Aarhus School of Business M. Sc.

of Finance and International Business Department of Finance Fuglesangs All 4 DK-8210 Aarhus V

Master Thesis

Capital Asset Pricing Model and Arbitrage Pricing Theory

An application of market equilibrium models to the Polish market

Authors: Agnieszka Sawa Slawomir Sklinda

Written under supervision of Paula Peare, Associate Professor Department of Finance

Aarhus, 2003

INTRODUCTION ..................................................................................................................... 4 CHAPTER I MARKET EQUILIBRIUM MODELS -THEORY AND ASSUMPTIONS .......................... 6 1.1 APPLICATION OF MARKET EQUILIBRIUM MODELS............................................................ 6 1.2 ARBITRAGE ..................................................................................................................... 7 1.2.1 Arbitrage mechanism and market equilibrium ................................................. 7 1.2.2 Limits of Arbitrage ................................................................................................ 9 1.3 CAPITAL ASSET PRICING MODEL (CAPM) .................................................................. 11 1.3.1 Standard version ................................................................................................ 11 1.3.2 Zero beta version of the CAPM model ............................................................ 12 1.3.3 Assumptions of the standard Capital Assets Pricing Model ........................ 14
1.3.3.1 Market efficiency .......................................................................................................14 1.3.3.2 Decisions based on the mean-variance criteria ...................................................15 1.3.3.3 Homogenous beliefs .................................................................................................16

1. 4 ARBITRAGE PRICING THEORY ..................................................................................... 17 1.4.1 No arbitrage opportunities................................................................................. 18 1.4.2 Factor Model ....................................................................................................... 21 1.4.3 Firm- specific risk ............................................................................................... 22 1.4.4 APT relation ........................................................................................................ 22 1.4.5 Methodological concerns .................................................................................. 23 CHAPTER II CAPITAL MARKET EQUILIBRIUM MODELS EMPIRICAL TESTS ............................ 26 2.1 CAPM EMPIRICAL EVIDENCE ....................................................................................... 26 2.1.1 Early CAPM tests ............................................................................................... 26
2.1.1.1 Lintner test (1968).....................................................................................................27 2.1.1.2 Black, Jensen and Scholes test (1972) .................................................................29 2.1.1.3 Fama and MacBeth test (1973) ..............................................................................30

2.1.2 Rolls critique (1977) .......................................................................................... 31 2.1.3 Later tests of the CAPM model ........................................................................ 33
2.1.3.1 Banz test (1981)........................................................................................................33 2.1.3.2 Fama and French test (1992)..................................................................................34 2.1.3.4 Kozickis and Shens test (2002) ............................................................................37

2.2 EMPIRICAL STUDIES ON APT ....................................................................................... 39 2.2.1 Investigation on variables influencing returns ................................................ 39 2.2.2 Approaches to APT model estimation ............................................................. 42
2.2.2.1 Statistical estimation of betas and factors .............................................................42 2.2.2.2 Portfolio method of factor estimation .....................................................................43 2.2.2.3 Betas arbitrary choice..............................................................................................43

2.3 APT CONTRA CAPM .................................................................................................... 45 2.4 EMPIRICAL EVIDENCES IN POLAND ............................................................................... 48 2.4.1 Tests of market efficiency ................................................................................. 49 2.4.2 Multifactor models on Warsaw Stock Exchange ........................................... 50 CHAPTER III DATA DESCRIPTION .......................................................................................................... 53 3.1 DATA CHOICE ............................................................................................................... 53 3.1.1 Choice of the proxy for the market portfolio ................................................... 53 3.1.2 Length of estimation period .............................................................................. 55 3.1.3 Observation frequency ...................................................................................... 56 3.2 CHARACTERISTICS OF DATA USED FOR CAPM AND APT TESTS ................................ 58 3.2.1 Characteristics of data used for CAPM test ................................................... 59
3.2.1.1 Returns on Shares ....................................................................................................59 3.2.1.2 Warsaw Market Index (WIG) ...................................................................................61 3.2.1.3 Risk Free Rate ..........................................................................................................62

3.2.2 Variables used for APT test .............................................................................. 62

3.2.2.1 S&P 500 .....................................................................................................................63 3.2.2.2 Polish Zloty (PLN) Exchange Rate .........................................................................63 3.2.2.3 International Price of Gold .......................................................................................65

CHAPTER IV EMPIRICAL TEST OF CAPM .............................................................................................67 4.1 CALCULATION PROCEDURE ..........................................................................................67 4.1.1 CAPM test methodology....................................................................................67 4.1.2 Portfolio grouping ...............................................................................................72 4.1.3 Risk free rate variability .....................................................................................73 4.2 EMPIRICAL TEST OF THE CAPM ...................................................................................74 4.2.1 Time-series regression ......................................................................................75 4.2.2 Cross-sectional regression ...............................................................................78 CHAPTER V APT ESTIMATION AND TESTS .........................................................................................87 5.1 METHODOLOGY .............................................................................................................87 5.1.1 Estimation procedure .........................................................................................87 5.1.2 Methods of testing and Estimation ..............................................................88 5.1.3 Factor Analysis overview ..................................................................................91
5.1.3.1 Factor Analysis formal model ..................................................................................92

5.2 FACTORS ESTIMATION- EMPIRICAL RESULTS................................................................94 5.2.1 Variables analyzed .............................................................................................94

5.2.1.2 Suboptimization .........................................................................................................94 5.2.1.2 Number of cases .......................................................................................................95 5.2.1.3 Sampling adequacy ..................................................................................................95

5.2.2 Number of factors ...............................................................................................98

5.2.2.1 Kaiser rule ..................................................................................................................99 5.2.2.2 Cattell rule ................................................................................................................100 5.2.2.3 Variance criterion ....................................................................................................100

5.2.3 Factoring methods ...........................................................................................101

5.2.3.1 Maximum Likelihood Factoring .............................................................................101 5.2.3.2 PCA versus PFA .....................................................................................................102 5.2.3.3 PCA results ..............................................................................................................103

