Analysis of Indonesian Stock Exchange

Analysing Capital Asset Pricing Model in the Indonesia Stock Exchange

Abstract

The CAPM model depends on many factors to assure that this model is very useful for investor to predict what will happen in the future. The CAPM is simple consider the many assumptions that underlie the model, whether valid or invalid. Firstly, zero transaction costs, the CAPM assumes trading is costless so investments are priced to all fall on the capital market line. If not, some investments would hover below and above the line, with transaction costs discouraging obvious swaps.

However, we know that many investments (such as acquiring a small business) involve significant transaction costs. Secondly, available risk-free assets, the CAPM assumes the existence of zero-risk securities, of various maturities and sufficient quantities to allow for portfolio risk adjustments. Thirdly, borrowing at risk-free rates, the CAPM assumes investors can borrow money at risk-free rates to increase the proportion of risky assets in their portfolio. In fact, we would predict that the capital market line should become kinked downward for riskier portfolios (ß > 1) to reflect the higher cost of risk-free borrowing compared to risk-free lending.

The last one is beta as full measure of risk; the CAPM assumes that risk is measured by the volatility (standard deviation) of an asset's systematic risk, relative to the volatility (standard deviation) of the market as a whole. But we know that investors face other risks: inflation risk -- returns may be devalued by future inflation; and liquidity risk, investors in need of funds or wishing to change their portfolio's risk profile may be unable to readily sell at current market prices. Moreover, standard deviation does not measure risk when returns are not evenly distributed around the mean (non-bell curve). This uneven distribution describes our stock markets where winning companies have positive returns that greatly exceed losing companies' negative returns.

Introduction

1.1 Capital asset pricing model

Capital Asset Pricing Model (CAPM) is a model based on the proposition that any stock's required rate of return is equal to the risk free of return plus a risk premium, where risk reflect diversification. The model of CAPM is a development based on Markowitz's portfolio theory. CAPM is one of the models that can be used by the investors to predict the company stock return, which is up to now still controversial among the financial management experts regarding their accuracy for predicting the company stock return. On the other hand, the positive CAPM uses the systematic risk of individual securities to determine the fair price, which is also called market risk or undiversifiable risk, is the portion of an asset's risk that cannot be eliminated by diversification. The systematic risk indicates how including a particular asset in a diversified portfolio will contribute to the risk of the portfolio.

In order to ignore the effect of unsystematically risk on the valuation of securities, we assumed that investors have eliminated unsystematically risk by holding diversified portfolios. As Sharpe (1964) observed: the proper test a theory is not the realism of its assumptions but the acceptability of its implications. The case study for this essay is taking data from Indonesia Stock Exchange that impact on factories during economic crisis period and it is using Mean Absolute Deviation (MAD) to measure the exact CAPM whether the market far enough to predict the stock market in the future.

The Security Market Line

The cross sectional plots of the mean excess returns on the portfolios against the estimated betas indicated that relation between excess return and beta was linear. However the intercept and the slope of the cross-sectional relation varied with different sub periods and were not consistent with the traditional form of CAPM that indicates more consistent of the zero betas. The existence of a linear relationship between risk and return is Security Market Line (SML). The systematically risk of a security could be defined as comparing with the risk and return of the market and the risk-free rate of return. As a result, we can calculate return for the security and hence a fair price. The equation of the SML can be defined as:

Ri = Rf + βi(Rm - Rf)

where :

  • Ri = the expected return on asset i

  • Rf = the risk-free rate of return

  • βi = the beta coefficient of security i

  • Rm = the return of market

In fact, the SML, the beta of the market is always 1, thus the systematic risk of security can be measured. The beta of security measures followed by how much the return market change according to systematic factors and it depends on share market as well. For instance, a stock market with beta 1,5 will be estimate increase the price 15% if the index of stock market increase 10%.

In capital market equilibrium, the required return on an asset must equal its expected return. Thus, the SML equation can also be used to determine an asset's required return given its Beta.

The capital asset pricing model (CAPM) is based on particular assumption such as:

    1. Investors are rational by maximising their utility and as much as do not take risk for risk's sake

    2. All information to investors should be free and fully interpretation. Hence, investors are able to have expectation

    3. Investors have authority to borrow and lend at the risk-free rate

    4. Investors hold diversified portfolios and taking away all unsystematic risk.

    5. Capital market could be interpreted as a perfectly competitive need to required conditions such as large number of buyers and sellers; the entire participant cannot determine the market; free taxes and transaction; no barriers to the market; and securities are divisible.

    6. Investment happens over a single and standard period.

All the assumptions above are clearly implemented in the most of the stock exchange around the world. Indonesia stock exchange (IDX) has authority to provide information and managing the company's market in Indonesia for investors. As information,

1.2 Literature reviews

As summarisied in Watson and Head (pp. 222-234 in 4th edition), central to the CAPM is the existence of a linier realtionship between risk and return known as capital market line. In this case, investor can select portfolios on the line according to their risk preferences.

Test of the stability of beta calculated using historical returns of shares in relation to historical returns of the market. As a result, if β>1.00 share price will be increase and tend to lower than market price.

