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Abeysekera Mahajan 90 Internation Arbitrage Pricing Theory an Empirical Investigation

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Abeysekera and Arvind Mahajan Source: Southern Economic Journal, Vol. 56, No. 3 (Jan., 1990), pp. 760-773 Published by: Southern Economic Association Stable URL: http://www.jstor.org/stable/1059376 . Accessed: 21/03/2013 05:47

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SARATH P. ABEYSEKERA ofManitoba University Manitoba,Canada Winnipeg, ARVIND MAHAJAN TexasA & M University Texas CollegeStation,

I. Introduction The Arbitrage refined andextended (APT) of Ross [23; 24], later Pricing Theory [8], byConnor Huberman et al. [16], Dybvig[11], Stambaugh and Rothchild [15], Huberman [29], Chamberlin and Titman[14], Ingersoll has [4], Grinblatt [17], Chen, Roll, and Ross [5] amongothers, attracted considerable attention as a testable to the alternative [20]-Mossin Sharpe[26]-Lintner Model (CAPM).' The APT resembles theCAPM inthesensethat both [21] CapitalAssetPricing are linear modelswhere theCAPM is a single factor modelwhiletheAPT assumes that (market) m unobservable factors drive thesecurity time. The of the APT prices through pricing equation is developed the"no arbitrage ina linear between condition," by imposing resulting relationship and risk. return systematic expected Similarto the extensions of the singlecurrency CAPM to a multicurrency environment, Solnik [27] extended the APT to theinternational to the markets, International capital leading Since the a theoretical framework to (IAPT).2 IAPT provides Arbitrage Pricing Theory investigate theexistence of factors that andto checkwhether thesefactors are "priced"in returns, generate theinternational it is possible to empirically test thevalidity oftheIAPT jointly capitalmarkets, with thehypothesis that theinternational markets are The ofthisstudy capital integrated. purpose is to developand empirically testthesehypotheses and it is organized as follows.SectionII a briefdiscussion of the IAPT. SectionIII describes thetestable provides hypotheses implied utilized in thisstudy to testthesehypotheses. by theIAPT and thedata and themethodology results obtained arereported in section IV andsection V concludes thepaper. Empirical

*The authors theextremely comments of an anonymous referee and thefinancial gratefully acknowledge helpful assistance from theCentre for International Business intheFaculty Studies ofManagement oftheUniversity ofManitoba. 1. In light of Shanken an empirical theAPT pricing [25] andDybvigandRoss [12], from standpoint, relationship shouldbe viewedas an approximation rather than an identity. 2. For example,see Solnik[28], Grauer, and Stehle[13] forproblems encountered in empirically Litzenberger, theCAPM and forICAPM, see Solnik[28] andAdler andDumas[3]. testing

760

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761

II. International Arbitrage PricingTheory(IAPT) theproblem As shownby Solnik and Ross, theAPT, and hencetheIAPT, overcomes of agare over when asset demands summed the of who universe investors use different gregation This is because the portfolios in international CAPM context to measurereturns. numeraires of individual assetswhereas thefactors in theAPT are theoretical averages weighted represent oforiginal whichare notconstrained to be portfolios assets. constructs of theAPT, Solnik'sderivation oftheIAPT further Besidestheusual assumptions assumes and in a international markets, capital homogeneous expectations given perfect integrated country short are computed overa very timeinterval.3 Giventheseassumptions and that thereturns it is in a foreign thereturns of an asseti measured is given shown that j, Fr, currency by

where in foreign rH= return on asseti measured j currency in itsdomestic on asset i measured ri = return currency inS, theexchange variation ofcurrency rate j expressed )/S,- 1 = random sj = (St S,- 1 in units of thedomestic currency between risj = Cij = covariance ri andsj, and variance of si. 0-2 = modeland hence,fora It is further assumedthatthereturn generating processis an m-factor i .4 domestic security + + - + bimfm (2) " -i lf of security i. Combining whereFi is the meanreturn (1) and (2) Solnikshowsthat equations evenin foreign terms thedomestic entails no risk andhenceshouldearnzero arbitrage portfolio the APT in in holds a environment returns equilibrium. Thus, pricing relationship multicurrency for as well. In specific, a givensecurity i, ri = Fi + bi

ri = Ao + Albii + " + Aimbm. (3)

If a risk-free billof foreign assetsinj's economy) then (anditis one ofthemany country j exists follow the its domestic should whose stochastic return (2) currency relationship component Ry willbe sj [27, 452, n.9]. Therefore,

s = E(sj) + bjlf + -.-+ bjmfm+ i;. (4)

ir = rj

+ bllfi

+

--'

-+

bmfm

+ vj

(5)

of theAPT, see RollandRoss [22]. 3. Fora concisedevelopment havebeenomitted. thetimesubscripts in theexpression 4. For simplicity,

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762

where

bk = (bik - bjk) [k 1, 2,...,m], and vj = (iiUj).

