UNIVERSITY OF ECONOMICS ERASMUS UNVERSITY ROTTERDAM HO CHI MINH CITY INSTITUTE OF SOCIAL STUDIES VIET NAM THE NETHERLANDS VIETNAM – THE NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS SYSTEMATIC RISK IN THE CAPITAL ASSET PRICING MODEL FOR AUSTRALIA: A CLINICAL DEATH? BY NGUYEN CONG THANG MASTER OF ARTS IN DEVELOPMENT ECONOMICS Ho Chi Minh City December 2017 TIEU LUAN MOI download : skknchat@gmail.com UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES HO CHI MINH CITY THE HAGUE VIETNAM THE NETHERLANDS VIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS SYSTEMATIC RISK IN THE CAPITAL ASSET PRICING MODEL FOR AUSTRALIA: A CLINICAL DEATH? A thesis submitted in partial fulfilment of the requirements for the degree of MASTER OF ARTS IN DEVELOPMENT ECONOMICS By NGUYEN CONG THANG Academic Supervisor: Dr. VO HONG DUC Ho Chi Minh City December 2017 TIEU LUAN MOI download : skknchat@gmail.com DECLARATION I hereby declare, that the thesis entitled, “Systematic Risk in the Capital Asset Pricing Model Australia: A Clinical Death?” written and submitted by me in fulfillment of the requirements for the degree of Master of Art in Development Economics to the Vietnam – The Netherlands program. This is my original work and conclusions drawn are bases on the material collected by me. I further declare that this work has not been submitted to this or any other university for the award of any other degree, diploma or equivalent course.
Ho Chi Minh City, December 2017 Nguyen Cong Thang TIEU LUAN MOI download : skknchat@gmail.com ACKNOWLEDGEMENTS I would like to express my special thanks of gratitude to my academic supervisor Dr. He gave me the golden opportunity to do this wonderful project on the topic of capital asset pricing model. I know that, for the last 20 years, you has been spending your youth, your effort to make your life and your future thrive in Australia. I appreciate this opportunity.
I did not realize that my high school knowledge, my skill I had developed as an Android developer could help me jump over challenges during the process of thesis accomplishment. On that way, I learnt Visual Basic and R and I expect that they are my friends when I struggle with messy data. I want to say thanks for my supervisor and for those introducing Beta and R to me. I would also like to send my first few words to my friends at the Business and Economics Research Group (BERG) at Ho Chi Minh City Open University MA.
Thach Ngoc Pham and MA. Anh The Vo. Your attitude at work makes me wisdom with a positive slogan “If my work gets wrong, do it again”. Furthermore, drinking milk tea on every Thursday afternoon is a cute moment to me at BERG.
After all, I leave my last few words to Mom and Dad. This thesis is for you. This work is my gift to you. I have put all great effort to develop and complete this very first academic study.
From the bottom of my heart, I apologize for your tears. I should have focused on getting thing done to have lived happily and planned carefully my future. My dearest loved Mom and Dad! I am still a kid, are not I? TIEU LUAN MOI download : skknchat@gmail.com ABBREVIATIONS C4F: Cahart four-factor model. CAL: Capital allocation line.
CAPM: Capital asset pricing model. DDM: Dividend-discount model. FF3F: Fama-French three-factor model. GICS: Global Industry Classification Standard.
HML: High minus Low. MPT: Modern portfolio theory. SMB: Small minus Big. TIEU LUAN MOI download : skknchat@gmail.com ABSTRACT On the ground of a well-known Markowitz (1952)’s Modern Portfolio Theory, Sharpe (1964) and Lintner (1965) developed a specific relationship between risk and expected return, which has been named as the Sharpe-Lintner Capital Asset Pricing Model (CAPM).