5.3 TIME-SERIES REGRESSION .........................................................................................106 5.4 CROSS-SECTIONAL REGRESSION ...............................................................................114 CHAPTER VI POSSIBLE REASONS FOR CAPM AND APT FAILURE ............................................125 6.1 BETA INSTABILITY........................................................................................................126 6.2 INAPPROPRIATE PORTFOLIO GROUPING APT CASE ...............................................128 6.3 MARKET INEFFICIENCY AND LIQUIDITY........................................................................129 6.4 VALUE WEIGHTED INDEX AND CAPITAL DOMINANCE OF A FEW COMPANIES ...............131 6.5 LOW SIGNIFICANCE OF THE MARKET AS A SOURCE OF CAPITAL.................................132 6.6 SHORTCOMINGS OF APT FACTOR ANALYSIS .............................................................132 6.7 DIVERSIFICATION OF THE FIRM-SPECIFIC RISK ...........................................................134 6.8 SMALL NUMBER OF VARIABLES ...................................................................................135 6.9 SHORT ESTIMATION PERIOD .......................................................................................136 REFERENCES: ...................................................................................................................137 APPENDIXES ......................................................................................................................144

Introduction
Polish capital market is very young. It was set up in 1812 however just before the II. World War it was liquidated for over fifty years. Warsaw Stock Exchange was reactivated in 1991 and since then it has been developing constantly. Studies carried out by Szyszka (2003) revealed that the efficiency of that market is improving as well. If Polish capital market was efficient enough, the market equilibrium models could be assumed to work on it. Market equilibrium models that are Capital Asset Pricing model and model created on the basis of Arbitrage Pricing Theory have applications in many fields of finance. They could support in the decision making process of Polish corporate managers and investors. Due to implementation of APT or CAPM models, decisions concerning the choice of a portfolio that meets certain investor criteria could be made. Moreover, investors using these models would be able to identify overpriced and underpriced assets. Furthermore, asset pricing theories could be applied in budgeting process, as they help with cost of equity estimation. Thus, the aim of this paper is to test the standard versions of the market equilibrium models on Warsaw Stock Exchange and therefore answer the question if standard CAPM or APT could be useful for Polish investors and corporate managers. Despite of the fact that such studies were conducted on many foreign markets, this research is the first that empirically analyses both market equilibrium models on Polish capital market. However, the study conducted in this thesis faced a few important problems. The study limitations are associated mainly with characteristics of the WSE that is still developing. The fact Polish capital market is only twelve years old resulted in a relatively small

number of firms analyzed and short estimation period. Those are respectively 100 companies examined within three-year period from 2000 to 2003. The research objective determined the structure of this paper. Therefore, chapter one concerns theoretical issues associated with market equilibrium models. It describes shortly their application and assumptions required to create these models. Furthermore, it discusses these issues with relation to Polish business environment. The second chapter analyzes studies concerning CAPM and APT empirical tests that might suggest the methodology of developing these models. Chapter three discusses the choice of data employed in the models. Two next sections discuss testing techniques that are traditionally used when estimating these models, chose the method most appropriate to Polish capital market and then describe tests results. Finally, the last chapter focuses on problems faced while developing and testing both models. Moreover, it suggests improvements that could be made in order to create models delivering more reliable results. Based on the methodology applied in this paper both market equilibrium models do not describe expected rates of returns on the WSE. Neither market beta nor other macroeconomic factors examined satisfactory explain the returns. According to obtained results, standard models should not be applied by Polish investors and corporate managers in their decision making process. However, similar research can be carried out in a few years. It is likely that Polish capital market will be more efficient because of the increasing integration of the capital markets. Furthermore, it is believed that market economy in Poland will be much more liberalized and therefore market efficiency will be bigger. Due to the fact that the estimation period would be longer, the estimated results would be more reliable. 5

CHAPTER I Market Equilibrium Models -Theory and assumptions

This chapter presents market equilibrium models, their application and assumptions discussing them with relation to Warsaw Stock Exchange.

1.1 Application of market equilibrium models

In spite of the fact that CAPM and APT models tested in this study were implemented for the first time over thirty years ago, they are still applied in finance. First of all, they are used in a modern portfolio theory that is an attempt to understand the market as a whole. According to this theory investments are described statistically, in terms of their expected return rate and their expected volatilities. Market equilibrium models help to identify acceptable level of risk tolerance, and then find a portfolio with the maximum expected return at that level of risk. Second, application of CAPM and APT is a tool on the identification of unique opportunities, when shares are either over- or undervalued. The capital market equilibrium models enable estimate the expected value of the equity in terms of returns. Finally, these models are of crucial importance in capital budgeting processes. Applying time value techniques involves estimating a discounting rate. A very common approach is weighted average cost of

capital, which is composed of the cost of equity and the cost of debt. The first one can be estimated by using capital market models. As market equilibrium models are useful in so many areas of finance, they could support Polish investors and corporate managers in their decision processes as well.

1.2 Arbitrage
Both market equilibrium models assume that markets arbitrageurs are able to ensure market equilibrium and therefore to prevent mispricing. There is, however, the question that needs to be answered, namely whether the market equilibrium is a fact or only a theory.

