~ties, this type of risk retilains even

in eflic~ent combination. Since all other types of risks can be avoided by

diversification only the responsiveness of an assets rate of return to the level

o f e c o n o ~ n ~ c activity is relevant In assessing risk. Prices w ~ l l therefore adjust

until there is a linear relationship between ~nagnitude of such responsiveness

and expected return.

Blume and ~ r i e n d ~ made an effort to exanline theorct~cally and

empirically why the market line theory does not adequately expla~n d~tfererit~!~l

return on financial assets. Several types of risk return trade off impl~ed by

stocks of New York Stock Exchange for three different periods were done

The results cast doubt on the validity of market line theory, on the other hand

confirms the linearity of relationship for NYSE stocks. Beta co-effic~enls

were estimated by regressing ~nonthly investment relatively adjusted for cal~ititl

40~rwin Friend and Marshall Blume, "Measurement of Portfolio Perforniance Under Uncertainty", The American Econon~ic Renew. Sep 1970. Pp.561-574.

129

changes and cash dividends upon the corresponding values of Fisher

combination link relatives. Beta coefficients were estr~nated for each cotntnon

stock in NYSE for period 1950 January to Dece~tiber 1954. Portfolios were

constructed on the basis of these estimates. Likewise beta of tlie portfolios

were estimated. Finally arithmetic average return were regressed on beta

coefficient in linear and quadratic form. The results revealed relationship of.

average realised return for NYSE listed common stock to their correspond~rig

betas appeared very close to linear, suggesting CAPM is useful in explaining

returns in well seasoned colnmon stock. They suggested in the I~glit of

existence of market segments for securities and bonds, that the best arid safest

method to formulate risk return trade off to estlmate e~iipir~cally over tlie

class of assets and the period of interest.

To examine the relationship of one parameter performance measure

to risk Friend and Blume. Constructed 50 individual portfolio of 25. 50. 75

and I00 securities. Performance were regressed against two measures of

portfolio risk i.e., /3 and standard deviation of the portfolio return. These

regressions were derived using performance and r ~ s k measures calculated w~th

both monthly investment relatives and continuously co~npounding return or

natural logarithm of monthly relatives. The results showed risk adjusted

performance is dependent significantly on risk. Rate of return is posit~vely

related to risk. For cross sectional data relationship is quite high The

correlation of logrelatives were higher than other correlations

130

~ a 1 1 ~ ' has made a study to establish the role of changes in accounting

techniques on risk return equilibrium. The income of a firm can Increase or

decrease because of changes in 'real events' affecting it's operatlon or

alternatively because it adopts a new technique for measuring income If the

stock market cannot distinguish the two sources of incollie change, then ~t

might misled. The study has probed into the situation of market

disequilibriu~n and the probable cause over cross sect~onal regression

equations. The study observes that market is able to adjust to the

disequ~librium caused by risk changes. It appears that changes in accounting

techniques is not associated with other market disequilibriu~n and the efficient

market hypothesis.

Coles and ~oewnste in~ ' have analysed the effect of parameter

uncertainty on equ~librium asset prices. Although the amount of estimation

r~sk is same for all securities in a systematic case and hence parameter

uncertainty is largely irrelevant for equilibrium, the result of this study has

differed much using one per~od Sharpe Lintner's CAPM The study lias

compared the equilibria that arises under non parametric uncerta~ntles and

paralneter uncertainty. The study establishes the fact that when one considers

4 ' ~ a y Ball, "Risk Return and Disequilibrium - An Application to Charlges in Accounting Technique", Journal of Finance, May 1972, PP.343-352.

4 2 ~ o l e s L, Jeffrey and Uri Loewenstein, "Equilibriu~n Prlcing and Portfolio Composition in the Presence of Uncertain Parameters". Jo~t' / l f l l of Financial Economics, Vo1.22, 1988, pp.279-303.