Thisimplies is invariant in which that them-factor to thecurrency return generating process andtogether theoriginal thereturns with setofassumptions, aredenominated the gives following for relation a givensecurity: pricing J = A + A bI + + AJ bj (6)

EJ = LJB* (7)

of meanreturns, whereE/ is theN-element row vector N is thenumber in the of securities + is and is a the matrix row vector of elements. (m 1) augmented loadings portfolio, B*j Lj A majorconsequence ofthetwopricing therisk (3) and(6) is that (i.e., relationships premia thepriceimplication of (or their contribution between structure to) thecovariance A's) represent assetreturns and thecurrency j [27, 453]. Thatis:

)biI + Cij = (A1 - AJ

...

+ (Am - A )bim

(8)

thereturn from whereCij is thecovariance between asseti andthepercent changein exchange in units ofthedomestic rateof currency j measured currency. theIAPT empirically andrejected thejointhypotheses Cho, Eun, and Senbet[7] also tested is and that APT is that theinternational market the valid Howcapital integrated internationally. and this while Senbet used international common factors for test Cho, Eun, ever, purposes, study andhenceprovides ofSolnik's utilizes common factors a direct test claimson theIAPT. domestic discusstheempirical to test theIAPT and theresults The following sections procedures applied obtained.

III. EmpiricalTests

Hypotheses

This studyempirically evaluatesthe validity of theIAPT (alongwiththejoint hypothesis of thefollowing four H4: Hi through international integration) bytesting capitalmarket hypotheses

and the corresponding H 1. The equalityof the intercept terms risk free rates. Ho : Ha: Ao = Rj

Ao Rj.

763

Ha :

m # mj.

thereturns one numeraire to wherem is thenumber currency from converting before offactors theconversion tocurrency and mj is thenumber another j. after offactors risk H3. Thestatistical oftheestimated premia. significance Ho:

Ha :

Ak= 0,

Ak # 0,

k = 1,...,m

k = 1,...,m,

estimated themodel(Cij) and covariances H4. The equality of thecurrency-asset through data (Cij). observed thosecomputed using

Ha :

Ci #

Cij.

Data are(a) themonthly returns on individual The basicdataunits usedinthestudy stocks for (adjusted industrialized dividends and stocksplits)inthree countries, viz., Canada,theU.K. andtheU.S.; and(c) theTreasury billrates inthethree countries. The period ofthis rates; (b) thespotexchange months from 1973 to December in 168 1986-the whole January encompasses span which study theflexible rateregime. The security in selection criterion data wereavailableduring exchange on of listed is based random selection securities for the test entire forming continuously portfolios countries' Londonand NYSE i.e., Toronto, majorstockexchanges, periodon each of thethree the bill rateis proxied rate of All and AMEX. The risk-free each country. by 90-dayTreasury The Canadianstockmarket in thisstudy arebased on month-end observations. datautilized data wereobtainedfrom the Stock Data MasterFile fortheToronto StockExchange, compiled by datawereprovided theLaval University, Quebec. The U.K. stockmarket bytheLondonSchool forResearch datasourcewas theCenter in StockPrices, of Businessand theU.S. stockmarket rates andTreasury billrates from ofChicago.Data on foreign wereobtained exchange University theBankofCanadaandtheBankofEngland. theU.S. FederalReserve System, Methodology based on subsets of all existing of securities As theAPT allowstesting assets,sevengroups (or universe were from constructed each ofthethree countries' (i.e., 21 portfolios security portfolios) of 40 randomly selected securities.' in all), each consisting themonthly on all returns Initially, as in in their homecountry the numeraire were used the where securities each currency analysis, to theMaximum Likelihood FactorAnalysis was subjected (MLFA) by prespecifying portfolio thefactor of factors from one to eight to determine thenumber loadings. tests oftheAPT arejointtests oftheAPT pricing that most oftheexisting It shouldbe noted

with of forming of securities. Our and Modest[19] showsadvantages 5. Lehmann many portfolios largenumber and318Canadiansecurities which of 168monthly return observations choicewas based upontheavailability persecurity in oursample. forinclusion qualified

