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INTRODUCTION
Multi factor models for returns generation
Multi factor models attempt to describe asset
price returns and their covariance matrix as a
function of a limited number of risk attributes.
Factor models are thus based on one of the
fundamental tenets of financial theory: no
reward without risk. The Capital Asset Pricing
Model
(CAPM)
first
presented
by
Sharpe(1964), Linter(1965) and Mossin (1996)
is a single factor model and remains one of the
most popular empirical models of the return
generation process. This model uses stock beta
as the only relevant risk measure. But
empirical studies could not confirm this
restrictive statement. Ross (1976) posited a
more general multiple factor structure for the
returns generating process, known as the
Arbitrage Pricing Theory (APT). However, he
was unable to explain the nature or specify the
number of factors. Further work carried out in
this field by Chen et al (1986) attempts to
explain some of these factors. Fama and
French (1992) find that the main prediction of
the CAPM is violated for the US stock market.
Exposures to two other factors, a size-based
factor and a book-to- market-based factor,
often called a value factor, explain a
significant part of the cross-sectional
dispersion in mean returns. Their paper was
the foundation for a number of empirical
studies in this direction.
General structure of multi factor models
In their general form, factor models posit that
the period returns of different assets are
DATA SAMPLE
For the purpose of our study, we used the
securities constituting the BSE 100 index.
Though there are over 5000 listed securities in
the various Indian stock markets, most of
them are very thinly traded. Hence, we
considered only the top 100 stocks as
identified in the BSE 100 index. The BSE 100 is
a broad-based and value-weighted stock
market index. The sample companies
constitute the major proportion of the total
market capitalization and liquidity in the
Indian equities market. Another important
reason for using the stocks constituting BSE
100 as opposed to an even broader index was
the limitation of the statistical package in
handling greater number of variables.
The share price data for a three years period
between November 1999 and October 2002
was obtained from Prowess, a highly
normalized database maintained by the Center
for Monitoring the Indian Economy (CMIE).
This database is widely used by researchers
and
practitioners to
obtain
financial
information on Indian companies and security
markets.
The price data has been adjusted for
capitalization changes such as stock splits and
bonus issues.
This share price data was then converted into
weekly logarithmic returns. We have used
weekly returns instead of daily returns to
reduce the number of outliers in the data, as
factor analysis is very sensitive to statistical
outliers.
The weekly returns were computed using the
capitalization data only, and the dividends
were ignored. However, this should not have
a significant impact on the study, as the
Figure 1
R for various factor solutions
2
0.88
0.87
R2
0.8712
0.8734
0.86
0.8542
0.85
0.8452
0.84
0.8362
0.83
0.82
0.81
2
Number of factors
Table 1
Stocks with loadings > 0.5 on respective factors
Factor 1
Pharma Factor
Factor 2
Technology
Factor
Factor 3
Old
Economy
Factor
Factor 4
FMCG factor
Factor 5
Unknown
Dabur
Satyam
BPCL
Asian Paints
Corporation Bank
Abbott
Global
Telesystems
HPCL
HLL
Aventis
Pfizer
SSI
Escorts
Wockhardt
Titan
Silverline
Neyveli
Lignite
SCI
Britannia
Ranbaxy
Novartis
Pentamedia
Graphics
Infosys
IPCL
GSK Consumer
Healthcare
Nestle
MTNL
Digital
Globalsoft
Wipro
Tata Power
Visualsoft
Tata
Chemicals
Gujarat
Ambuja
Grasim
HFCL
Hughes
Software
HCL
Infosystems
Zee
IOC
Bank Of India
Dr. Reddy's
Colgate-Palmolive
TISCO
India Cements
HCL
L&T
NIIT
ACC
P1
P2
P3
P4
Table 2
Sensitivities and explanatory power of
five factor model
F1
F2
F3
F4
F5
R2
.017* .324 .211 .118 .275 .906
.169
.225 .325 .166 .135 .758
.201
.378 .206 .189 .145 .930
.317
.182 .269 .171 .206 .925
P5 .29
.206 .316 .172 .189 .837
Average:
0.871
* denotes insignificance at 5% level
The average adjusted R2 across the five
portfolios is 0.871. Moreover, the sensitivities
are highly significant. Of the 25 different
sensitivity estimates, all but two are significant
at the 5% level.