131

the real pay off rather than expected return on securities are exogenous, the

parameter uncertainties are largely found relevant for equi l~br iu~n ~narket

we~ghts, value of market, expected return on the market and the betas

~ e e ~ ' has made an attempt to derive two functional fornis of CAPM

w h ~ c h will e x p l ~ c ~ t l y include the investment hor~zon parameter to Improve tlie

explanatory power by reducing the bias of estimated systetnatic risk In CAPM

Constructing an index for true investrnent horizon the study has used

hkel~hood ratio method and CES funct~on method to introduce the parameter

for reducing the bias of a systematic risk Results based on severity f ivs

randomly selected NYSE securities the study reveal that CAPM 1s non-llnear

under the assumption that the investment horizon for a security is finite and

unknown. However the analysis made to compare llnear and non linear

results of CAPM, establishes that non Irnear CAPM is ~iiost sultable and

functional form for estimating systematic risk as in reality tlie investment

horizon is ~nostly unknown

In an attempt to utilise the CAPM model to estimate comlnon stock

returns In Indian envlronlnent ~ a l w a r ~ ~ considered the ~nonthly return data

for twenty year per~od relating to 239 stocks regularly traded 111 Bombay stock

4 3 ~ e e F Gorge, "Investment Horizon and Functional Form of Capital Asset Pricing Model". Review of Economic a r d Starrsrics. 1976. No 3. PP 356-362.

4 4 ~ a l w a r B. Yalguresh, "Bombay Stock Exchange Rate of R e t u r ~ ~ a ~ i d Efficiency", lrzdian Ecor~on~ic Journal. Vo1.35. No.4, pp.69- 12 1

132

exchange. The excess return revision of the ~narket ~nodel is considered and

tested for statistical significance of beta estimate to establish it to he an

explanatory variable for security returns The results, however, lend ev~dence

to establish the CAPM as good descriptor of security returns in actwe lnd1;111

equ~ties market.

~ r i n i v a s a n ~ ~ has made an atte~npt to test CAPM in Indian envlronlnent

by considering data relating to stock price and market nldex (ET) for 85 lirms

during 1985-86. Wh~le analysing the results by estimating the regresslon run

at two d~fferent phase, the first be~ng time serles regresslon for each

securities realised rate of return and market portfolio, the second pass 111 a

cross sectional regression using the slope of first pass regression The results

establ~shed an expost test of CAPM.

However ~ e i n ~ a n u ~ n ~ ~ wh~le studying whetl~er premlum tllat are rwt

explained by beta exists indicated that simple CAPM does not adequately

describe stock return behaviour An investor can on the bas~s of size data can

form portfolios that systematically earn abnormal return Persistent positive

abnormal returns for sinall firm portfolios violate null hypothesis that mean

abnormal returns associated with simple one period CAPM are zero.

45~rinivasan, S , "Testing of CAPM Asset Pr~cing Model in Indl:l~l Env~ronment, Vo1.5, No I , Jan-Mar 1988, pp.51-59.

4 6 ~ a r c C. Reinganu~n, "Abnormal Returns in Small Fir111 Portfol~o". Fln~ticral Analyst Journal, March-April 1981, p.5256

131

~ 0 1 1 ~ ~ raised strong doubt about empirical testlng o f CAPM. He

polnts out that the only testable hypothes~s is associated with the theory IS

whether the market portfolio is mean variance eftic~ent Secondly III

ernp~r~ca l testlng a proxy measure must be used for the market portfolio huh

unless the market port fol~o can be ~dent~f ied exactly 11 1s ~lnposs~hle to accel~t

or reject the CAPM. Roll argues that using a proxy for the market port fol~o

as a bench Inark for assessing performance is ~ n v a l ~ d .

Stephen A ~ o s s ~ ~ focused on the attrectlve o f CAPM. He po~rits o ~ ~ t

that i t IS due to 11's potential~ty o f testab~l~ty That 1s v;~r~ables are

e~npir~cal ly observable and statlstlcally testable and 11 IS a paratiieterlsallorl

of simple general equil~brium. However the alternative n~odel APT oflers

the hope o f relalnlng sllnplicity o f CAPM and it's posit~ve or~er i ta t~o~l w l i ~ l e

avoldkng theoret~cal difticult~es.

Several stud~es have suggested returns on securltlcs do not beliave >I\

tlie slmple CAPM predicts they should Fisher lack^^ tried sliou, that hy

relating one o f the assulnptions o f CAPM 1.e an investor may take longer

short position o f any size In any asset including the risk less asset slid

47~tephen A Ross, "The Current status o f CAPM", The Jorrr.1101 of A~lance. June 1978, pp.885-899

4 8 ~ o l l . R,, " A Cr~t lque o f the Asset Pr lc~ng Theory's Tests", Jorrr,lnl of F~t~ancial Economics. March 1977.