CAPM or the Sharpe-Lintner CAPM is a well-known and most widely used model for estimating a rate of return/cost of capital. The CAPM confirms that only systematic risk – denoted by ß (beta), does matter and investors are only compensated for taking systematic risk. Since its introduction, many studies have been conducted in an effort to assess the validity of the CAPM in practice. Practitioners and regulators around the world including Australia, Germany, New Zealand and United Kingdom employed CAPM as a primary model to estimate asset’s return.
However, various studies demonstrated that CAPM appears to underestimate returns for low-beta assets and overestimate returns for high-beta assets. The criticism went further as Fama and French (1992) introduced the three-factor model to estimate the asset’s return. The Fama-French three-factor model has been proven to work well in the US market and that beta is alive in the American context. However, in contrast to the US market, Vo (2015) argued that the Fama-French three-factor model has been proven to not work well in the Australian context.
A work by Savor and Wilson (2014) concluded that beta, or systematic risk, is still alive in the US market. A similar question is that whether or not beta is still alive in Australia because Vo (2015) has never tested this hypothesis? We are not aware of any study on the issue which has been conducted. This study is conducted to fill in the gap. This study examines the validity of the Capital Asset Pricing Model (1965) in the context of Australia on the ground of the pioneering work by Savor and Wilson (2014) for the US.
The choice of Australia is important because, among all nations in the Asia-Pacific region, Australia is one of a few which has required data for the analysis to be conducted. In the heart of the CAPM, beta is considered an important measure of systematic risk which is generally defined as an uncertainty about general economic conditions, such as GNP, interest rates, or inflation. From that perspective, a key purpose of this study is to examine and quantify whether or not systematic risk is responsive on the days when macroeconomics news/events are announced or scheduled for announcement. TIEU LUAN MOI download : skknchat@gmail.com On the ground of Savor and Wilson (2014), four different types of portfolios are considered in this study including: (i) 10 beta-sorted portfolios; (ii) 10 idiosyncratic risk-sorted portfolios (iii) 25 Fama-French size and book-to-market portfolios; and (iv) industry portfolios.
In addition, macroeconomic events include announcements in relation to growth, inflation, employment, central bank announcements, bonds, housing, consumer surveys, business surveys and speeches from the Prime Minister or the Governor of the Reserve Bank of Australia. Days with these events are allocated into the group (the so-called a-day) which is separated from the n-day (non-announcement days) group. In addition, in this study, a sensitivity check, which is beyond Savor and Wilson (2014), by adopting different definition1 of the a-day group including (i) macroeconomics announcements which consist of news about growth, inflation, employment, Central Bank, bonds and speeches; (ii) microeconomics announcements which contains news related to housing, consumer survey and business survey; (iii) economics announcements which are basic news about news about growth, inflation, employment, housing, consumer surveys, business surveys and speeches; and (iv) financial announcements which are combined by news about Central Bank and bonds. This study is conducted on a sample including more than 2,200 Australian listed firms collected from Bloomberg for the period from 1 January 2007 to 31 December 2016 is employed.
As such, the total of nearly 2 million observations has been used in this study. Using the linear regression with panel-corrected standard errors method and Fama-Macbeth regression across various portfolios, two fundamental findings achieved from this study are as follows. First, there is evidence supporting the presence of systematic risk in the Australian context. Second, the above evidence may disappear when different portfolio formations and different definitions of macroeconomic events are adopted.
In summary, whether or not beta, or systematic risk, is alive in the Australian context depends on how portfolios are formed and macroeconomic events are classified. These fundamental issues are generally known as puzzles in asset pricing studies and multi factor model has never been proven to withstand well when different markets/time/techniques are tested. 1 An appreciation to an anonymous reviewer who provides critical comments to the previous version of the paper which was presented at the Vietnam’s Business and Economics Research Conference on 16-18th November 2017. TIEU LUAN MOI download : skknchat@gmail.com TABLE OF CONTENTS CHAPTER 1 INTRODUCTION .1 An overview of asset pricing model .4 A choice of Australia in this study.