Test of the security of market line

E(Ri) = Rf+Bi(E(Rm)-Rf)

Where

E(Ri) = expected return on an individual company

Bi = the company's beta

The existence of a linear relationship between risk and return is Security Market Line (SML). The systematic risk of a security could define as comparing with the risk and return of the market and the risk-free rate of return. As a result, we can calculate return for the security and hence a fair price. The equation of the SML can be defined as:

Ri = Rf + βi(Rm - Rf)

where :

  • Ri = the expected return on asset i

  • Rf = the risk-free rate of return

  • βi = the beta coefficient of security i

  • Rm = the return of market

In fact, the SML, the beta of the market is always one, thus the systematic risk of security can be measured. The beta of security measures followed by how much the return market change according to systematic factors and it depends on share market as well. In capital market equilibrium, the required return on an asset must equal its expected return. Thus, the SML equation can also be used to determine an asset's required return given its Beta.

1.3 The Indonesian Stock Exchange

CHAPTER 2

METHODOLOGY

2.1 Introduction to the methodology of the CAPM

This research will be basing on theoretical from Watson and Head (pp. 210-240, 4th edition), empirical test beta, and experimental using STATA. The problem of the investors here are:

  1. Investors purchase financial assets such as shares of stock because they desire to increase their wealth (i.e. earn a positive rate of return on their investments). The future, however, is uncertain; investors do not know what rate of return their investments will realise.

  2. The future is uncertain. Investors do not know with certainty whether the economy will be growing rapidly or be in recession. As such, they do not know what rate of return their investments will yield. Therefore, they base their decisions on their expectations concerning the future.

  3. Most investors do not hold stocks in isolation. Instead, they choose to hold a portfolio of several stocks. When this is the case, a portion of an individual stock's risk can be eliminated such as diversified away.

Due to investors are risk averse, they will choose to hold a portfolio of securities to take advantage of the benefits of Diversification. Therefore, when they are deciding whether to invest in a particular stock, they want to know how the stock will contribute to the risk and expected return of their portfolios. The standard deviation of an individual stock does not indicate how that stock will contribute to the risk and return of a diversified portfolio. Thus, another measure of risk is needed; a measure of a security's systematic risk. The CAPM assumes invests have the same beliefs about expected returns and risks of available investments. Nevertheless, we know that there is massive trading of stocks and bonds by investors with different expectations. We also know that investors have different risk preferences. Again, it may be that the capital market line is a fuzzy amalgamation of many different investors' capital market lines. The way of composing the right-side factor portfolios also influences the performance of an asset-pricing model. We propose an alternative way of handling the three standard factors (size, distress, and momentum) that produces estimated alphas closer to zero. Notably, the size and distress factor portfolios are split up into two factor portfolios, one for the smallest or most distressed stocks risks and one for regular size and distress risks.

2.2 The meaning and calculation of beta

2.3 Determining the risk-free rate and the return of the market

Market Performance

The relationship between the beta of a security. In addition, the risk and return of the security and the market is defined as follows:

Where: = standard deviation of security i's returns

= standard deviation of return of the market

= correlation coefficient between the security's returns and the market returns.

= covariance of returns of security i and the market

Note that, by definition, the beta of the market equals 1. An asset's systematic risk, therefore, depends upon its covariance with the market portfolio. The market portfolio is the most diversified portfolio possible as it consists of every asset in the economy held according to its market portfolio weight. For instance, find the expected return on a stock given that the risk-free rate is 6%, the expected return on the market portfolio is 12%, and the beta of the stock is 2.

Ri = 6% + (12%-6%)2 = 18%

For example to look for value of beta on a stock given that its expected return is 20%, the risk-free rate is 5%, and the expected return on the market portfolio is 15%.

βi = = 1.5

The Mean Absolute Deviation (MAD)

The impact of economic crisis in in Indonesia badly affected the capital marketers at Jakarta Stock Exchange. The economics crisis period in Indonesia made the capital marketers have difficulty in analysing and predicting the stocks return of companies.

2.4 Empirical tests

CHAPTER 3

ANALYSIS

3.1 Data Collected From The Indonesia Stock Exchange

3.2 The analysis and findings

3.2.1 The stability of beta test

3.2.2 The security market line test

3.3 Discussion

CHAPTER 4

CONCLUSION

Bibliography_______________________________________________

  • Begg, D. Fischer, S. Dornbusch, R. 2005, Economics Eight Edition, McGraw-Hill Education, United Kingdom.

  • Fisher, Donald E. Ronald J. Jordan. 1995, Security Analysis and Portfolio Management Sixth Edition, Englewood Cliffs, New Jersey: Prentice Hall.

  • http://finance.yahoo.com/q/hp?s=ABBA.JK&a=03&b=4&c=2002&d=03&e=30&f=2008&g=d viewed on 15/06/2008.

  • http://www.idx.co.id/NewsAnnouncements/EventsPressRelease/tabid/124/articleType/ArticleView/articleId/133/Default.aspx viewed on 05/06/2008.

  • Pinches, George E. 1987 Essentials of Financial Management, Second Edition, Harper & Row, Publisher's, Inc. New York.

  • Sharpe, W. 1964, The Journal of Finance Vol. 25, No. 2, Papers and Proceedings of the Twenty-Eighth Annual Meeting of the American Finance Association New York, N.Y. December, 28-30, 1969 (May, 1970), pp. 418-420.

  • Watson, D. Head A. (2007). Corporate Finance Principles & Practice. Essex & England: Pearson Education Ltd.

Appendix

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