49~ isher Black, "Capital Market Equilibriuln Will) Restr~ctrd Borrowings", Journal of Busi~~ess, July 1972.

134

can borrow o r lend any amount he wants at nsk less rate of Interest, CAPM

holds good ~ o s l n ' ~ trled In hls work to investigate the properties of a

market for nsky assets on the basls of a s~rnple model of general e q ~ ~ ~ l r b r ~ u t n

of exchange, where lndlvldual Investor seek to Inaxlmlse preference functrons

o\,er expected y ~ e l d on thew portfolio A theory of market rrsk premii~m IS

outl~ned and ~t IS shown that general equll~brlum lmpl~es the existence of .ir)

cnlled market l ~ n e relating to per dollar expected y~eld and standard d e v ~ a t ~ o n

of y e l d The concept of prlce of rlsk is expressed In terms of thls l ~ n e

Determinants Systematic Risk - B

~ o w r n a n ' s ~ ' study lndlcates that same financ~al (Account~ng)

ia r~ables are h~ghly correlated with a rnarket based measure of rrsk It g ~ v r s

fheoretlcal justificat~on of relat~onshlp between firm's systemalrc rlsk and

firms leverage and accounting beta. Where as no dlrect relationship that

cxlst hetween earnlng variability divldend size and growth of firm The

theoretical justrficatlon extended by Bowman starts wlth the base of CAPM

of sharpea 21ntneg3 and MoslnS4 Based on the formulation of CAPM.

an Mosln, "Equll~brlum In A Capltal Asset Market", Econo~netncn. Vol 34, No.4, Oct. 1966, pp.768-783

" ~ o b e n G. Bowman, "The Theoretical Relationship Between S)stematlc Rlsk and F~nanclal (Accounting Vanable)", Journal of Ffnance. K0.3. June 1979, pp.617-630

5 '~harpe, W F.. op c ~ r . pp.425-442

5 3 ~ ~ n t n e r , J . , op. crf.. pp.587-615

' ' ~ o s i n . J , op. cri pp 763-783.

13s

Bowman has shown the effects of drfferent financ~al variables as follow

Leverage effect - The existence of loarl rn caprtal structure makes

securrty more risker.

Accounting beta effect - Accountrng beta "B" is expla~ned as

covariabrlity of firm's accounting earnings with accountrng earnrngs of the

market portfolio Market based measure of rrsk (Systematic) IS theoretrcally

rclated to the accounting beta.

Earnrng Variabll~ty - Earnrng variabrlrty have a theoretical relatronsh~p

to market r ~ s k under certaln restr~ctrve assumptions. However there I S no

drrect relationshrp between earning variability and market risk

Dividends - In general the empirical results indlcate that, pay out ratro

does have srgnificant negative correlation wrth beta. However research has

also shown that when the pay-out ratro is adjusted for it's comrnencement

wrth earnings, rt no longer has a significant correlatron wrth beta.

"On a strictly aprion basis it is obvious that there is no theoretrcal

basrs for the relationship of dividends or payout ratlo to beta ~f any form

of dlvidend variable were related it should be in covariability form.

S ~ z e - The nsk whrch results from entenng into new investments is

a ilrnple weighted average of the risk of rndivrdual investment. This rrsuil

no way dependent upon the capltal stri~cture of the firrn I I I L O I L C ~

136

Therefore there 1s no necessary relat~onsh~p between slze and the systelnatrc

nsk

Growth - Growth can be defined In two ways Investment In prqecti

wlth an expected return h~gher than that of rxlstlng firm IS one form of

growth Growth by Investrng In projects rn the htgher expected return 1s

conlparable to lncreaslng slze As already mentroned slze and risk are not

related therefore no theoret~cal relat~onshtp between pro\*,th and rrsk

~ a ~ e r ' s t h e o r ~ ~ ~ 1s a dynamic model of a firrns earning behav~our

prowth and market valuatron The partlal theory presented by Mayer finds a

s~mple short cut method to measure relatronshrp between book and market

risk. It is an expllcrt valuatton formula for a long l~ved asset rn terms of

Investor expectallon about assets future cashflows. The real determ~nants of

asset's nsk ev~dent from the formula grven by Mayer In hrs part~al theory

Mayer's Theory rrrentions that return derlved from the real sector.

