Effectiveness of asset pricing models with time varying beta an indian evidence

Abstract

The Asset Pricing Models define the relationship between the risk and return of security. They are widely used in the pricing of risky securities as well as in computing the expected returns for the securities (assets) given the market risk and return. The most widely used asset pricing model in finance is the Capital Asset Pricing Model, developed by Mossin (1966), Lintner (1965), and Sharpe (1964) independently. The model explains that the expected return of an asset is based on the market return. Thus, it considers only the market return as an essential factor for generating expected returns. However, various empirical researchers have found that there are influences beyond the market that cause stock prices to move. These influences could be size, leverage, momentum, book to market equity, profitability, investment, price-earnings ratio etc. Hence, there was a need to test and develop the asset pricing models, which considers other factors as well. Contemporaneous models could not fully explain the returns, which led to the development of multifactor models. These multifactor models are those models that consider multiple factors for the return generating process. One such model is the Fama-French three-factor model developed in 1993 by Eugene Fama and Kenneth French. In this model, they considered two mimicking portfolios that proxy for common factors in returns relating to size and book to market equity along with the market return. The model has been well examined in the Indian context, and it is found to be applicable in the Indian stock market. However, empirical researches did not stop there. Fama and French were of the view to test other factors for their explanatory power in explaining the return generating process. They developed another model in 2012 by adding one more factor - profitability to the three-factor model. The model is known as the Fama-French four-factor model. After this, the most recent development of Fama and French has been the Fama-French five-factor model. This model incorporates