international arbitrage pricing theory

366 Pages·2014·11.51 MB·English

INTERNATIONAL ARBITRAGE PRICING THEORY:
EMPIRICAL EVIDENCE FROM THE UNITED
KINGDOM AND THE UNITED STATES
A thesis submitted for the degree of
Doctor of Philosophy
by
Arnold Cheuk Sang Cheng
Department of Accounting and Finance
The London School of Economics and Political Science
University of London
November 1992
/
UMI Number: U062860
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ABSTRACT
The objective of this thesis was to analyse the empirical applicability of the Arbitrage Pricing
Theory to international asset markets (UK stock market and US stock market) and to identify
the set of economic variables which correspond most closely with the stock market factors
obtained from the traditional factor analysis.
Factor analysis and canonical correlation analysis were used as the principal tools for the
empirical testing. Although factor analysis is frequently used, canonical correlation analysis
is an new technique in this area and provides a method of linking factors extracted from the
two sets of data. Various economic indicators were investigated as systematic influences on
stock returns. It was shown that, based on the foundations of the APT and the characteristics
of the factor scores from the factor analysis on the security returns and the economic
indicators, canonical correlation analysis is an approximate technique to link the stock market
and the economic forces.
The results using the UK data imply that there is a good correspondence between factor
scores generated by the factor analysis on the UK security returns and on the UK economic
indicators. The results using the US data show that there is also a fair correspondence, but
lower than that for the UK data, between factor scores generated by the factor analysis on the
US security returns and on the US economic indicators. The APT was also investigated in
an international setting by considering the UK data and the US data together. The results
show that the canonical correlation analysis successfully links the stock returns and economic
forces. The conclusion of these empirical findings is that security returns are influenced by
a number of systematic economic forces. The validity and applicability of the APT were also
empirically evaluated. The regression results show that the explanatory power of the APT
model is fairly good. The overall results obtained here appear to suggest that the APT
pricing relationship is supported by the testing methodology. In addition, the international
correlation structure of financial markets movements between the UK economy and the US
economy has been analysed.
3
On balance, the evidence favours the APT and there is available evidence of inter-market
linkage between the UK and the US. Individual sets of economic variables have been
identified which correspond most closely with the UK and the US stock market factors by
using the canonical correlation analysis. The results, at least partially, contribute to the
understanding of security market pricing.
ACKNOWLEDGEMENTS
I owe an incalculable debt to my supervisor, Dr. John L.G. Board for his advice,
encouragement, guidance, intellectual inspiration and many helpful suggestions. He has
pointed me in the right direction. I cannot find the words to pay adequate tribute to him.
I have benefltted from the kindness and assistance of many individuals in writing this thesis.
Specifically, I am very grateful to Professor Michael Bromwich, Professor Richard Morris,
Dr. Martin Knott, and my colleagues at the University of Liverpool.
My thanks go to Ms Sue Kirkbride for typing a difficult manuscript with great skill. I also
wish to express my appreciation to Ms Penelope Bromley.