1.2.1 Arbitrage mechanism and market equilibrium

The theory of arbitrage provides the answer. It says that the mechanism of arbitrage prevents any deviations from the equilibrium, as the actions undertaken by investors will immediately increase the price of undervalued assets and decrease the price of the overvalued ones. The mechanism of arbitrage was discussed for example by Elton and Gruber (1998), Francis (2000) and Grinblatt and Titman (1998). An example of the mechanism is presented below. Assume that Company 1 has overvalued stocks (Asset 1) and stocks of Company 2 are undervalued (Asset2). Hence the market is not in equilibrium and the assets must be placed beyond the Security Market Line. This situation is graphically presented on Diagram 1.1:

Diagram No 1.1: Pricing arbitrage undervalued asset (green) and overvalued (red)

SML
E(R) R1 R1 RM R2 RF

Asset 1

Asset 2

Source: M. Grinblatt i and S. Titman: Financial Markets and Corporate Strategy, Irvin McGraw-Hill Companies, 1998: 120

If the above situation occurs, following the arbitrage opportunity the abnormal profit could be earned without bearing risk. If assets are overvalued, an investor can obtain any point on the Security Market Line. It can be done through either purchasing /selling of individual shares or creating (from other accessible assets) a portfolio, which can be placed in any point on the SML. In such case, selling short the asset/portfolio placed on the SML (with the same beta coefficient as Asset 1) and buying long Asset 1, an investor can earn profits on the higher expected return. The value of the gain is marked by the red line and equals R1- R1. This investor will receive the abnormal return till the price of the Asset 1 reaches its true level R1. This mechanism is analogical for undervalued assets. In this situation an investor using the arbitrage mechanism can receive the abnormal return as well. Now one would sell short Asset 2 buying long portfolio on the SML with the same beta coefficient as Asset 2. Such investment will generate abnormal returns without any additional risk. The premium is marked green and equals R2- RF. 8

However, proponents of behavioural finance noticed that in a real business world prices can diverge from equilibrium.

1.2.2 Limits of Arbitrage

First of all, there are risks and costs associated with arbitrage that might limit it. Furthermore, according to behavioural finance the deviations from the fundamental value of assets can be caused by traders that are not fully rational and it might be difficult for rational traders to undo the capital dislocations made by less rational ones. According to the theory, a rational investor, who is taking advantage of the arbitrage profit opportunity ensures market equilibrium. Following the behavioral finance theory, not all the arbitrage opportunities can generate profits (Barberis and Thaler, 2002). The investment strategies may sometimes be costly and risky. Barberis and Thaler (2002) believe that traders perusing arbitrage strategy usually face fundamental and noise-trader risk. Furthermore, they need to pay the implementation costs. Fundamental risk might not be fully hedged as securities are not perfect substitutes and the strategy of selling one asset and purchasing another can incur the fundamental risk. The noise-trader risk is a risk that irrational investors can make the mispriced assets even more deviate from equilibrium. This risk may force arbitrageurs to liquidate their positions too early as there is a separation of brains and capital (Shleifer and Vishny, 2001). It is an agency problem, since portfolios managers do not operate their own money and return maximization instead of ensuring pricing equilibrium is of crucial importance for them. However, according to De Long et al.

(1990) arbitrageurs might make the price diverge from equilibrium, as well. If the market is dominated by positive feedback traders, overpriced assets might be purchased by investors making arbitrage profit, as they would expect that higher price will be pushed up even higher. Moreover, exploiting arbitrage is not costless. For example transaction costs that overwhelm potential arbitrage profit, would deter traders from exploiting arbitrage opportunity. Furthermore, it might be costly to learn about mispricing. It was believed that returns predictability is a sign of incorrectly set prices. However, Summers (1986) and Shiller (1984) presented that the demand of the irrational traders might be so strong that the returns can be unpredictable. Nevertheless, behavioral finance blames for mispricing not only investors but corporate managers as well who are responsible for assets issue. Theoretically, if assets are overpriced managers would decide to issue more assets in order to sell them at attractive prices. Then the oversupply should push prices back to equilibrium. However, the issue incurs costs and managers cannot be sure that investors overestimate their shares. Therefore, they might not decide to issue equity. Behavioral finance picks up the weaknesses of market equilibrium models focusing mostly on investor psychology and beliefs. To date, there are no behavioral models that might be applied instead of CAPM or APT in all of their applications. The reason for that might be psychological factors that cannot be quantified easily. It is possible that models combining both approaches will be developed in the future.

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1.3 Capital Asset Pricing Model (CAPM)

CAPM model was implemented almost 40 years ago by Sharpe (1964), Lintner (1965) and Mossin (1966) independently from each other. This model was the first and, as its popularity proves, successful attempt of defining the risk of cash flows from an investment tantamount to the expected rate of return. The CAPM model is the simplest version of the capital market equilibrium models, and is also called one factor capital market equilibrium model. Zero beta model1, which is one of many derivative of a standard version will be presented further in this section.

1.3.1 Standard version

The CAPM model describes the relationship between risk and expected return. Expected return of a security or a portfolio is defined by the systematic risk affecting the company and equals the sum of the rate on a risk-free asset and risk premium. The capital market equilibrium takes the following form: Ri = rf + ( rm - rf) i , Where Ri is the expected return on the equity (of a single company or portfolio), rf is a risk free rate, rm defines the expected return on the market portfolio and measures the sensitivity (risk) of expected return on equity Ri to the return on the market portfolio rm. Formal derivation o the model does not make many problems and is available in the literature ( for example: Elton and Gruber 1998, Francis 2000, Berndt 1996, Haugen 1996). Application of the CAPM model requires defining a risk free rate, expected market risk premium ( rm - rf) and calculation of the beta coefficient. It is computed based on the historical values as the slope coefficient in the regression of returns on the equity against market risk
1

well known as Black CAPM.

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premium. The Capital Asset Pricing Model is the most popular among American companies when estimating the cost of equity in the capital budgeting process. A recent study conducted by Graham and Harvey (2001) confirms the popularity of CAPM. According to their results over 73 percent of US firms apply the model while estimating the cost of equity. However, there was no such study conducted on the Polish market, hence no comments on the models popularity can be done.