As a standard of comparison, we use the BSE
100 index. This index is a value weighted
index, made of the same 100 securities that we
are analyzing. Thus, the relationship between
our five portfolios and the index is likely to be
higher than if we had chosen another market
index. Table 3 presented below shows the
results.
Table 3
Sensitivities and explanatory power for
the single index model
Beta
R2
Avg. return
P1
P2
P3
P4
P5
Average
0.693
0.510
0.734
0.493
0.448
0.746
0.595
0.395
0.391
0.388
0.503
0.24%
0.41%
0.06%
0.25%
0.38%
CONCLUSION
In this paper we have estimated a five-factor
return generating process for the Indian stock
market. We have found that five factors are
sufficient to describe the return generating
process. It is not possible to provide a
conclusive explanation for these five factors.
However the examination of the factor loading
matrix suggests that the four of the five factors
underlying the stock market could be termed
as Pharma Factor, Technology Factor, Old
economy Factor and FMCG Factor.
We have also showed that this multi-factor
model has better descriptive power than the
commonly used single factor market model.
The performance of this five-factor model is
particularly impressive for smaller stocks.
REFERENCES
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0.428
0.448
0.094
0.07
0.26
-0.062
0.259
0.407
0.4
0.324
0.448
0.288
0.069
0.148
0.019
0.158
0.21
0.198
0.447
0.562
0.162
0.33
0.363
0.121
-0.007
0.157
0.001
0.135
0.366
-0.029
0.375
0.043
2
0.128
0.199
0.189
0.037
0.289
0.376
0.394
0.025
0.127
0.043
0.243
0.304
0.188
-0.003
0.076
0.005
0.257
-0.067
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0.178
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0.736
0.313
0.146
0.311
0.495
0.799
0.088
0.063
0.063
0.139
0.08
0.34
3
0.171
0.27
0.213
0.199
0.452
-0.082
0.204
0.275
0.375
0.54
0.387
0.246
0.421
0.703
-0.138
0.114
0.211
0.368
0.209
0.379
0.12
0.117
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0.226
0.264
0.054
0.397
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0.119
0.506
0.228
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-0.026
0.283
0.341
0.562
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0.298
0.176
0.186
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0.345
0.016
0.512
0.396
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0.447
0.284
0.089
0.181
0.149
-0.143
0.167
0.528
0.37
0.224
0.231
0.511
0.146
0.141
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0.065
0.031
0.231
0.055
0.476
0.546
0.442
0.324
0.175
0.183
0.315
0.35
0.187
0.11
-0.045
0.322
0.284
-0.075
0.56
0.111
0.207
0.23
0.47
0.01
0.267
0.152
0.032
0.03
0.097
0.287
0.436
0.044
0.415
0.262
0.299
0.068
0.129
0.309
0.243
0.156
0.231
-0.046
-0.017
0.06
0.05
0.222
-0.268
0.038
0.337
0.638
0.618
0.292
-0.105
0.726
0.086
0.356
0.146
0.175
0.035
0.649
0.286
0.196
0.178
0.37
0.163
0.068
0.057
0.074
0.094
0.237
0.058
0.174
0.653
-0.033
0.126
0.184
0.247
0.466
-0.093
-0.023
0.154
-0.096
0.252
0.236
0.444
0.133
0.533
-0.025
0.066
-0.08
-0.059
0.283
0.239
0.237
0.211
0.174
0.449
0.375
0.032
-0.086
0.314
0.08
0.089
0.387
0.108
0.432
0.252
0.216
Stock
Indian Hotels Co. Ltd.
Indian Oil Corpn. Ltd.
IPCL
Indo Gulf Corpn. Ltd.
IDBI
Infosys Technologies Ltd.
