Investigation on Validity of Capital Asset Pricing Model in Small Capitalization Stocks and Large Capitalization Stocks

Abstract

To understand risk return relation, many researchers have created different sort of models, each having its own set of assumptions and varied risk factors involved in the analysis to postulate about the best results. These models are a fruitful way for investors to analyze any investment beforehand to identify the “complicated risk return relationship” and investigate the returns which they might be expecting from that particular stock with said percent of risk. Basically investors always want to explore the risk factors associated with any stock in order to get the desired outcome and earnings return from that specific asset. Amongst all these models, Capital asset Pricing Model (CAPM) stand out as one of the most usable and extensive choice which estimates the anticipated return with respect to the risk inherent in the stock. Basic aim of this study is to investigate the validity of Capital Asset Pricing Model in stocks on the basis of market capitalization. For this 20 companies are selected out of KSE 100 index. 10 companies having large capitalization stocks while other 10 consist of small capitalization stocks. Monthly data of 5 years from 2009-2013 is collected regarding stock prices of these companies. Market portfolio is constructed from KSE 100 index while rate on treasury bills was used for the calculation of monthly risk free rate. Time series as well as cross sectional regression is used to empirically examine the validity of capital asset pricing model in small and large capitalization stocks. When investigated empirically findings of the study showed that capital asset pricing model does not hold in Karachi stock exchange. The model failed to conclusively define the relationship between risk and return in both small capitalization stocks as well as large capitalization stocks. On the basis of findings of the study, it is revealed that systematic risk is not the only factor affecting the return on stocks. So investment decision based on capital asset pricing model will mislead the investors when it comes to invest in either small capitalization stocks or large capitalization stocks.