1.3.2 Zero beta version of the CAPM model

The standard version of CAPM model may be considered unrealistic, as it is rather impossible for a single investor to borrow or lend without any limitation at the risk free rate. Black (1972) releases this assumption presenting a version of the CAPM model where all assets are risky. The equilibrium can be achieved by substitution of any of the zero beta portfolios, which are placed on the continuous section RFC, instead of RF from the CAPM equation. Since RFZ is unrealistic, the minimum variance portfolio with beta coefficient that equals zero is marked with a sign Z and is placed on the crossing point of the curve K and the line RFC and the corresponding expected return rate equals Rz= RF. The zero beta coefficients mean a lack of correlation with a market portfolio. A graphical explanation of the situation is presented in Diagram No. 1.2

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Diagram No1.2 Zero beta portfolio (Z) on the efficient portfolio curve

E(R)

M.
RZ = RF

.S

.Z

Source: E. J. Elton and M.J. Gruber: Nowoczesna teoria portfelowa i analiza papierw wartociowych, WIG-Press, Warszawa, 1998, p. 378.

Hence, the security market line can be presented as follows:

Ri = R Z + i ( R M R Z )

The portfolio Z has certainly lower expected rate of return than the market portfolio, since its return is represented by the crossing point of the tangent to the curve K and the vertical axis. As the expected market return is a tangent point with the curve K, it must be placed above Rz. The portfolio Z will not be an efficient portfolio as well, because it is placed below the lowest variance portfolio, so it is possible to find a portfolio of the same variance but higher expected return. Hence, portfolio Z, although placed on the lowest variance curve is not efficient (formal derivation in Elton and Gruber 1998). Assuming that point S represents the lowest variance portfolio, all investors will hold portfolios placed on the efficient portfolios curve (SMK). Although portfolio Z is not efficient it is used in analysis because of its zero correlation with market portfolio. Since a combination of minimum variance portfolios gives a minimum variance portfolio, the aim of the analysis is to cerate such a combination that would be placated on the curve SMK. Investors that chose returns between RS and RM, will have a combination of zero beta portfolio and

13

market portfolio. On the other hand, investors that own a portfolio on the right side from the market portfolio M, will have a portfolio composed by short sale of Z portfolio and long purchase of market portfolio. Since the portfolio Z is inefficient, the overall sum of short and long positions must equalize. That is because in equilibrium all investors will posses only market portfolio.

1.3.3 Assumptions of the standard Capital Assets Pricing Model

The reality of financial events is so complex that in order to build any model describing it in a plain way simplifying assumptions need to be adopted. These assumptions are to eliminate factors, which marginally affect the modelled event. The CAPM assumptions can be grouped in three general conditions (Bailey 2001): A. Markets are efficient. B. All investors make their decisions on the basis of the mean-variance criteria. C. Investors have homogenous beliefs.

1.3.3.1 Market efficiency

This assumption is the least real and is composed of a number of interrelated factors: No transaction costs, which means that there are no costs associated with sale or purchase of an asset. This assumption is justified by the fact that transaction costs might change the return

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rate from an instrument depending on the investors position at the beginning of a considered period. Taking these costs into account significantly increase the complexity of the model. However, recognising their relatively low value low significance can be assumed. No institutional barriers in assets trade, which is directly related to the unlimited short sales possibility. This assumption in practice is rarely fulfilled, since investors are usually not able to sale short any amount of assets. Unlimited short sale and long buys at the risk free rate. As in the previous assumption the first part of this assumption is rather impossible, however its second part may be satisfied. Investors may lend their money at the risk free or even higher rate. Black (1972) relaxed this assumption and built a well known and accepted Market model. Assets are infinitely divisible, which means that investors can hold any amount of the asset. This assumption was created because predictions of the model would be inaccurate, as the indivisible assets would require a great amount of initial wealth of an investor. All assets can be bought or sold at the observed market price. There is a market for all kind of assets, even human capital. Individual investors decisions about their position in any assets will not affect their price(Hsu et al. 1974). This assumption implicates that the market is perfectly competitive with no mono- or oligopoly. The price is a result of all actions, not a particular investor. Taxes are neutral, hence all investors pay the same tax from all forms of income: dividends, interests and capital gains.

1.3.3.2 Decisions based on the mean-variance criteria

Should an investor be able to make his/her decision based only on these two variables, the returns must have normal distribution. Risk

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that accompanies the investment can be defined by the distribution of possible returns. As this distribution is assumed to be normal, it can be described by two measures: mean and variance (or its square root called standard deviation, which is much more popular in finance). Since all normal distributions are virtually the same, they differ from each other only in their means and variances. While all investors prefer higher returns to lower returns, ceteris paribus, it is true that they do prefer lower risk. It is described by the standard deviation of returns. This leads to the conclusion that if investment/portfolio/share risk is high, investors would accept it only if they would be rewarded by a high expected return. Consequently, if the expected return is low it would be accepted only if the related risk is low as well. Commonly applied mean-variance analysis is therefore a trade off analysis between the accepted risk and the required rate of return. Even if an investment bears no risk, investors would still expect nonzero return as an incentive to delay the current consumption. Shortterm government bonds may be considered an example of this kind of investment as their default risk is virtually zero. It is additionally assumed that all investors make their decisions only one period ahead and all of them define this period in the same manner. This assumption fringe in its classification upon the next group, introducing homogenous beliefs.

1.3.3.3 Homogenous beliefs

This condition states that all investors have the same, homogenous believes about the primary data, which are necessary to make portfolio decisions. These are mainly three groups of data characteristics: expected returns, variance (or standard deviation) of the returns and

16

the matrix including correlation coefficients between the returns on all pairs of shares. The expectations are a result of all available information and therefore the discussed assumption refers directly to efficient market theory, which presumes that each investor has an access to the same information. In practice this assumption is unlikely to be fulfilled, since information is not distributed among all of the investors to the same extend. Big financial institutions have much better access to the information than individuals. On the other hand individuals state too small percentage of market players to consider them statistically insignificant. However, banks may have more information about the companies they service than other investors, as banks remain in a close business contact with their customers. The problem of lack of information among the small investors is usually solved by observation of the investment decisions made by bigger and better informed institutions. Although the latter have time advantage, it must be discounted by the price of gaining information.