I am thankful to my grandmother, my parents, and my brother, Gerald, who have provided
invaluable care, constant encouragement and moral support over the years.
Finally, I am thankful to the LSE for providing not only a stimulating place to do research,
it was also a happy place for research.
To
MY GRANDMOTHER
MY PARENTS
GERALD
with
unbounded love, admiration, and gratitude.
CONTENTS
ABSTRACT 2
ACKNOWLEDGEMENTS 4
CONTENTS 6
LIST OF TABLES 11
CHAPTER 1 INTRODUCTION 15
1.1 OBJECTIVES AND CONTRIBUTIONS OF THE STUDY 16
1.2 OUTLINE OF THE THESIS 17
CHAPTER 2 THE THEORETICAL DEVELOPMENTS AND
ORIGINS OF THE CAPM
2.1 INTRODUCTION 20
2.2 THEORETICAL DEVELOPMENTS AND ORIGINS OF THE
CAPM 21
2.2.1 MEAN-VARIANCE EFFICIENCY CRITERION 21
2.2.2 CAPITAL ASSET PRICING MODEL 23
2.3 RESTRICTIONS AND EXTENSIONS OF THE CAPM 29
2.4 THEORETICAL PROBLEMS OF THE CAPM 30
2.4.1 THE ABSENCE OF RISK-FREE ASSET AND THE
RESTRICTIONS ON SHORT SELLING 30
2.4.2 TAXATION AND TRANSACTION COSTS 32
2.4.3 THE EXISTENCE OF NONMARKETABLE ASSETS 33
2.5 EMPIRICAL PROBLEMS OF THE CAPM 34
2.5.1 THEORETICAL AND PRACTICAL PROBLEMS
WITH RISKLESS ASSET 34
2.5.2 EMPIRICAL DISTRIBUTION OF SECURITY
RETURNS 36
2.6 EMPIRICAL TESTS OF THE CAPM 37
2.7 THE ROLL’S CRITIQUE 38
2.7.1 LIVING WITH THE ROLL’S CRITIQUE 39
2.8 CONCLUSION 42
2.9 THEORETICAL DEVELOPMENTS AND ORIGINS OF THE APT 42
2.9.1 INTRODUCTION 42
2.9.2 BASIC ASSUMPTIONS 43
2.9.3 DERIVATION OF THE APT 45
2.9.4 COMPETITIVE-EQUILIBRIUM VERSIONS OF THE
APT 49
2.10 COMPARING THE APT WITH THE CAPM 52
CHAPTER 3 A LITERATURE SURVEY OF THE EMPIRICAL
RESEARCH ON THE ARBITRAGE PRICING
THEORY
3.1 EARLY STUDIES 56
3.2 EMPIRICAL TESTS OF THE APT : EARLY STUDIES 61
3.3 EMPIRICAL TESTS OF THE APT : THE DHRYMES CRITIQUE 67
3.4 EMPIRICAL TESTS OF THE APT : NON-US STUDIES 71
3.5 INTERNATIONAL APT 73
3.6 EMPIRICAL TESTS OF THE APT : NON EQUITY STUDIES 74
3.7 OTHER APPROACHES 75
3.8 MACROECONOMIC FACTORS OUTSIDE THE APT 77
3.9 EMPIRICAL TESTS OF THE APT : MEASURED-
MACROECONOMIC FACTOR APPROACH 78
3.10 MEASURED-MACROECONOMIC FACTOR APPROACH :
NON-US STUDIES 82
3.11 CONCLUSION 83
CHAPTER 4 FACTOR ANALYSIS
4.1 INTRODUCTION 87
4.2 THE MATHEMATICAL MODEL FOR FACTOR STRUCTURE 87
4.2.1 ESTIMATION OF THE FACTOR LOADINGS 90
4.2.2 FACTOR ROTATION 92
4.3 FACTOR EXTRACTION TECHNIQUES 96
4.3.1 MAXIMUM-LIKELIHOOD FACTOR ANALYSIS 96
4.3.2 PRINCIPAL FACTOR ANALYSIS 100
4.4 THE CRITICAL ASPECTS OF FACTOR ANALYSIS 104
4.5 CANONICAL CORRELATION ANALYSIS 108
4.5.1 THE CANONICAL MODEL III
4.5.2 INTERPRETATION 112
4.6 FACTOR ANALYSIS AND PRINCIPAL COMPONENTS
ANALYSIS 114
CHAPTER 5 STOCK MARKET FACTORS AND APT:
THE UK EVIDENCE
5.1 INTRODUCTION 118
5.2 BACKGROUND 119
5.3 DATA DESCRIPTION 120
5.4 METHOD 123
5.5 PRINCIPAL FACTOR ANALYSIS 124
5.6 MAXIMUM-LIKELIHOOD FACTOR ANALYSIS 130
5.6.1 FACTOR PATTERNS 131
5.6.2 ROTATION OF FACTORS 132
5.7 RISK MEASURES AND AVERAGE RETURNS 137
5.8 DISCUSSION 141
5.9 NON STATIONARTTY 144
5.10 SUMMARY 145
CHAPTER 6 THE FACTOR STRUCTURE OF THE UK
ECONOMY
6.1 INTRODUCTION 150
6.2 BACKGROUND 151
6.3 DATA DESCRIPTION . 153
6.4 METHOD 156
6.5 PRINCIPAL FACTOR ANALYSIS 156
6.6 MAXIMUM-LIKELIHOOD FACTOR ANALYSIS 159
6.7 DISCUSSION 166
6.8 CONCLUSIONS 167
CHAPTER 7 STOCK RETURNS AND ECONOMIC FORCES:
THE UK EXPERIENCE
7.1 INTRODUCTION 168
7.2 BACKGROUND 169
7.3 EMPIRICAL RESULTS USING THE CANONICAL
CORRELATION ANALYSIS APPROACH 170
7.4 INTERPRETATION OF CANONICAL VARIATES 174
7.5 DISCUSSION 179
7.6 CONCLUSION 183
CHAPTER 8 STOCK MARKET FACTORS AND APT:
THE US EVIDENCE
8.1 INTRODUCTION 187
8.2 DATA DESCRIPTION 187
8.3 METHOD 188
8.4 PRINCIPAL FACTOR ANALYSIS 190
8.5 MAXIMUM-LIKELIHOOD FACTOR ANALYSIS 204
8.5.1 FACTOR PATTERNS 205
8.5.2 ROTATION OF FACTORS 211
8.6 RISK MEASURES AND AVERAGE RETURNS 221
8.7 DISCUSSION 223
8.8 SUMMARY 225