764

and an assumed number offactors. As thetheory does notaddress the (or estimated) relationship issue of thenumber of relevant theapproaches taken factors, are variedamong by researchers different studies.For instance, Roll and Ross [22] determined 5 as theappropriate of number factors from a smallsampleof portfolios and utilized thisas theappropriate forall their number And for theprecedence established and Gultekin Friend, portfolios. byRollandRoss,Dhrymes, In a morerecent Lehmann and Modest[19] assume5, 10 and [9] also used 5 factors. study, in their 15 factors As thegeneral to thedetermination of thenumber of factors study.' approach is ad hoc, we conducted theMLFA foreach of the21 portfolios under to determine the study of number factors from one to Not we the appropriate eight. surprisingly, although employed based on theChi-square statistic in our Maximum usual criterion Likelihood FactorModel to determine themodeladequacy, theresults obtained did notclearly a uniquenumber of provide factors whichwas consistent forall the7 portfolios of a particular Rather securities. country's a specific of factors thanarbitrarily number to represent all portfolios of a country, we choosing each portfolio analyzed separately. 7 portfolios The monthly ofeach country's werethen transformed to thetwoforeign returns 42 newportfolios currencies as thenumeraire.7 Each of theresulting thus formed with converted MLFA was also to as before to determine its modeladequacyand thefactor returns subjected loadings. This study theGeneralized Least Squares(GLS) regression employs procedure, following Roll and Ross and Dhrymes, and Gultekin therisk Friend, [9; 10],to estimate premia,

L* (B*'V- B*)-I B*'V'- 1R (9)

of time-series B* is the augmented whereL* is the matrix and riskpremia, factor intercepts V is theestimated covariance matrix andR is thematrix ofreturns. loadingmatrix, L* are subjected terms extracted from to tests To testH 1, theintercept to determine their and their to the risk-free The differences between the rates.8 appropriate significance equality andtherisk-free arecomputed terms rates for eachmonth andthese estimated differences intercept A more to a t-test to determine their levelof significance. testis conducted are subjected robust the monthly time-series of the intercept terms on therisk-free ratesin orderto by regressing of a and a the test zero coefficient of This allowsanalyzing intercept slope unity. perform joint andthetime-series oftheregression errors. the"goodness-of-fit" properties H3 to determine thesignificance The Chi-square testis utilized fortesting of thevector of risk The five series of risk or A's are extracted for this L* in from relation premia premia. purpose thehypothesis that all factors arepriced to test for eachportfolio of securities (9) andthestatistic in a givencurrency is: with returns expressed

TXkW- - X2

cameto thetentative that oneeigenvaluedominates thecovariance 6. Trzcinka matrix, [30], basedon thefinding five valuesbehave Itfurther found that thefirst modeldescribes conclusion that onefactor differently eigen security pricing. five factors arerelevant. to thefact that from therestalluding onlythefirst into with theCanadian dollarandthepoundsterweretranslated 7. Forinstance, all U.S. security returns returns in 42 (7 portfolios Thistransformation resulted month-end rates. theappropriate exchange utilizing lingas thenumeraire x 3 countries x 2 foreign ina currency with other than their homecurrency. newportfolios returns currencies) expressed forthemonthly risk-free ratesin numeraire are monthly 8. As all portfolio returns returns, j, Ri, were proxy manner: ratein numeraire theavailableannualized calculated from j inthefollowing 90-dayT-bill

Ri = (1 + annualized 90-day T-bill ratej)1/12 - 1.

765

Akt. =

T =

(lI/T) (T=l(Akt - Ak)(kt -A Xk) ofrisk timeseriesestimates k = 1,... m vector, premia = 168. number of observations

statistic is asymptotically The test with m degrees offreedom. Thenullhypothesis that Chi-square is 0 for all k m at a level of if confidence thecomputed 1,...., Ak = rejected given Chi-square is greater than thecritical valueat that level. In addition, thesignificance oftheindividual risk totest is performed a t-test terms, premium In the matrix the vector of is t-statistics notation, using following procedure. computed by: t = T -M -(Diag(S))-1 where T = M = S = number of observations of themeansofthetimeseries vector ofeach coefficient vector of standard deviations.

Ifthecomputed are larger than thecritical t-values valueat a given levelofsignificance, then the nullhypothesis that thegivenrisk is not different from zero is premium significantly rejected. In order to testH4, we utilize therelationship (8). given byequation

where as before, and Cij andsj are defined = risk associated with k withassetreturns factor measured in the domestic Ak premia currency. k whenassetreturns are expressed in foreign Ak = riskpremiaassociatedwithfactor as thenumeraire. j's currency country coefficient forasseti estimated in measured (or loading) bik = thefactor usingitsreturns thedomestic currency. The leftside of the above expression (equation(8)) is computed directly usingobserved data and theright side is obtained from theestimates of riskpremia and thefactor loadings. is tested The equalityof thesetwo quantities based on usinga multivariate pairedcomparison If T2 statistic.9 thecomputed than thecritical value,thenthenull Hotellings' T2 valueis larger is rejected. of their equality hypothesis

inthecase ofa portfolio ofU.S. securities, 9. Forinstance, with Canadiandollar comprised Cij andCij associated returns on thisportfolio us to havea vector of differences wereobtained returns enabling poundsterling (dlk). Similarly, ofdifference another vector of U.S. securities (d2k)provide d' = [dlk,d2k], k = 1,2,... ,n = 40 with