3 CHAPTER 2 LITERATURE REVIEW .1 Modern Portfolio Theory .2 Capital Allocation Line .3 Capital Asset Pricing Model .4 The Downside of the CAPM.5 Fama-French’s Three factor Model .6 Cahart’s Four factor Model .7 Fama-French’s Five factor Model. 14 CHAPTER 3 DATA AND METHODOLOGY .1 A brief description of the method .2 Data requirements and data sources .1 Ten beta-sorted portfolios and Ten idiosyncratic risk-sorted portfolios .2 The 25 Fama-French size and book-to-market portfolios.4 Calculations of portfolio’s beta and portfolio’s return .2 Fama-MacBeth regression. 31 CHAPTER 4 EMPIRICAL RESULTS .1 Pooled regression’s result.2 Fama-MacBeth regression’s result. 39 CHAPTER 5 CONCLUDING REMARKS AND POLICY IMPLICATIONS.
42 TIEU LUAN MOI download : skknchat@gmail. 58 TIEU LUAN MOI download : skknchat@gmail.com LIST OF TABLES Table 2-1 Factor classification. 18 Table 2-2 Approaches to Portfolio Formations. 22 Table 3-1 Summary of the number of firms in 10 beta-sorted portfolios and in 10 idiosyncratic risk-sorted portfolios.
27 Table 3-2 Summary of the number of firms in the 25 Fama-French size and book-to-market portfolios. 29 Table 3-3 Summary of the number of firms in industry portfolios. 30 Table 4-1 Regression results use linear regression with panel-corrected standard errors method. 33 Table 4-2 Regression results use Fama-MacBeth regression to value weighted return manipulation.
37 Table 4-3 Regression results use Fama-MacBeth regression to equal weighted return manipulation. 38 TIEU LUAN MOI download : skknchat@gmail.com LIST OF FIGURES Figure 2-1 The attainable E, V combinations. 6 Figure 2-2 The Capital Allocation Line. 8 Figure 2-3 The strategic investment of investors.
9 Figure 2-4 Equilibrium in the capital market. 10 TIEU LUAN MOI download : skknchat@gmail.com 1 CHAPTER 1 INTRODUCTION 1.1 An overview of asset pricing model Since the 1950s, asset pricing has seized great attention from policymakers, academics and practitioners which pushes it to the forefront of finance. On the ground of the Modern Portfolio Theory (MPT), Markowitz (1952) presented the efficient frontier to demonstrate the trade-off between return and risk of an investment portfolio. Few years later, building on the earlier work of Markowitz (1952), the Capital Asset Pricing Model (CAPM) was developed by Sharpe (1964) and Lintner (1965).
The CAPM gained acceptance for use by academics and practitioners for an extended period of time until the introduction of the three-factor model by Fama and French in 1992. This three-factor model has been widely applied to explain the observed stock returns. In addition, various empirical studies provided evidence to argue that the CAPM does underestimate (overestimate) the return for low (high) beta asset. However, empirical evidence has generally provided mixed evidence in relation to the validity of CAPM for the purpose of estimating the expected equity return.
Regardless of the criticism, CAPM still holds its position of superiority of acceptance and use. 74 per cent of 392 United State Chief Financial Officer (CFO) utilized CAPM to evaluate the cost of equity capital (Graham and Harvey, 2001). Similarly, Brounen, Jong and Koedijk (2004) discovered that 43 per cent of 313 European CFO’s decisions used CAPM for the same purpose. Mckenzie and Partington (2014) in their report to the Australian Energy Regulator revealed that regulators in Australia, Germany, New Zealand and United Kingdom employed CAPM as a primary model to estimate the cost of equity while regulator in the United State of America utilized Dividend Discount Model (DDM) as the first option and CAPM as the second option.
Vo (2015), in his recent work, argued that the application of the Fama-French three-factor model into public policy under the context of Australia is not recommended.