Research proposal

Topic: Testing application of CAP Model on KSE-Pakistan A Case study on Refinery Sector

Su!"itted to: Su!"itted !y:

#r$ Syed %a&ar 'ussain %aseef Ah"ad

M(A

)nd Se"ester

*roup C

+nstitute of Manage"ent Sciences 'ayata!ad Pesha,ar$

+ntroduction According to Giaccotto, (2007) in the in the last half of 20 th century many model in the finance literature came for valuation of assets which were tested,criticized and finally replaced. ar!owitz ("#$2%"#$#) model of mean variance&efficient frontiers is the foundation of this model.'n the literature of (inance )apital Asset *ricing odel has always their importance. +he model was first introduced ,y laureate -illiam .harpe ("#/0, "#/1).and +reynor ("#/"). And then further developed ,y ossin ("#//), linter ("#/$, "#/#) and 2lac! ("#72) for studying relationship ,etween the e3pected return and ris!..+his model divides the total ris! relating to an asset in two parts4 one is sytematic and other is unsystematic.'n this odel for )alculating 53pected return regression is used.

-iterature Re.ie, According to (6agannathan 7 -ang, "##0) investors demand a higher e3pected return for investing in pro8ects, or securities which having high ris!. )apital Assets *ricing odel ()A* ) is ,eing used ,y the finance managers and investors in predicting the 9is! of the investment and to find the e3pected return of the stoc!. :nsystematic ris! can ,e get rid ,y the portfolio diversification4 however investors are given the ,enefit for the systematic ris! of underlying security which is difficult to ,e diversified. And when there is high systematic ris! then the e3pected return is also high (;au 7 <uay, "#71). According to (.hafer and vov!=s,200>) )A* is using one independent varia,le which is not enough for estimating return. +hey tested their research on a fifty sample size of companies for a period of si3 year (2000 to 200$). 'n order to find out the stoc!=s return this model ()A* ) is tested in different areas of the world ,y different authors in order to find stoc!=s return. (;au 7 ?uay, "#71) tested )A* on +o!yo stoc! mar!et and come to the conclusion that the odel is valid to the +o!yo stoc! mar!et and the result are accurate4 the investors were compensated for ta!ing systematic ris! in stoc! mar!et. +his research covered the period of five years ((rom @ct "#/1 % .ep "#/#) having sample size of "00 companies. According to ((ama And (rench,"##/), it is not only the ,eta to e3plain the ris! and return and also factors li!e earnings to price ,cash flow to price ratios and sales growth of past. +hey concluded that due to reliance of )A* on a single factor li!e ris! management, it is not an appropriate model ,ut the philosophy in )A* to 8ustify premium for a security which is ris!y is over and high then the ris! free rate. +hey also concluded that Ar,itrage pricing odel is ,etter then )A* while e3plaining systematic ris!. (28orn and hordahl, "##>) in their study find out the relationship ,etween e3pected return and time varying ris! in stoc!

mar!et of .wedish. which covered fourteen years period ("#77 to "##0) having the sample size of >0 firms. +he study tested on the validity of )A* ,y Auang, (2000) which covered period of eight years ("#>/ to "##0) with sample size of #0 firms. 't was conducted on the two different sets one having high ris! and another was low ris! set. Ae searched out that the high ris! sets are ma!ing conflict with )A* whereas there is consistency in the low ris!. Ae concluded that )A* result is not valid ,ecause the return does not show us the actual position. (Gomez and zapatro, 2000) conducted a research from .7* $00 inde3 covering 2/ years period ("#70 %"##>) with sample size of 220 :. securities. 'n which two ris! factors (") standardized mar!et systematic ris! factor (2) active management ris!. +he two ,eta model are fovered ,y the interpretation of these results. ((raser and Aamelin!, 2001) showed that in past findings of different research the results of )A* are right at that time ,ut when Ar,itrage *ricing +heory come into ,eing the result are more accurate. +hey ta!e 7 sectors sample size which covered 22 years ("#7$ %"##/) for their research and conducted on the ;ondon stoc! e3change. +he )A* result were compared in this study with that of the result showed ,y GA9)A model. )A* and GA9)A result of ris! and return result were different such that GA9)A gives accurate result ,ut )A* does not give accurate result. 'n another research of (hung and -u, (200$) which was conducted on sample size of #2/ companies covering >" years ("#21% 2001).+his study was conducted in order to show two important features in time series called non%linearity and asymmetry. +hey come into conclusion that )A* model gives inappropriate ,etas if not incorrect. 'n Aong Bong ()heung and -ong,"##2) tested the application of the )A* model in the 5?uity ar!et covering a period of nine years ("#>0 to "#>#).+his study was conducted in order to find out the relationship ,etween various measures of ris! and returns of stoc!..o they concluded that application )A* is wea! in e?uity mar!et. And only for the year ("#>1 %"#>$) mar!et ris! was priced. )A* fails when tested on :. and 8apan stoc! mar!et in order to show accurate result of return which was conducted on #$ companies sample size and covered eleven years ("##/ t0 200/) and show negative result ,ecause of volatility in returns (Aui and )hristopher, 200>). (-ong and +an "##") applied the )A* in .ingapore .toc! e3change for their validity and result o,tained through )A* show the relationship among average return and systematic ris! appeared in ,eta is linear. +he 2eta ris! premium sign was opposite and only some of the ,eta coefficients were significant. +he study show significant result for s!ew ness in individual stoc!s for two years in total of five years ,ut for the portfolio their was no significant effect of s!ew ness. 'n *a!istan different authors conducted research on )A* on Barachi .toc! e3change. 'n study of (Aanif and 2hatti, 20"0) conclude that re?uired return which we calculate in )A* are not correct ,ecause this odel relies only on one single factor called 2eta.+hey conducted their research on a sample size