1. 4 Arbitrage Pricing Theory

The classic APT was implemented by Ross in 1976 as an alternative to Capital Asset Pricing Model. It considers more than one factor influencing assets returns. The theory deduces that firm-specific risk is fairly unimportant to investors holding well-diversified portfolios and it might be pretended that firm-specific- risk is not present. Thus, the risk of securities can be described by factor beta coefficients only. In equilibrium, where 17

arbitrage opportunity does not exist, assets returns will satisfy an equation relating expected returns of securities to their factor betas. This risk-expected return relation was called APT and can be written formally:

Ri = RF + ik k + i
j =1

The derivation of APT requires only three general conditions to be met: 1. No arbitrage opportunities. 2. Returns can be described by a factor model. 3. There is large number of securities, so that it is possible to form portfolios that diversify the firm specific risk of individual stocks.

1.4.1 No arbitrage opportunities

The Arbitrage Pricing Theory is based on the Law of One Price. The rule says that all goods of the same risk should be sold at the same price thus market can reach equilibrium preventing arbitrage. There are further requirements similar to assumptions concerning CAPM that relate to market efficiency, investors homogenous beliefs and their mean- variance investment criteria. These assumptions ensure that there is no arbitrage opportunity and market is in equilibrium what is crucial for APT. According to Jajuga and Jajuga (1999) there are eight such requirements for APT significance: No transactional costs. Assets divisibility No taxes on incomes generated by capital market Unlimited short sale and long buys Investors can borrow at the risk free rate No barriers on assets sale or purchase

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Decisions based on the mean-variance criteria Individual investors decisions about their position in any assets will not affect their price

Above assumptions are partly met by Warsaw Stock Exchange. First of all, there are transactional costs in Polish market but if the transaction size is large, costs are relatively small and they can be neglected (Rubaszek, 2002). Furthermore, assets divisibility condition can be assumed as well. In a real business world, the smallest unit that can be traded on a real market is one share that cannot be divided into parts and then traded. Nevertheless, it can be supposed that market participants invest in the purchase of one expensive share. Assuming this situation shares could be seen as divisible. Moreover, the no taxes condition could be supposed. Taxes on capital gains are going to be introduced in 2004 or 2005 but there is no explicit regulation of this issue right now. Nowadays, only dividends and interests on bank deposits are taxed. There is a visible impact of important institutional investors on stock prices of the companies with the greatest capitalisation in Poland. However, firms characterized by smaller capitalisation are very sensitive to speculative actions of individuals or a group of noninstitutional investors. As an example, it might be said that the group manipulated the price of Efekts stocks making it few times greater. This incident took place ten years ago, but it is a proof that Polish market does not meet the assumption that individual investor is not able to influence stock prices (Rubaszek, 2002). Moreover, APT allows short sale of securities. Polish law has regulated this issue on 21st December 1999. Warsaw Stock Exchange opened a

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special internet platform in order to collect investors orders and encourage market participants to short sale or purchase of securities. However, there are only five brokerage houses dealing with short sale. These transactions accounted for 0.01 or 1.18 percent of all transactions on WSE. According to Maciejewski and Mejszutowicz (2003) the reason for this situation is that the whole system is too complicated. Furthermore, borrowers charge high fees what deter lenders. Therefore, short sale of securities is not very popular among Polish investors. This fact might imply that arbitrage can be limited and thus making prices diverge from equilibrium. Furthermore, in real business world investors that borrow funds need to pay premium to the borrower as a price of the loan. Thus, the assumption of borrowing at risk free rate is not fulfilled in reality. The next condition requires securities to be traded without any barriers. It is believed that this requirement is met on Polish market as it is ensured by law (Dz. U. of 2002 year. No 49, position. 447). The last issue refers to investors. They are assumed to allocate their funds taking into account only expected returns and securities risks. That is true that the majority of investors while making financial decisions focuses mostly on these two issues (Rubaszek, 2002). However, it cannot be assumed that all investors behave in the same manner. Having in mind the assumptions presented above, the APT model can be implemented. Nevertheless, these eight assumptions are usually not met in a real business world. APT proponents believe that the basic advantage of the theory is the fact that not all of the assumptions need to be met (Haugen, 1996). 20

1.4.2 Factor Model

APT begins with the assumption on the return generating process. If individuals believe that the random returns on the set of assets are explained by K-factor linear model:

Ri = a i + ik I k + i
k =1

where: i=1,, n Ri is random return on asset i ai is the expected return on the asset i

ik factors coefficients
i are the mean zero asset specific disturbances assumed to
uncorrelate with the K and with each other

Then, the security is differently sensitive to each I k factor. However, all of I k factors have the same value for all securities. Moreover, each I k variable have impact on more than one security. Returns of all securities depend on I k that are changing constantly and ik

coefficients that are specific for each security. Terms i are assumed to reflect the random information that is unrelated to other assets. Too strong dependence on i would suggest that there are more than k common factors. Furthermore, n should be much bigger than number of factors k. According to Roll and Ross (1980) the formula reflects the nature of assets in different states of nature.

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1.4.3 Firm- specific risk

The assumption of diversified firm-specific risk is of utmost importance for APT, as it allows for relating returns to factor betas. Roll and Ross assumed that the number of assets analysed is approximate to infinity and the portfolios are perfectly diversified. Moreover, all variances of residuals have weights equal squared amount invested in asset, as residuals are uncorrelated. Thus, for the perfectly diversified portfolios the residuals risk would be close to zero.

If i were excluded from the model, the formula would say that each asset i has returns that are an exact linear combination of the returns on riskless asset and the returns on k other factors. Thus, the riskless return and each of the k-factors can be described as linear combination of k+1 others returns. Any other assets return, since it is a lineal combination of the factors, must be also a combination of the first k+1 returns. Therefore, the portfolios of the first k+1 assets can be a perfect substitute for all of the assets in the market. Such substitute should be priced equally. Thus, the APT suggest that only limited number of risk components exists. Therefore, if there are only a few systematic risk components, economic aggregates (for example GDP, inflation rate, interest rates etc.) could be expected to be such factors.