766

a,b ofTesting tothe Results the Terms Are Risk-Free Rate TableI. Summary Hi That Intercept Equal

Number of Factors, m (1) Securitiesand CurrenciesUsed US (2) USINCD (3) USINUK (4) CDN (5) CDINUS (6) CDINUK (7) UK (8) UKINCD (9) UKINUS (10)

1

2 3 5 7

7

7 6 6

7

7 6 6

7

7 6

6

6 5

6

6 6 7

6

6 6

7

7 7 7

7

7 7

4

6 8

6

5

6

6 6

6

6

6

6

7

6

7

6

6

6

7

7

7

7

7 7

7

7

7 7

6 6

6

6

7

6

6

6

7 7

7

7

= Rj, H, :Ago a. Ho : AJo #Rj. that theHo is true ofportfolios b. Number (i.e., failtoreject indicating Ho at90% levelofconfidence). in U.S. $. measured c. US - U.S. security returns in Canadian$. measured USINCD - U.S. security returns in poundsterling. measured USINUK - U.S. security returns in Canadian$. measured CDN - Canadiansecurity returns in U.S. $. measured CDINUS - Canadiansecurity returns in poundsterling. measured CDINUK - Canadiansecurity returns in poundsterling. measured UK - U.K. security returns in Canadian$. measured UKINCD - U.K. security return in U.S. $. measured UKINUS - U.K. security return

IV. Results theresults ofthetest ofH I that theintercept riskTableI summarizes terms equatetheappropriate free of factors Column1 of Table I givesthenumber usedin theanalysis whilecolumns rates.'0 in which 2 through 10 showthenumber of portfolios we failed to reject For thenullhypothesis. in of in the case the U.S. returns measured dollars column Canadian instance, (i.e., 3) security in 6 outof 7 U.S. security witha specification of 5 factors, we failto reject thenullhypothesis In brief, in 34 outof 72 cases for we failto reject thenullhypothesis all 7 portfolios, portfolios. in 36 out of theremaining 41 cases we failto reject thenullhypothesis for6 portfolios, and in 2 cases, we failto reject theremaining thenullhypothesis for 5 portfolios. Therewas no instance

=8 E(dk) = 1

A test ofHo : 8 = 0 versus Ha :8

and

cov(dk)=

T2 = n'Sd-S1d > [(n - 1)p/(n -p)]Fp,n-pa

where

d= (1/n)E dk

k=1

Sd =

(1/n

k=l

of d' need notbe assumedand T2 has a X2 distribution witha level of Since n - p (or 40 - 2) is large,normality and Wichern See Johnson details. [18, 227-30] for significance. forall summary from 10. Detailedresults tablesareavailable theauthors uponrequest.

IAPT: AN EMPIRICAL INVESTIGATION of Testing Terms AreEqual toZeroa,b Table II. Summary Results Hi ThattheIntercept

767

US (2)

USINCD (3)

Securities andCurrencies Usedc USINUK CDN CDINUS CDINUK UK (4) (5) (6) (7) (8)

UKINCD (9)

UKINUS (10)

3 4 5 6 7 8

1 2

0 3

3 3 3 3 3 2

0 1

1 2 2 2 2 2

0 2

2 3 3 2 2 2

0 0

0 0 0 0 1 1

0 1

1 1 1 2 1 2

0 0

1 1 1 1 1 1

0 0 0 0 0 0

0 0

4 3 3 4 2 2

2 2

1 1 0 0 2 1

2 2

a. Ho : Ah = 0, Ha: 0. Ao of portfolios that theHo is true b. Number (i.e., failto reject Ho at 90% levelofconfidence). indicating measured in U.S. $. c. US - U.S. security returns in Canadian$. measured USINCD - U.S. security returns in poundsterling. measured USINUK - U.S. security returns in Canadian measured CDN - Canadiansecurity returns $. in U.S. $. measured CDINUS - Canadiansecurity returns in poundsterling. measured CDINUK - Canadiansecurity returns in poundsterling. measured UK - U.K. security returns in Canadian measured UKINCD - U.K. security return $. in U.S. $. measured UKINUS- U.K. security return