Ingersoll-Rand (India) Ltd.
Larsen & Toubro Ltd.
Madras Cements Ltd.
MTNL
Mahindra & Mahindra Ltd.
Mirc Electronics Ltd.
Monsanto India Ltd.
N I I T Ltd.
National Aluminium Co. Ltd.
Nestle India Ltd.
Neyveli Lignite Corpn. Ltd.
Nicholas Piramal India Ltd.
Nirma Ltd.
Novartis India Ltd.
Pentamedia Graphics Ltd.
Pfizer Ltd.
P&G
Punjab Tractors Ltd.
Ranbaxy Laboratories Ltd.
Raymond Ltd.
Reliance Capital Ltd.
Reliance Industries Ltd.
S S I Ltd.
Satyam Computer Services Ltd.
Shipping Corpn. Of India Ltd.
Siemens Ltd.
Silverline Technologies Ltd.
State Bank Of India
Steel Authority Of India Ltd.
Sun Pharmaceutical Inds. Ltd.
T V S Motor Co. Ltd.
Tata Chemicals Ltd.
TELCO
Tata Iron & Steel Co. Ltd.
Tata Power Co. Ltd.
Tata Tea Ltd.
Titan Industries Ltd.
Videocon International Ltd.
Videsh Sanchar Nigam Ltd.
Visualsoft Technologies Ltd.
Wipro Ltd.
Wockhardt Ltd.
Zee Telefilms Ltd.
1
0.349
0.03
0.267
0.427
0.288
0.007
0.402
0.046
0.24
-0.184
0.193
-0.113
0.341
0.159
0.346
0.116
0.187
0.417
0.176
0.483
0.175
0.532
0.142
0.431
0.308
0.154
0.263
0.094
0.179
0.04
0.295
0.25
0.191
0.235
0.287
-0.008
0.421
0.29
0.246
0.297
0.193
0.096
0.509
0.303
-0.273
0.132
0.113
0.342
0.135
2
0.224
0.173
0.086
0.135
0.132
0.75
0.132
0.353
0.052
0.273
0.428
0.417
0.268
0.575
0.088
-0.095
-0.045
0.212
0.432
0.119
0.755
0.159
0.018
0.193
0.24
0.265
0.497
0.37
0.787
0.808
0.016
0.155
0.78
0.184
0.127
0.102
0.112
0.133
0.098
0.145
0.239
0.245
0.213
0.378
0.447
0.727
0.735
0.4
0.627
3
0.296
0.56
0.569
0.448
0.23
0.007
0.351
0.459
0.399
0.23
0.247
0.221
0.267
0.18
0.421
0.003
0.63
0.116
0.208
0.029
0.077
0.036
0.349
0.284
-0.043
0.271
0.298
0.229
0.013
0.088
0.594
0.314
0.171
0.384
0.397
0.198
0.264
0.536
0.396
0.479
0.552
0.322
0.378
0.393
0.29
0.097
0.121
0.079
0.017
4
0.321
0.233
0.008
0.345
0.254
0.044
0.318
0.141
0.213
0.402
0.358
-0.047
0.155
0.133
0.081
0.459
0.124
0.204
-0.045
0.17
0.006
-0.072
0.352
0.304
0.228
0.187
0.276
0.341
0.237
0.177
0.09
0
0.045
0.223
0.12
-0.011
0.251
0.166
0.414
0.31
0.247
0.181
0.174
0.09
0.222
0.119
-0.179
-0.085
0.037
5
0.033
0.054
0.163
0.273
0.179
0.297
0.01
0.457
0.062
0.484
0.341
0.011
0.241
0.101
-0.038
0.187
0.045
0.332
-0.056
0.139
0.106
0.091
-0.093
0.108
0.485
0.234
0.316
0.389
0.083
0.132
0.162
0.374
0.172
0.419
0.221
-0.102
0.283
0.189
0.28
0.335
0.031
0.39
0.054
0.004
0.426
0.062
0.177
0.532
0.136