includes ~lnrnedlate cashflows less economlc deprec~atron plus any change In

the present value of future investment opportunrtles. IS transferred to financ~al

sector and the return rece~ved from that IS d~stnbuted to the share holder The

r~nportant fact is that the real return on an asset IS never observed dlrectly

unless shares In 11 are traded In natlonal and eftic~ent market

teewa wart. C. Mayer, "The Relat~onshtp Between Real and F~nanclal hleasures of R ~ s k and Retlrrn". RlsL and Rerirrn I I T Forn~rce. Ed hy I Frrcnd 2nd .I L Blckseler. Voi I . 1975. pp 48-60

137

Beaver Ket t le r and ~ c h o l e s ~ ~

BKS were the empirical pioneers ~n Investlgatlng the real de te rm~~lants

of systematic nsk which d e t e r ~ n ~ n e s the e q u ~ l ~ b r ~ u m level of prices In CAPhl

context BKS cons~dered seven account~ng variables l ~ k e div~dend payout.

growth ~n assets, financial leverage proxying for financ~al rlsk. I ~ q u ~ d ~ t ) . size

ln terms of fixed assets. earning variabil~ty and account~ng beta The earnlng

or accoi~nt~ng beta IS noth~ng but the slope coeffic~ent of the rsgresslon of

firms accountlng earnlng on the average normal~srd earnlng of the sntlrr

sample of firm It 1s a measure of cycl~cality that is the extent to whtch the

fluctuation in the firm's earnlngs are correlated wlth fluctuat~on In earnlngs of

the firms Since stock prlces clearly respond to earnlng both ind~v~dually and

generally the earnlng beta and the stock beta are supposed to be strongly

correlated BKS tested the re la t~onsh~p between these vanable and beta by

cross secttonal test on the sample of 307 firms for whlch complete accounting

and stock prlce data were ava~lable for the period 1947-65 Four repeat tests

were run. Flrst the data were split into two sub-penods w l t h ~ n each p e r ~ o d

tests were performed both on individual securit~es and portfol~o formed by

ranking the stocks on the basts of accountlng variables For each of the four

case leverage and accountlng beta had s~gn~ficanc corrrlat~on IS des~red

d~rection. However size had weaker correlat~on and the relationsll~p of

growth l iqu~dity with beta of the firm could not be interpreted confidently as

-

5 6 ~ e a v e r s W Kettler and Scholes. M . "The Assoclatlon Between Varket Determined and Accounting Determ~ned Risk Measures". Accoiit irt~i!:

K e l ' i e ~ t . Oct. 1970. pp.654-82

138

the relatronsh~p of first per~od changed dralnatically In the second per~od

Each variability and payout also had significant correlation as expected

B.K.S. Regression Results

Contemporaneous Association between Market Determined Measure of Risk and Selected Accounting Variables

a) Rank correlat~on coefficient are glven In the top row and product moment correlation are in parenthesis in bottom row.

b) The portfolio correlations are based upon 61 portfolios of 5 securit~es each.

Source.Beaver W H. Kettler P. and Scholes M , "The assoclatlon hetween Market Determined and Accounting determined Risk Measures". Accout~ring Revrew, October 1970, p 669

139

whrte5' followed broadly the same methodology as BKS but wlth

Important difference in variable definrtrons. He hypotheslsed three main

factor charactenst~c of hrgh beta firm.

1) High Debt Ratio

Whlte defined debt ratlo in terms of market value Thrs varrable

effect on beta is predicted and supported In BKS sttldles

2 ) Rapid Growth in Sales or Operating Earning

Measured by log of relatrve change of variable over the perlod

examined

3) High Asset Beta

Defined as the slope coefficrent of regressron of each firm's

percentage changes in sales on the contemporaneous percentage change rn

Gross National Product This is analogous to B K S 's accountrng Beta ln

that each measure firms cycllcality. Srnce the Investor 1s concerned with

covariance of each stock's return wrth the rate of return of e n t ~ r e market, he

IS concerned likewise with the covariance of each firm's income w ~ t h natronal

Income, the ~ n d e x used in the national one rather the average of the firms in

the sample under consideration, to avoid the error that wrll creep in if sample

average is used though reasonably large sample may have hrgh correlation

with the national Income. White has considered change in sales is a better

5 7 ~ h i t e , R,, On the Measurement of Systematic Risk. Unpl i l~l~shc(/ Ph D Tttesis, MIT, 1972.

