Stock Returns and Risks: An Empirical Assessment Using Modified CAPM Approach

Abstract

Modern portfolio theory assists stakeholders in financial markets to optimize their portfolios to attain expected return at a specified level of risk and uncertainty. However, the conventional capital asset pricing model (CAPM), proposed by Sharpe (1964) and Lintner (1965), fails to accurately estimate the expected rate of return of stock equities due to the presence of external uncertainties, and rapid changes in macroeconomic dynamics. Therefore, this study has adopted a modified CAPM that incorporates additional factors besides beta to more accurately estimate the expected return of stock equities. It highlights these exposures by using time-varying beta CAPM, applied to the cement industry of Pakistan for the period from January 2016 to March 2022. The results show that the expected rate of return is very much close to risk free rate of return in the cement industry of Pakistan. Furthermore, the findings of the study confirm that the prediction of expected rate of return depends on variations in estimation techniques and data availability. Additionally, by introducing the concept of a reference portfolio and a market portfolio, the modified CAPM represents an improvement over conventional method. Moreover, by breaking down the beta deviations into long-term and short-term components, this new method allows for precise computation and simplifies the prediction of expected returns in both equity and portfolio investments. The findings of this study will be beneficial for investors, financial analyst, and portfolio-managers in the decision-making about portfolio investments.