forat least5 of the7 portfolios, wherewe did notfailto rejectthenullhypothesis irrespective As one of ownnumeraire orin anyother in their weremeasured of whether thereturns currency. of thepricing term modelrepresents the of theIAPT is that theintercept themajorimplications to theIAPT. risk-free rate,theseresults provide support forthevalidity of Hi couldbe due to a weak thesupport that To eliminate thepossibility to determine whether theintercept terms aresignificantly was conducted setof tests test,another in Table II, indicate thatin the case of U.K. summarized fromzero." The results, different thenullhypothesis inpounds returns (column 8), all 7 portfolios reject sterling expressed security of thenumber of factors used. The case of theintercept terms are equal to zero,regardless that U.S. in Canadiandollars whereas Canadiansecurity returns (column 5) also showstrong support to the The most relevant show mild in dollars U.S. H1. returns figures relatively support security thantheir are measured in a currency other returns to theIAPT are whenportfolio pertaining in columns These are contained homecurrency. 3, 4, 6, 7, 9 and 10 of TableII and in general in U.K. security returns are measured forthecase where to HI, particularly lendweak support Canadiandollars. of Hi by regressing thetime-series estimates of testing the results Table III summarizes oftheportfolios risk-free rates. indicate on thecorresponding terms Here,a vastmajority intercept is unity. of regression is zeroandtheslopecoefficient that term theintercept of themodelsas aboutthegoodness-of-fit As all theabove testsof Hi entailassumptions we these in more detail. ofthevariables, investigated properties wellas thetime-series properties in the showa general lack-of-fit of thesetests.The results the findings Table IV summarizes does appearto be a on therisk-free rates.Autocorrelation terms theintercept modelregressing to the The strong of theresiduals is notstrongly and thenormality support supported. problem

11. These tests weresuggested bythereferee.

768

Number of

Securitiesand CurrenciesUsedc

m Factors,

(1)

US

(2)

USINCD

(3)

USINUK

(4)

UK

(5)

UKINUS

(6)

UKINCD

(7)

CDN

(8)

CDINUS

(9)

CDINUK

(10)

1 3 4 5

6 7 8 2

7

6

7

5

7

7

3

5

5

6

6

6

6

6

6

6

6

6

5 5 5

6 4 7

5 5 4

5 6 7

6 6 6

6 6 7

7 7 7

7 7 7

6 6 6

6 6 6

6 6 7

6 6 6

6 6 6

6 7 7

6 6 6

6 7 7

6 6 6

7 7 7

a. Model: Aot= o + IRft+ et, Ho : ao = 0, 1 = 1, Ha :ao = 0,a 1 1. at 10% levelof significance. basedon F-test that theHo is true of portfolios b. Number indicating in U.S. $. measured c. US - U.S. security returns inCanadian$. measured USINCD - U.S. security returns in poundsterling. measured USINUK - U.S. security returns in poundsterling. measured UK - U.K. security returns in U.S. $. measured UKINUS - U.K. security return in Canadian measured UKINCD - U.K. security return $. in Canadian measured CDN - Canadiansecurity returns $. in U.S. $. measured CDINUS - Canadiansecurity returns inpoundsterling. measured CDINUK - Canadiansecurity returns from ofAot vs. Rft oftheResidual andTime-Series of Goodness-of-Fit Table IV. Summary Regression Properties

at 5% Level Failure to RejecttheNullHypothesis of Significance in Parentheses*) (As a percentage Null Hypothesis 1. Goodness-of-Fit is notadequate

2. No Autocorrelation with lag of one period 3. No Autocorrelation with lag of 12 periods 4. Model is adequate (Residual is white noise withk = 24) Residual is normally distributed

Partial Autocorrelation Function Partial Autocorrelation Function Box-Pierce Test Kolmogorov D-statistic

11 (6.5) 11 (6.5) 160 (95.2) 96 (57.1)

5 (3.0) 18 (10.7) 105 (62.5) 107 (63.7)

6 (3.6) 6 (3.6) 138 (82.1) 86 (51.2)

5.

769

ofTesting H2 Thatthem-Factor Model Is Invariant to theCurrency inWhich theReturns Results Table V. Summary a,b Are Expressed

Canadian Returns Security Denominated in CDN$ (5) US$ (6) ? (7) ? (8)

0

0 0 0

0

0 0 0

0

0 0 3

0

0 0 3

5 6

7 8

4 5

1 2

4 5

1 2

1 2

2 5

3 4

6 7

3 4

6 7

0 0 1 6 7

0

0 0 0

0

0 0 0

0

0 0 0

1 4

2 4

4 6

2 4

4 6

2 4

4 6

a. Ho : m = m, Ha : m # mj of portfolios m factors are sufficient b. Cumulative number (i.e., failto reject indicating Ho at 90% confidence level).