I40

proxy for changes in expected earnlng than one per~od change In accountlnp

earnings. Wh~te found asset beta-the cyclicallty vanable and debt ratlo both

have strong posltlve relationsh~p wlth beta In l~ne wlth B K S study All the

var~ables considered found to be significantly related In expected dlrect~on

Thus White's result support the conclusions of BKS study

WHITE REGRESSION RESULTS OF VARIADLES

T stattstlcs In parenthes~s below coefficient.

Regression

(R" 71)

(R' = 71)

(R' = 71)

(R' = 71)

Source:Whlte, R., On Assessments Systematic R~sk , Unpublished Ph D Thes~s, hllT, 1972.

ona ads^' - provlde additional and somewhat dlscouraglng evidence

on BKS accounting beta as a determinant of firm's stock beta. He dealt with

onad ads, N.J., "Evidence on Information Content of Accountfng Numbers Accounting Based and Market Rased Estimates o f Systematic R l \ h " . .lour~lal of F i t ~ a ~ ~ c r a l Qun~lritnrrve A ~ i n l ~ ~ i s . June 1973. j)]) 407-414

Constant

0 505 (4 540)

0.153 (0.969)

-0 347 (-2 3 10)

-0 294 (-2.530)

Sales

7 160 (4 100)

Asset Beta

0.325 (4 380)

0 247 (3 880)

0.274 (7 650)

0.220 (7.220)

Earning

7.680 (5.030)

Variables Market

Debt Ratio

2 450 (2 620)

2 350 (4 560)

1 690 (3.620)

141

random sample of 99 firms for a per~od 1946-67 and three seben year

sub-penod. The accountlng betas were measured by regression of the firm's

earnlng to the aggregate earnlngs of all firms cons~dered

X J = a + b , X , + e , x I + e s

Where.

X, = firm j's earnlngs

X, = aggregate earnings or all forms for wh~ch complete data was avarlable over 1946-67

X, = That party aggregate earnlngs of all other firms in J ' s Industry whlch could not be expla~ned by X, and

e, = an error term reflecting unsystematic r ~ s k

Gonads tested for correlat~on between stock betas and accountlng

betas measured In terms of scaled net rncome and found no sign~ficant

relatlonsh~p for any sub-penod T h ~ s IS exactly counter to the BKS study for

accountlng betas derrved from first drfference In scaled Income.

Marc ~ e r l o v ' ~ through his p~oneering study Identify the Important

corporate variables respons~ble for the volatilrty of ~ n d ~ v ~ d u a l common stock

He reckoned variables like growth of earnings available to common stock

holders, mean retarned earnings per dollar to total assets, mean rec~procal of

leverage, mean inventory turnover, mean gross plant per dollar of total assets

and 21 industry dummles The regression results show an R~ value of 0 425.

0 515,0.280,0.493, for 1950-54, 1955-59, 1960-64 and 1950-64 respectively

,r,diiat~np tlie rrroderat;l) good expianalor} lioirzr of iorporaic ilzsirip!r>r

Correlation between According and Stock Betas - Gonads results

a - significant at 5% confidence level b - sign~ficant at 1 % confidenc~ level

Source:Gonads N.J. "Evidence on the Information content of Accounting numbers - Accounting Based and Market Based Est~mates of Systematic nsk". Journal of Quanrrrarive Analysis, VIIl June 1973. pp.407-44.

