Validation of CAPM in predicting stock price at stock Exchange (PSX)

Abstract

Investigation of Capital Asset Pricing Model (CAPM) and conditional Capital Asset Pricing Model (CAPM) on Pakistan Stock Exchange is done in this study. The data of 15 companies gathered from Pakistan stock exchange on monthly and quarterly basis. This data was analyzed on the basis of two tailed paired sample student t-test. The test was applied on Capital Asset Pricing Model (CAPM) and conditional Capital Asset Pricing Model (CAPM) for comparing the results with actual results of market. Results show that Capital Asset Pricing Model (CAPM) was unable to predict the actual results while Conditional Capital Asset Pricing Model (CAPM) is able to predict the actual results of market. The error between actual and Capital Asset Pricing Model (CAPM) was also analyzed on monthly and quarterly basis. On monthly basis the results show that there are some companies which are gaining a positive mean error and investor are getting benefit out of it. On quarterly basis there were not even a single company having positive mean error that’s why the stock s were not giving as much benefit to investors on quarterly basis. It is recommended that investor must focus on the companies giving positive mean error to get benefit out of it. The calculation of CAPM, conditional CAPM and error are calculated on MS excel. The comparison of both the models will help investor to choose between them. Investors are rational and they invest in that security or asset whose market returns or actual results give them batter results. Prediction of future is also very important for investors because if they know that investment is going to lose money in market they will divest and if they know that a particular asset will reap benefits in future they will invest in that asset. For that the prediction of error is more important for investors. The prediction of positive error of a particular company and investing in that company’s stock is key to success. The error in the actual and CAPM results is because of other macroeconomic factors effecting the results like unstable political and economic condition of country by which investor lose or have interest in the Pakistan Stock Exchange. CAPM consider only one risk while in conditional CAPM risks other than systematic risk are also taken into consideration. Conditional CAPM used in this study consider the error term between actual results and CAPM results. This error is than added back to CAPM results to form it a conditional CAPM. The error generated by the difference of actual and CAPM results comprises of all the other risk factors affecting stock price