1.4.4 APT relation

In order to track the return on the portfolio with no firm-specific risk a tracking portfolio with weights of 1 ik on the risk free security, i1
j =1 K

on factor portfolio 1 and i 2 on factor portfolio 2,., finally ik on factor portfolio k can be constructed. Therefore, the expected return of the portfolio that tracks the investment would be:

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RF + ik k
j =1

where 1 k are risk premiums of factor portfolios. If the investment and this tracking portfolio have the same expected return, there is no arbitrage opportunity. Thus, the APT equation for all investments with no- firm specific risk can be formulated as follows:

Ri = RF + ik k
j =1

This relation should hold in the absence of arbitrage opportunities. On the left-hand side an expected return on investment is presented and on the right-hand side there is the expected return of a tracking portfolio depending on the same factor coefficients. If there is only one significant factor in APT model then the asset pricing equation can be presented as a straight line. Two-factor models graphical presentation will be a plane as there are three points necessary to describe a plane. These points will be two coefficients and expected return. More than two factor model presents a hyperplane.

1.4.5 Methodological concerns

The theory proponents believe that there are two most important advantages of APT. The first one is the liberal character of its assumptions compared to CAPM assumptions. The second benefit is

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that the theory significance can be verified statistically. The second issue is discussed by the theory opponents. There were economists trying to assess if the APT model is testable. The first studies on APT statistical tests show that a researcher carrying out a factor analysis may face methodological difficulties. APT opponents usually believe that the assumption of diversified firmspecific risk is weak APT opponents such as Schanken (1982) and Dhrymes et all (1985), researched how the theory works when limited number of assets is assumed or when the economy analysed is of the limited size. Shanken (1982) criticized the idea of APT testability. The return-factors linearity assumption was pinpointed as the mistake in the theory formulation. They concluded that employing the infinite number of assets is not enough to neglect the firm-specific risk. Furthermore, APT models are prone to manipulation, as neither the factors generating returns nor their number were specified in the theory. One of the most important problems concerning the arbitrage pricing theory testability is the number of assets in the analysed portfolios. Dhrymes et al. (1984, 1985) stated that for the number of assets ranging from 15-60 the number of significant factors increases from 3 to 60. Therefore, the number of assets analysed in groups is of utmost importance in the model estimation. Furthermore, Dhrymes et al show that the number of factors generated by factor analysis depends on the number of observations throughout the time and the numbers of analysed macroeconomic variables. However, Haugen (1996) believes that the most significant factors will be estimated even on small samples. Weaker and therefore less important factors can surely disappear, unless the sample analysed is large enough. The less visible factors are not valuable for empirical

24

researchers, thus APT proponents believe that the sample size does not matter. Furthermore, APT in the contrary to CAPM gives explicit predictions about the portfolios efficiency. Haugen (1996) gives the following example. It was assumed that there are n factors and n portfolios and that each of them is a substitute for one of the factors. According to Grinblatt and Titman (1998) these portfolios will be efficient portfolios only if they were created according to APT. Thus, the empirical verification of the theory is easier than CAPM empirical tests. However, the problem of APT testability is still unsolved.

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CHAPTER II Capital market equilibrium models empirical tests

This chapter focuses on CAPM and APT empirical tests. Presented studies might be useful in testing these models on Warsaw Stock Exchange as they present different methodologies of estimation and tests. Furthermore, the empirical basis of researches includes these that were carried out on Polish market. These papers might suggest, whether these models can be implemented on the WSE.

2.1 CAPM empirical evidence

In this section the results of the most significant CAPM tests will be chronologically presented and discussed. The literature can be divided into two parts: early CAPM tests, conducted in 70s and later tests (after the Rolls critique).

2.1.1 Early CAPM tests

In the early CAPM tests the technique of two-stage regression analysis was commonly applied. The first phase of this analysis was the timeseries regression, which was to estimate the beta coefficients of each analysed company. In the second phase the cross-sectional regression was run, while the average rate of return was a dependent variable and a corresponding beta coefficient became an independent variable. The

26

aim of the regression was to estimate the Security Market Line, which would allow to state if its theoretical values were consistent with the empirical findings. The most significant empirical studies on this topic were conducted by: Lintner, quoted by Douglas (1968), Black, Jensen and Scholes (1972), Blume and Friend (1973) as well as Fama and MacBeth (1973).

2.1.1.1 Lintner test (1968)

Based on the sample of 301 randomly chosen companies Lintner estimated beta coefficients regressing yearly returns on shares against yearly returns on market index. Years 1954-1963 were the estimation period for the equation:

R i ,t =

+ bi R M

,t

+ e i ,t

where bi is the beta coefficient for the company i. The second phase was the cross-sectional regression:
2 Ri = a1 + a 2 bi + a 3 S ei + i

2 where S ei is a variance of the residual ei. The obtained results stay in

contradiction to the CAPM theory because of three reasons. First of all, the coefficient a1 should approximately equal the value of the risk free rate, but it appeared to be higher of any value possibly taken by RF in the examined period. Second, the coefficient a2, which defines the price of the accepted risk, although statistically significant, had much lower value than expected.