Among these sales growth proved to be hlghly slgniticant variable over all

periods, growth In earnings showed less Important than growth In sales

Retained earnings per dollar of total assets was sign~ficant and leverage had

the expected positive association, gross plant per dollar of total assets

exhibited negative association

59h.larc Nerlov, "Factors Affecting Difference Among Rate o f Returns on Investlnents in Individual Corninon Stock", Revie~v of Ecor~onircs and Srarrsncs, Vol. 1, No 3, Aug. 1968, pp.312-33 1

143

Htll and stonem In thetr arttcle trted to extend both theoretical and

empirical knowledge 1) the relat~on between accounting based and marker

based measures of systemattc rtsk 2) the effect of financtal structltre on

s)stematlc r ~ s k The emptrtcal study covered 28 years from 1947 to 1974

uhtch was d tv~ded lnto 14 year sub-pertods For 1947-60 and 1961-74

sub-per~ods 240 and 324 firms and for the enttre pzriod 150 firms were

studted. The etnptrtcal tests supported the concluston that financtal structure

and systemattc operattng r ~ s k are stgntficant detertntnants of per~od to per~od

changes In market beta.

Rosen Bergand and Mc ffibben6' t r ~ e d 31 tndependent vartables of

u,h~ch 1 1 were based on stock market data Matnly they confirmed to the

results of BSK w h ~ t e and Gonads However, the leverage. var~abtltty of

earntngs growth In sales and earnlngs are found postltvely stgntficant. No

stgntficant relattonsh~p was found In case of dtvtdend pay out and accounttng

Beta

~ a m a d a ~ * , in their study t r ~ e d to find out the associatton between

m ~ ~ l l , N C. and Stone. B K , "Accountrng Betas, Systemat~c Operattng k s k and Ftnanc~al Leverage - A Risk Composttton Approach to the Determinants of Systematic Rtsk", Journal of Financial and Quanrirarive Ana/ysis. Vol.XV. No.3. Sept.1980, pp 595-635.

6 1 ~ o s e n b e r g , B. and M c l b b e n , W , "The Pred~ctton of Systemartc and Specific Risk in Common Stock". Journal of Finarlc~al artd Quar~rimrive Analysis, Vol 8, March 1973, pp 317-334

6 2 ~ a m a d a , R S , "Effect of The Firm's Capital Structure In The Systemattc Risk of Common Stocks". Jo11r17al of Ft~tnrzcr. lune 1973. :'I1 4.35-45 1

1 44

firms leverage and systematlc nsk and after testlng on 304 firms concluded

ahout 21-24% of observed systematlc r ~ s k can be explained by the financaal

leverage

Mandelkar and ~ h e e ~ ~ e r a m ~ n e d jolnt impact of operating and

financial leverage on systematlc nsk. The study ~solates the degree of

operatlng leverage from operatlng r ~ s k to h ~ g h l~ght jolnt Impact of DOC and

FOL on systematlc r ~ s k F ~ n d ~ n g s suggest that degree of operatlnp and

financ~al leverage explaln a larger portlon I e about 38-48% of varlatlon In

Beta

Conclusion

Thus from the above d ~ s c u s s ~ o n on exlstlng l~terature one can

summanse the last 40 years developlnent on modern investment and portfol~o

theory as follow

Share pnceslreturns do not d~splay any systernatlc or recogn~zable

pattern I e they behave randomly w h ~ c h ~mplles future prlces changes of a

g v s n share can not be pred~cted from past changes l ~ k e w ~ s e the returns

However stock market w~sdom suggests that share prlces are

determined by many risk factors. At the same tlme securltles when comblned

6 3 ~ a n d e l k a r N Gershon and Rhee Ghon, S , "The Impact of the Degrees of Opera t~ng and F ~ n a n c ~ a l Leverage on Systetnat~c R ~ s k of C o ~ n n ~ o n Slock". Journnl qf Fina~~cial arid Quanrimriir A ~ i n / ) s r r . March lciR4 ; . : 45-77

14.5

nsk get dlluted I e a portson of varlarlon In ~ t s returns IS cancelled out because

of complementary varratlon In 11s constrtuent secilrltles ~ n d ~ c a t ~ n g

d~vers~fication reduces the unsysternatlc nsk

The nsk that IS not dtversrfiable called the systernatlc nsk IS linearly

related to the rate of return as postulated by the w~dely accla~med CAPM

However some researchers have come out challeng~ng the CAPM due to rts

restrlctlve nature

The nsk of a company can be to a great extent expla~ned by the

spec~fic nature of the company