in light ofthese and in conjunction IAPT provided results, bytheF-tests(TableIII) is weakened of thet-tests is with theresults our overall results. (TableII), H1 onlymildly supported by thefindings of thetestof hypothesis H2 that Table V summarizes thenumber of factors, to theforeign thereturns of factors converting currency, equalsthenumber m, before mj, after to the foreign For instance, in column2 the returns j as the numeraire. converting currency inU.S. dollars) measured noneofthe7 portfolios U.S. security indicates model returns (regarding or 4 factors and of 3 are used out 7 that indicated 5 factors only1 portfolios adequacywhen1, 2, to lendsupport to theIAPT one shouldobserve For theseresults that thenumber are sufficient. witha specific of portfolios of one country's securities number of underlying factors shouldbe in whichtheir are For invariant to thecurrency measured. when U.S. returns instance, security in dollars in are denominated U.S. Canadian dollars returns (column (column 3) and 2), security of portfolios in poundsterling indicate that are 5, 6 and 8 factors (column4), thesame number to explainthereturns. sufficient of factors, As postulated to remain m, is expected by theIAPT, thenumber unchanged, of thecurrency in whichthereturns are denominated. One wouldexpect,therefore, regardless as one movesacrossthecolumns in TableV for to observe of a given thesame figure portfolios results do fulfill this and one can The a pattern discern generally requirement, country. reported in the columnsmove closelytogether as the number of factors is wherefigures prespecified columns for a downthethree The picture increased (i.e., moving securities). particular country's is cloudedbecausethereported results arefor theaggregate number of however, depicted bythis, of individual when are and the behaviour converted to different returns portfolios portfolios ignore currencies. theindividual whichcomprised the Table VI sheds lighton thisby identifying portfolios in Table V. Column1 of Table VI indicates thenumber of factors aggregate figures reported 2 through 10 showtheidentity of used in themodelwhilecolumns number) (i.e., theportfolio of for which met the criterion. In the case U.K. theindividual securities, Chi-square portfolios in columns when5 factors are prespecified, instance, (in aggregate terms) 8, 9 only2 portfolios weresufficient to explain thereturn that 5 factors and 10 in Table V indicated generating process

770

ofTesting TableVI. Results Individual Portfolios Which Indicated mFactors AreSufficient H2--The Canadian Security Returns Denominated in CDN$ (5) N

N N

2 3

N N

N N

CDN$ (3) N

N N

? (4) N

N N

2 2

? (7) N

N 2

CDN$ (9) N

N N

US$ (10) N

N N

N N 2 2 2

2 2 1 2 2

N N N 1,5 1,5 1,5 1,3,4,5 1,3,4,5 1,3,4,5 1,3,4,5 1,3,4,5 1,3,4,5 1,2,3,4,5,6 1,2,3,4,5,6 1,2,3,4,5,6

in theU.K. market. Table VI showsthat boththeseportfolios 1 and 5) number (i.e., portfolio behavein a manner consistent withtheIAPT. Table VI, in general, is supportive of theIAPT in viewof thebehaviour of individual andthis trend becomes more as the portfolios pronounced number of factors in themodelincreases. Another testable there is a linear between hypothesis implied bytheIAPT is that relationship theriskmeasures in thefactor embodied and theexpected returns. IAPT suggests that loadings thesefactors shouldbe priced(ifthey are associated withan asset'ssystematic and hence risk) their shouldbe significantly different from coefficients, relationship Aj's, in the IAPT pricing zero. Roll and Ross [23, 1089-98]amongothers evaluated thisusingtheindividual t-statistics whichwerecomputed theresults oftheregression Thisprocedure, byutilizing however, analysis. has two majordrawbacks. are not across First,thet-statistics factors,12 generated independent and second,thefactors from different The way regressions mayhavedifferent interpretations.'3 outof thisdilemma, as suggested andGultekin a Friend, [9; 10, 77] is to conduct byDhrymes, vector ofrisk rather than thesignificance test oftheindividual jointtestof thecomplete premia, risk premia.'4 Table VII summarizes thefindings from thetestof thehypothesis H3 that theriskpremia vectors arenotsignificantly from different zero.Thereported results showthat with theexception of a fewcases (forinstance, Canadiansecurity with the8-factor we model),in general portfolios failto rejectthenullhypothesis. it shouldbe notedthat as thenumber of factors in However, themodelis increased, a growing number of portfolios tendto reject thenullhypothesis (i.e.,

12. The dependence arisesas a result of augmenting theloadings matrix to estimate Ao's wheretheaugmented matrix is notdiagonal.See Roll and Ross [22, 1091] 13. This is due to thenon-uniqueness ofthefactors, thefirst factor from one group i.e., for instance, mayor may notcorrespond to thefirst factor obtained from another toalleviate this group.Cho [6] has attempted problem. 14. We performed forindividual tests risk t-statistics as wellas a jointChi-square test for significance premia using thevectors of riskpremia. The testofhypothesis H3 utilizing for t-tests individual risk indicated that mostofthe premia riskpremia associated with different factors werenotsignificant at 90% confidence level.Results ofthese t-tests arequite consistent withthoseof theChi-square tests and are notreported heredue to spaceconsiderations. Theseresults can be obtained from theauthors uponrequest.