27

Finally, assuming that the CAPM is true a3 as a coefficient of additional independent variable should be statistically insignificant. Therefore, Lintners results are not coherent with the theory, since a3 is positive and statistically significant. A response to the above analysis was a study conducted by Miller and Scholes (1972), who concentrated their efforts on a critique of the methodology applied by Lintner. There were three planes of the critique. First, the notation of tested equation was incorrect, since it did not include the models reliance on the risk free rate in the proper manner. If the original model takes the form of:
Ri ,t = RF ,t + i (RM ,t RF ,t )

then
Ri ,t = (1 i )RF ,t + i RM ,t

The situation gets more complicated if RF is not constant over time. Second, heteroskedasticity, which is often present in the financial timeseries, is interpreted as an inconstant variance of the returns over the estimation rejection. The last, and as it appeared the most important reason for the CAPM failure was a beta estimation error in the time-series regression. The estimated beta coefficient, biased with the estimation error, becomes an independent variable, which must lead to the false estimation of the parameter describing the variable. period. Although Miller and Scholes found the heteroskedasticity, they decided that it is not a cause of the CAPM

28

2.1.1.2 Black, Jensen and Scholes test (1972)

Black, Jensen and Scholes (BJS) overcame the problem of beta coefficients estimation error, which was a cause of Lintners study failure. The methodology of this study will be discussed in details later on, since based on a similar methodology the test of the CAPM model on the Polish market will be conducted. BJS used only the shares, which were listed on the NYSE within the period 1926-1965. Based on the data from the subperiod 1926-1930 beta coefficients of the individual shares were estimated. These parameters were computed against the unweighted market index, composed of all shares listed on NYSE. The next stage was to sort the companies according to their beta value and dividing them into ten portfolios, so that the first portfolio contains the decile of the companies with the highest beta coefficient and the last portfolio was created by the decile of companies with the lowest values of this coefficient. Next, for each of the portfolios, series of twelve monthly returns realised in the next year 1931, were calculated. This process was repeated shifting the sequence one year ahead, which means that based on the period 1927-1931 beta coefficients were estimated. Based on the estimated beta coefficients companies were sorted in portfolios for which twelve monthly returns were computed. Having the portfolios monthly returns calculated, BJS could estimate the portfolios beta coefficients using the same index, which was used to beta coefficients estimation of individual companies. The final version of the tested model took the following form:
RP ,t = RF ,t + P (RM ,t RF ,t )

29

where RP is a return on the portfolio P. Using the estimated beta parameters of each portfolio, in the cross-sectional regression the Security Market Line was estimated:
RP = a 0 + a1 P

where a0 is a risk free rate, if the one exists. The value of this coefficient was 0.0519, which is 6.225 percent yearly. Because it is statistically more than the average interest rate of the government bonds in the studied period, the results support Black CAPM version. Black allows long buying of the government bonds at the risk free rate but forbids their short sailing. The obtained market risk premium was 0.01081, which is 12.972 percent yearly. The results strongly support the zero beta version of CAPM model. The estimated SML does not reveal any signs of curvilinearity and the determination coefficient for the cross-sectional regression equals almost unity.

2.1.1.3 Fama and MacBeth test (1973)

Applying a similar procedure to BJS Fama and MacBeth (FM) formed 20 portfolios, for which the beta coefficients were estimated in the first phase. The difference comes from the fact that the beta coefficients computed against data from the period t were a basis to form the predictions of the rates of return in the period t+1. Unlike BJS, Fama and MacBeth in the second phase repeated the regression separately for each month in the period 1935-1968. Due to the fact that this technique was employed, FM could analyse the changes in the parameter values over time. The estimated cross-sectional equation was as follows:

30

RP ,t = 0,t + 1,t P 2,t P + 3,t S e, P + p ,t

Having the monthly regressions estimated, the average values of estimated parameters were calculated in order to test the hypothesis regarding all four coefficients. The results can be summarised in four points. First, the average value of the intercept 0,t should be equal to (for the standard version of the CAPM) or greater than (for the Black CAPM) the risk free rate. Second, the average value of 1,t coefficient should be positive. Third, the average value of 2,t coefficient determines if there are any signs of curvilinearity. According to the theory this coefficient should be statistically insignificant and eliminating this variable should not decrease the value of the determination coefficient. Finally, the residual variance should not be statistically significant while estimating the average returns on the portfolio. It is because investors can eliminate this factor through diversification of their portfolios. Hence, the average value of the coefficient 3,t should not be statistically different from zero. The results obtained in the FM studies are consistent with CAPM theory. Similarly to the BJS research, the outcomes support the Blacks version of the CAPM model. However, one aspect of the study should be criticised, namely FM did not use a weighted index, hence it can not be treated as the reliable proxy of the market portfolio. This argument is presented by Roll (1977), who criticised the early tests of the CAPM model.

2.1.2 Rolls critique (1977)

Roll criticised tests of the CAPM model of that time arguing that they are mathematical tautologies. The presented prove confirms that even

31

if the index applied is the market portfolio, but some other on the efficient portfolio, then there always will be a linear relationship found between the expected return on a share and its beta coefficient estimated with the respect to the efficient portfolio. Furthermore, the indices used are not market portfolios. According to the definition of the market portfolio, it should consist of all assets available to the investor. Market indices do not include bonds, real estates, gold and many other investment opportunities. Hence, the so far conducted tests may only verify the hypothesis of the particular index efficiency, but can not be considered a CAPM model tests. The conclusion is that testing the CAPM model is not possible because of the purely theoretical idea of the market portfolio. Since the market portfolio grouping all risky assets is non-existent, it is impossible to calculate its return and therefore CAPM can not be a testable theory. However, Stambaugh (1982) proved that the CAPM model test is not sensitive to the enrichment of the proxy for the market portfolio in additional investment opportunities. He built a few versions of the CAPM model starting with NYSE index as a proxy for the market portfolio, next extending it by the government and corporate bonds market, then adding the real estate market and finally including even durable goods market2. Applying Lagrange multiplier tests to verify the hypothesis, Stambaugh could not reject the Black CAPM version, concluding that the Rolls critique was too strong. Stambaughs results. Increasing the composition of the proxy for the market portfolio did not influence

Such as vehicle market.

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2.1.3 Later tests of the CAPM model

A brand new series of empirical attacks on the CAPM model consisted in identifying variables other than beta coefficient that could explain the average expected returns on shares.