of si3ty companies Barachi stoc! e3change for period of si3 years (2000 to 200>).'n total 0/0 results of e3pected return versus actual, )A* was supported ,y only twenty eight result. According to (5atzaz and Attiya, 200>) when single factor traditional model of )A* was matched with multi ris! conditional model the traditional )A* model performance are accurate while e3plaining the relationship of return and ris! ,ut this accuracy was for few year and for few stoc!s. 'n this study they conducted research on a sample size of 1# stoc!s and which covering period of "2 years ("##0 to 2001) and in this study the they come into conclusion that conditional factor model is ,est tool for decision ma!ing then that of single factor traditional )A* . 'n another study (Aanif, 200#) which was conducted on to,acco sector for a period covering 1 years (2001%2007) applied )A* and come to the conclusion that this model ()A* ) is not appropriate for pricing the assets ,ecause ,eta calculated does not give accurate re?uired rate of return. )A* uses mar!et return and ,eta in decision ma!ing and ris! compensation ,ecause of which their e3ploration power is very wea!. 'n a study of (9aei and ohammadi, 200>) tested )A* on a sample size of 70 companies from CA.DA< "00 for a period of "2 years ("##1 to 200$) and concluded that )A* calculated cost of capital and used for pricing ,ut the estimation methods changed fre?uently. (rom the a,ove studies ' conclude that in spite of criticism on )A* due to relies on single factor (2eta) and avoiding other ris! factors. .till the model is very helpful in understanding the ,ehavior of security in the mar!et and valuation of security. Also the relationship ,etween ris! and return is helpful in pricing of asset. .o the )A* has retains its importance in literature. . Purpose of the study +he purpose of study attempts to find out applications of )apital Asset *ricing odel on Barachi .toc! 53change (B.5).A )ase study will ,e conducted on 9efinery sector companies which are listed on Barachi .toc! 53change (B.5). +he purpose of the study and report is to fulfill the re?uirements for 2achelor of 2usiness Administration (22A) at the 'nstitute of anagement .ciences, *eshawar.

Scope of the study +he research will ,e conducted on *a!istan=s e?uity mar!et such that B.5 and will cover period of five years (200$ to 200#) and will ta!e sample size of four companies from refinery sector of B.5. All data is secondary which is ta!en from different we,site on the internet.

-i"itations of the study +o ta!e other sector other than refinery sector of the Barachi .toc! 53change is too difficult to manage the data and cover the report on time ,ecause there is too much company in every sector. .o ,ecause of time constraint and difficulty in data availa,ility 9efinery sector is selected for this study.

Methodology of the study (or this research the data collected from refinery sector consists of four companies listed on Barachi stoc! e3change for five years (200$%200#). +he data is secondary type ,ecause all the data collected from ,usiness recorder we, site on monthly ,asis. And mar!et inde3 data and +%2ill rate is collected from the state ,an! we,site. onthly 9eturn will ,e calculated ,y using following formulaE 9i F (*"% *0)&*0 -here 9i is return *" is closing price and *0 is opening price After calculation of return, the return is su,tracted from interest free rate and after deducting this we get value. +his is dependent varia,le in this study. 9i%9f (dependent varia,le) ar!et return is o,tained as followsE 9m F ('nde3"%'nde3o)&'nde3o -here 9m is mar!et return 'nde3" is closing inde3 and 'nde30 is opening inde3

After calculation of mar!et return, the mar!et return is su,tracted from interest free rate and after deducting we get value. +his is independent varia,le in this study. After finding the dependent and independent varia,le regression is run in the icrosoft 53cel office. +his process will give value of ,eta and after putting the value of ,eta in the following formula we get e3pected return. 5(9) F9f G2 (9m%9f) @nce the e3pected return is calculated, we will compare it with actual return, if actual return is greater than e3pected return, then security is under%valued or vice versa.

Significance of the study +his report is useful for the students of management in general and +he study will help investors to determine that what is the relation ,etween ris! and e3pected returns of the securities of the refinery companies listed on B.5, and how this relation impact the pricing of those securities

Reference: 5atzaz and Attiya, (200>). +esting ultifactor )apital Asset *ricing odel in )ase of *a!istani ar!et. International Research Journal of Finance and Economics, Hol. 2$, pp ""1% "0>

(ama.(.5ugene and (rench. 9. Beneth, ("##/). +he )A* Alive. The journal of finance, Hol .$", Co $, pp"#17%$>.

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Giaccotto, )., (2007). Discounting mean reverting cash flows with the )apital Asset *ricing odel. The Financial review 12. G@*, inistry of finance= Ieconomic survey of *a!istan 2001%2007, 'slama,ad, *a!istan . Aargis. Bent, (2002). (orms of foreign 'nvestment ;i,eralization and ris! in emerging stoc! mar!ets. The Journal of Financial research 2$E".

Aanif, . 7 2hatti, :., (20"0).Halidity of )apital Assets *ricing odelE 5vidence from B.5%*a!istan. 5uropean 6ournal of 5conomics, (inance and Administrative .cience.