Market anomalies, asset pricing models, and stock returns: evidence from the Indian stock market
| Pages | 306-328 |
| Published date | 03 August 2015 |
| DOI | https://doi.org/10.1108/JABS-06-2014-0040 |
| Date | 03 August 2015 |
| Author | Saumya Ranjan Dash,Jitendra Mahakud |
| Subject Matter | Strategy,International business |
Market anomalies, asset pricing models,
and stock returns: evidence from the
Indian stock market
Saumya Ranjan Dash and Jitendra Mahakud
Saumya Ranjan Dash is
based at Indian Institute
of Management, Indore,
India. Jitendra Mahakud
is based at Indian
Institute of Technology,
Kharagpur, India.
Abstract
Purpose –This paper aims to investigate whether the use of conditional and unconditional Fama and
French (1993) three-factor and Carhart (1997) four-factor asset pricing models (APMs) captures the role
of asset pricing anomalies in the context of emerging stock market like India.
Design/methodology/approach –The first step time series regression approach has been used to
drive the risk-adjusted returns of individual securities. For examining the predictability of firm
characteristics or asset pricing anomalies on the risk-adjusted returns of individual securities, the panel
data estimation technique has been used.
Findings –Fama and French (1993) three-factor and Carhart (1997) four-factor model in their
unconditional specifications capture the impact of book-to-market price and liquidity effects
completely. When alternative APMs in their conditional specifications are tested, the importance of
medium- and long-term momentum effects has been captured to a greater extent. The size, market
leverage and short-term momentum effects still persist even in the case of alternative unconditional and
conditional APMs.
Research limitations/implications –The empirical analysis does not extend for different market
scenarios like high and low volatile market or good and bad macroeconomic environment. Because of
the constraint of data availability, the authors could not include certain important anomalies like net
operating assets, change in gross profit margin, external equity and debt financing and idiosyncratic
risk.
Practical implications –Although the active investment approach in stock market shares a common
ground of semi-strong form of market efficiency hypothesis which also supports the presence of asset
pricing anomalies, less empirical evidence has been explored in this regard to support or repute such
belief of practitioners. Our empirical findings make an attempt in this regard to suggest certain
anomaly-based trading strategy that can be followed for active portfolio management.
Originality/value –From an emerging market perspective, this paper provides out-of-sample
empirical evidence toward the use of conditional Fama and French three-factor and Carhart four-factor
APMs for the complete explanation of market anomalies. This approach retains its importance with
respect to the comprehensiveness of analysis considering alternative APMs for capturing unique
effects of market anomalies.
Keywords Market anomaly, Emerging market, Stock return, Momentum, Asset pricing model,
Risk factor
Paper type Research paper
1. Introduction
Identification and empirical validation of factors which explain the cross-sectional variation
of expected stock returns has been one of the key issues in the investment management
research. Over the past two decades, there has been considerable research to support
that the predictable component of stock returns can be associated with several firm
characteristics or commonly perceived market anomalies. The existence of anomaly effect
as cross-sectional determinants of stock returns negates the cross-sectional relation
between average stock returns and systematic risk measured by alternative asset pricing
models (APMs hereafter). Interpretation of such empirical evidences across developed and
Received 20 June 2014
Revised 9 December 2014
Accepted 20 March 2015
PAGE 306 JOURNAL OF ASIA BUSINESS STUDIES VOL. 9 NO. 3, 2015, pp. 306-328, © Emerald Group Publishing Limited, ISSN 1558-7894 DOI 10.1108/JABS-06-2014-0040
emerging markets around the world is, of course, strongly debated. The present paper
attempts to shed more light on this debate by investigating whether cross-section of
expected stock returns is better explained by risk factors suggested by alternative APMs,
or market anomalies. More importantly, we seek to examine the use of Fama and French
(1993) three-factor and Carhart (1997) four-factor APMs in their alternative specification for
the complete explanation of market anomalies.
The role of firm characteristics or financial market anomalies for the determination of
cross-section of stock returns behavior (Amihud, 2002;Banz, 1981;Jegadeesh and
Titman, 1993;Stattman, 1980) has long been recognized as a challenge to the central
paradigm of the traditional asset pricing literature. In common, related literature suggests
two competing arguments on the cross-sectional regularity of such anomalies. First, the
apparent role of firm characteristics is the resultant of market inefficiency or profit
opportunities, and they are mere chance results that often seem to disappear after
documented in the academic literature (Dimson and Marsh, 1999). Second, the
documented firm characteristics serve as proxies for the riskiness of firms and, therefore,
serve as the better determinant of cross-section of stock returns behavior (Fama and
French, 1992;Chan and Chen, 1991). However, the debate between the two competing
arguments is still open and has drawn considerable attention in the investment
management research.
Following the risk-based argument of market anomalies, the available literature conjecture
that the identification and empirical validation of financial market anomalies have been
indeed a joint hypothesis test of informational efficiency of the market and predictability of
APMs (Schwert, 2003;MacKinlay, 1995). Rejection of the tests suggest that either the
market examined is not efficient, i.e. market anomalies are mere chance results (Schwert,
2003) appeared due to methodological illusions (Fama, 1998), or the equilibrium APMs fail
to properly describe stock returns behavior due to its inappropriateness, i.e. bad model
problem (Fama, 1998;MacKinlay, 1995). However, if the joint hypothesis is rejected, it still
fails to give a conclusive stand to attribute such rejection to either any one of the
aforementioned hypotheses. For instance, testing a three-factor model (Fama and French,
1993) for explaining the cross-sectional regularity of firm size (MC) and book-to-market
price (BP) ratio may lead to a situation where the proposed three-factor model may not be
able to capture the MC or BP effects, even though the proposed three-factor model
contains risk factors (small minus big, i.e. SMB, and high minus low, i.e. HML) that are
empirically motivated from the risk-based argument of MC and BP. In such a scenario, it will
be unconventional to argue that persistence of MC and BP effects are mere chance results
or methodological illusions (Schwert, 2003;Fama, 1998), and premature to discard the
claim that the systematic risk factors involved in the three-factor model (Fama and French,
1993) are inappropriate and subject to the bad model problem (Fama, 1998). Similar line
of argument can also be advocated with respect to the four-factor model (Carhart, 1997),
which augments the three-factor model with the momentum (MOM) risk factor. Given the
case of an opposite scenario, i.e. if the factor models are able to explain the market
anomalies, then also it will be premature to discard the propositions, e.g. stock market is
efficient (anomalies are resultant of market inefficiency) or anomalies are mere chance
results with no systematic risk attributes. We mention such an attempt as premature
because this will discard the theoretical argument of systematic risk-based explanation for
such firm characteristics, which motivates the development of alternative multifactor APMs
(Carhart, 1997;Fama and French, 1993;Pastor and Stambaugh, 2003).
To circumvent such issues, in recent finance literature, attention has been gradually shifted
from mere identification of market anomalies and testing their empirical cross-sectional
regularities to a more fundamental question, i.e. what explains expected returns, risk
factors or firm characteristics that are commonly perceived to be market anomalies. It has
been argued that if the empirically motivated risk factors of alternative multifactor APMs
(Fama and French, 1993;Carhart, 1997) represent market wide systematic risk, then after
VOL. 9 NO. 3 2015 JOURNAL OF ASIA BUSINESS STUDIES PAGE 307
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