771

Results ofTesting H3 ThattheRiskPremia Table VII. Summary Vectors AreInsignificantly Different from Zeroa,b

US (2) 7 6 4 4 5 3 2

USINCD (3) 7 5 4 4 4 3 2

Securities andCurrencies Usedc USINUK CDN CDINUS CDINUK UK (4) (5) (6) (7) (8) 7 5 4 4 4 3 2 7 7 7 6 5 5 0 7 7 7 6 6 5 0 7 7 7 7 5 5 0 7 7 7 7 7 7 5

UKINCD (9) 7 7 7 7 7 7

UKINUS (10) 7 7 7 7 7 7 4

7

3

a. Ak= 0, k = 1,2,...,m, Ak#0, k = 1,2,..., m b. Number of portfolios that theHo is true (i.e., failto reject indicating Ho at 90% levelof confidence usingthe test). Chi-square c. US - U.S. security returns measured in U.S. $. in Canadian USINCD - U.S. security measured returns $. USINUK - U.S. security in poundsterling. measured returns CDN - Canadiansecurity in Canadian measured returns $. CDINUS - Canadiansecurity in U.S. $. measured returns CDINUK - Canadiansecurity inpoundsterling. measured returns UK - U.K. security in poundsterling. measured returns UKINCD - U.K. security inCanadian measured return $. UKINUS - U.K. security measured in U.S. $. return

theIAPT). Overall,theresults of H3 do notsupport theIAPT. Interestingly, these results support are similar to thoseof previous forthisparticular studies butin thecontext of the hypothesis, domestic APT. Forexample, andGultekin conducted a similar test oftheAPT Friend, Dhrymes, U.S. security returns dataandfound in 36 outof42 portfolios that therisk were utilizing premia different from zero. and similar from insignificantly Abeysekera Mahajan[1; 2] report findings ofAPT in theU.K. andCanada. Hence,this their tests failure toreject thenullhypothesis study's that theriskpremia areequal to zerois notaltogether in light oftheresults obtained in surprising tests of the APT. previous empirical single currency The results of themultivariate test basedon Hotelling's T2 statistic of H4 that theestimated and theobserved covariances are equal indicate of thenullhypothesis currency-asset rejection castsdoubts on thejointhypothesis of (at ac = .10) in all possiblecases.'"Thisoutcome clearly markets and the of the IAPT for the Canadian and the integrated capital validity pricing U.S., U.K. securities.16

V. Summaryand Conclusions Thispaperderived four totest thevalidity oftheIAPT andsubjected them toempirical hypotheses individual Canada,theU.K. andtheU.S. As scrutiny utilizing monthly security pricedatafrom

15. Due to their theseresults arenotreported herebutcan be obtained from theauthors similarity, uponrequest. to reject ata = .05 in only 4 outof 168possible We failed thenullhypothesis cases. 16. As Solnik [27] pointsout "thatthe assumption of onlym common factors and independent residuals imply on currency-asset severeconstraints covariance the testof H4 directly checksthe adequacyof the model's matrix", underlying assumptions.

772

in all empirical ofvarious tests this conducted oftwohypotheses, models, pricing study jointtests theIAPT is a validinternational assetpricing andthat viz., that international capital theory capital markets are wellintegrated. Resultsobtainedin thisstudyprovideweak support to hypothesis H1 thatthe risk-free ratesare equal to thecorresponding estimated terms of the models thusweakly tested, intercept theIAPT. The results indicate that thenumber offactors in a given supporting generally economy is invariant to thecurrency inwhich thereturns aredenominated areconsistent with and,therefore H2. As data limitations H2 to these results hypothesis precluded subjecting parametric testing, haveto be cautiously thethird from two H3, thetestresults interpreted. Regarding hypothesis different and theChi-square theriskpremia are not (i.e., thet-test test)showthat procedures from different zero. This finding does notsupport theIAPT and is similar to the significantly results obtained studies the domestic APT. The results of H4 by testing testing hypothesis show that theassumption of an m-factor modelandindependent residuals do indeed constraints impose on themodel. ofthisstudy do notlendsupport On balance,theresults totheIAPT. However, theseresults are subjectto samplesize constraints and thelimited of some tests. These caveats power along withthe well recognized of testing thejointhypothesis of theIAPT beingvalid and problem shouldencourage further tests of theIAPT using international beingintegrated capitalmarkets moresophisticated testprocedures andlarger datasets. References

