Time Series Variations of Stock Returns within Emerging Markets: An empirical study on the Capital Asset Pricing and Fama & French Three Factor Model

Abstract

Although considered as being more volatile, a general market sentiment urges investors to include stocks of emerging markets within their portfolios. The inclusion is justified based on two historical observations. Firstly, emerging markets’ stocks have historically outperformed stocks of developed countries in terms of higher stock returns. Secondly, stock markets within emerging markets do not move exactly like stock markets within developed countries. Thus, investments within emerging markets experience low correlations with investments in developed countries. Thereby, diversification benefits are realizable by portfolio managers. Based on historical data from 1990 to 2013, this research study finds mixed evidence concerning higher volatilities and higher returns within the emerging countries of India, Indonesia, Pakistan, Philippines and South Korea. In turn, this study shows clear benefits in terms of low correlations for investments within emerging markets. Therefore, this study argues that portfolio managers should generally include stocks from emerging markets within their portfolios. When deciding to invest within emerging markets, the stock selection is the most crucial task for portfolio managers. Therefore, equity asset pricing models can be employed to understand the risk and return characteristics of stocks. Academic literature offers mixed results concerning the validity and performance of traditional asset pricing models within the context of emerging markets. Therefore, this study performs an empirical study on the time series variations of stock returns from 2003 to 2012 within the above mentioned emerging markets. By employing global as well as domestic versions of the Capital Asset Pricing Model and the Fama & French Three Factor Model, risk factors, like beta, size and value, are analyzed concerning their influence on stock returns. In general, this study shows that domestic models outperform their global counterparts. However, the choice between the domestic Capital Asset Pricing Model and the domestic Fama & French Three Factor Model depends on the individual country. Furthermore, the domestic Fama & French Three Factor Model can be accepted as a statistically valid asset pricing model within the context of South Korea. Unfortunately, this study rejects the validity of the tested asset pricing models within the rest of the countries. Therefore, further research needs to engage in amending and improving the existing equity asset pricing models in order to improve their relevance.