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The research study aims to test the new augmented and improved version of the Arbitrage
Pricing Theory (APT), termed Downside Risk-based Arbitrage Pricing Theory (DRAPT). The augmented version is based on the inclusion of the security factors downside
betas, semi-variance, and semi-covariance risk methods. The inclusion of these new risk
factors improves both the theoretical and methodological applications of the model in
response to the limitations and restrictions of the conventional factors’ models. The
mean-variance hypothesis is replaced by the mean-semi-variance hypothesis and the
asymmetric behavior of stock returns’ distribution empirically suggests the use of an
alternative factors’ model, based on the downside risk. This comparative study is based
on the monthly stock returns of 199 firms listed on the PSX and 1073 firms listed on
NYSE. The observed economic, financial and global factors are the explained and stock
returns are the explanatory variables for the study period of 1997-2017. The findings of
the study indicate that the DR-APT model with pricing restrictions in the form of
unconditional linear factors model endows the better performance over the study period.
All of the observed pricing factors, except exports for Pakistan and exports along with
the exchange rate for the USA are significant for pricing the security returns in the
augmented DR-APT model. The findings of all the tests corroborate the DR-APT as a
better model to price stock returns in volatile emerging and developed markets conditions
compared to the conventional APT model. The outcomes of the study are useful for the
investment and fund managers, investors, economists, and company managers for
forecasting security returns, cost of capital calculations, risk assessment and firm
valuations.
Syed Asim Shah, Muhammad Khan, Hassan Raza. (2019) Pricing Downside Risk in Arbitrage Pricing Theory: A Comparison Across Emerging and Developed Markets, NUML International Journal of Business & Management, Volume 14, Issue 2.
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