1. Abeysekera, Sarath P. and Arvind U.K. Stocks."Journal Mahajan,"A Testof theAPT in Pricing ofBusiness Financeand Accounting, Autumn 1987,377-91. 2. CanadianStocks."CanadianJournal June Sciences, , "A Testof theAPT in Pricing ofAdministrative 1987, 186-98. 3. Adler,Michaeland Bernard Portfolio Choice andCorporation Finance:A Synthesis." Dumas, "International Journal ofFinance,June1983,925-84. 4. Chamberlin, Factor and Man-Variance on Large Structure, Garyand MichaelRothchild, "Arbitrage Analysis AssetsMarkets." Econometrica, 1983, 1281-304. September 5. Chen,Nai-Fu,Richard Roll and Stephen Forces andtheStockMarket." Journal Ross, "Economic ofBusiness, 1986,383-403. July 6. Cho, David C., "On Testing theArbitrage Factor Journal Pricing Theory: Inter-Battery ofFinance, Analysis." December1984, 1485-502. 7. An Empirical Investi, Cheol S. Eun andLemmaW. Senbet,"International Arbitrage Pricing Theory: Journal gation." ofFinance,June1986,313-29. 8. Connor, "A Unified Beta Pricing Journal October1984, 13-31. Gregory, Theory." ofEconomic Theory, 9. Dhrymes, PhoebusJ., IrwinFriend and Mustafa N. Gultekin, "A Critical Examination of theEmpirical Evidenceon theArbitrage Journal June 1984,323-47. Pricing Theory." ofFinance, 10. Examination oftheImplications ofArbitrage , "An Empirical , and Pricing Theory." ,Journal and Finance,March1985,73-99. ofBanking 11. Dybvig,PhilipH., "An Explicit Boundon Individual Assets'Deviations from APT Pricing." Journal ofFinancial Economics, December1983,483-96. 12. and Stephen Journal Ross, "Yes, theAPT is Testable." 1985, 1173-88. ofFinance, September 13. Grauer, Robert and Richard Rulesand Equilibrium in an Interntional Frederick, Stehle,"Sharing Litzenberger Under Journal June Economics, 1976,233-56. CapitalMarket ofFinancial Uncertainty." 14. Grinblatt, Markand Sheridan "FactorPricing in a Finite Journal Titman, Economics, ofFinancial Economy." December1983,497-507. 15. Huberman, to Arbitrage Journal October Gur, "A SimpleApproach Pricing ofEconomic Theory, Theory." 1982, 183-91. 16. Portfolios and Exact Arbitrage "Mimicking Pricing." , ShmuelKandel and RobertF. Stambaugh, Journal ofFinance,March1987, 1-7.

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of Arbitrage Journal 17. Ingersoll, Jonathan E., "Some Resultsin theTheory of Finance,September Pricing." 1984, 1021-39. Multivariate A. and Dean W. Wichern. Statistical N.J.: 18. Johnson, Richard Cliffs, Analysis. Applied Englewood Prentice Hall, 1982,pp. 227-30. Foundations of theArbitrage 19. Lehmann,Bruce N. and David M. Modest,"The Empirical Pricing Theory." Journal 1988,213-54. ofFinancialEconomics, September "The Valuation of Risky AssetsandtheSelection of Risky in StockPortfolios 20. Lintner, Investments and John, and Statistics, 1965, 13-37. ofEconomics February CapitalBudgets."Review in CapitalAssetMarket." October 21. Mossin,Jan,"Equilibrium Econometrica, 1966,763-83. 22. Roll, Richardand StephenRoss, "An Empirical of theArbitrage Journal Investigation Pricing of Theory." Finance,December1980, 1073-103. ofCapitalAssetPricing." 23. Ross, Stephen, Journal December "The Arbitrage 1976, ofEconomic Theory Theory, 341-80. inRisk RiskandArbitrage," andReturn inFinance, 24. "Return Vol. 1, edited Friend andJames byIrwin Mass.: Ballinger Bricksler. 1977,pp. 189-218. Cambridge, TestsoftheZero BetaCAPM." Journal 25. Shanken, "Multivariate 1985, ofFinancial Economics, Jay, September 327-48. A Theory ofMarket 26. Sharpe, William Under Conditions ofRisk."Journal F., "CapitalAssetPrices: Equilibrium 1964, 425-42. ofFinance,September 27. Solnik,BrunoH., "International Journal ofFinance, Arbitrage Pricing Theory." May 1983,449-57. . "Testing 28. International AssetPricing: SomePessimistic Views."Journal ofFinance,May 1977,50311. with 29. Stambaugh, Information." Journal 12, 1983,357-69. Economics, Robert, ofFinancial "Arbitrage Pricing ofFactors intheArbitrage 30. Trzcinka, June1986, Model."Journal Charles,"On theNumber ofFinance, Pricing 347-68.

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