2.1.3.1 Banz test (1981)

One of the first studies of this type was conducted by Banz (1981), who decided to test if the firm size can explain this part of variance in the returns, which is not explained by the beta coefficient. It was found that in the period 1936-1975 the average returns on the companies with low capitalisation were statistically higher than the average returns on the big companies, after adjusting for the risk in both groups. This relationship is commonly known as a size effect. The procedure of portfolios building applied in Banz (1981) test is similar to the BJS. All portfolios consist of companies listed on NYSE and the cross-sectional regression defines the relationship between the average returns, beta coefficient and relative size of the portfolios. Since the coefficient of the relative size variable is statistically significant even at the low levels of significance, Banz (1981) concludes that the CAPM model is not fully specified hence fails. The negative value of the coefficient should be interpreted as follows: the shares of the companies with higher capitalisation are characterised by lower, on average, rates of return than shares of the small companies. To support the results Banz conducted one more test. Two portfolios were created, each consisting of 20 shares. The first portfolio included shares of the companies with low capitalisation, whereas the second one included big firms. Both were constructed in that their betas were equal. Based on the same period as in the previous study Banz found

33

that the first portfolio indicates monthly on average 1.48 percent higher return than the second one and the difference is statistically significant. This outcome is consistent with previously obtained. The subsequent studies supported doubts about model

misspecification. Basu (1983) found that the ratios defining the firm size and E/P are interrelated, hence E/P should explain the expected returns as well. Additionally, Bhandari (1988) proves that the financial leverage ratio is positively correlated with expected rate of return. On the other hand, the same year as the Banzs study was released, Christie and Hertzel (1981) published a paper, in which they indicated that the companies decreasing their capitalisation became more risky and since beta coefficient was measured based on the historical data, it could not capture an increase in risk over the estimation period, hence the beta was lower. Reiganum (1981) and Roll (1981) indicated that the beta coefficient of small companies would be lower as it was an effect of thin trading.

2.1.3.2 Fama and French test (1992)

A sample, on which Fama and French (FF) conducted their test of the CAPM model, was constituted of companies listed on NYSE, AMEX and NASDAQU in the period July 1963 December 1990. FF created 100 portfolios first sorting the shares in ten portfolios with respect to their capitalisation and then, within each group, shares were sorted with regard to their beta coefficient value. Based on the cross-sectional regression analysis of the equation:

RP = 0 + 1 P + 2 P + P

34

where P is an independent variable defining the firm size, they came to the conclusion that 2 coefficient is negative (-0.17) and statistically significant (t statistics = -3.41). The beta coefficient, however, is statistically insignificant and this conclusion will not change even after exclusion of the size variable P. FF include one more factor in their analysis, book-to-market equity ratio (BV/P) and conclude that this variable explain much better the variance of average returns than the size variable. Shares characterised by the high value of the BV/P ratio generate higher returns on average. Even though this relationship does not necessarily have to be true in the short-term, it is held in the long-term. Unexpected might be the fact that FF applying the same methodology as FM (1973) came to completely inconsistent conclusions. This inconsistency is assigned to different estimation period. FF repeated the test for the period applied in FM studies and reached coherent results. Studies that are a response to the FF critique refer mostly to the data used. Three years after FF publication Korthari, Shanken, and Sloan (KSS) (1995) wrote a paper, in which they prove that the results obtained by FF depend mainly on the interpretation of the statistical tests. KSS conclude that beta coefficient from the estimated form of equation has a very high standard error, which does not allow to reject statistically a high range of the risk premiums. For example the estimated coefficient 1 with a value of 0.24 percent, has a standard deviation of 0.23 percent, which means that values of 1 may range from zero to 0.5. Amihud et al. (1992) share the view about the statistical noise, concluding that when applying more sophisticated estimation techniques the value of 1 coefficient would be positive and statistically significant. The same results were obtained by Black (1993), who suggested that the size effect might have been related only to the

35

estimation period applied by FF. He proved that for the period 19811990 the size variable did not affect the average rate of return and was statistically insignificant. Even if the size effect exists, there is a remaining question if its significance is high enough, because of the relatively low value of the small companies. Jagannathan and Wang (JW) (1993) state that in each of the groups tested by FF, 40 percent of the biggest companies were more than 90 percent of the market value of all companies listed on the NYSE and AMEX. In this case, the CAPM model holds its empirical validity. JW criticise that the market indices are used as a proxy for the market portfolio. They indicate that in the U.S.A. only one third of non-governmental assets is held by the industrial sector and only 30 percent of this amount is financed by the capital markets. Furthermore, the intangible assets like human capital can not be reflected by market indices. Finally, they conclude that beta coefficient of an individual company is not a constant value over time and the reality can be much better described by the CAPM model that allow the coefficient to vary over time. The KSS critique refers to the second variable as well proving that the companies with high BV/P ratio at the beginning of the estimation period had much lower chances to survive, hence the lower chances of being included in Compustat, which was used in the survey. On the other hand, the companies that managed to survive together with companies added to the survey in the later period indicated on average higher returns. Taking into consideration the above reasoning Breen and Korajczyk (1993) verify this hypothesis using the same software and data as FF. Their conclusion is that the BV/P variable should be definitely less significant.

36

2.1.3.4 Kozickis and Shens test (2002)

The authors of this test question the contemporary methodology applied while testing the CAPM model. Kozicki and Shen (KS) consider the hypotheses stated incorrectly by FM were the basis for many further studies. They argue that insufficient evidence to reject the null hypothesis was considered sufficient to reject the model. KS state that this manner of testing leads to false rejection of the model in at least half of the studies. They suggest to test the CAPM based on the statistical test in which the theory is true under the null hypothesis. Applying this alternative statistical test, the model can not be rejected based on the data used by FF. The inverted formulation of the null hypothesis, in which the beta coefficient equals zero is following:

H0 : i = 0
It causes that the test is a subject to the error type I and II, which means that rejects the model when it is true and accepts when CAPM is false. There are four most popular reasons for the type I error to occur:

Low value of expected premium for the market risk. High variance of the errors in expected premium for the market
2 risk3 - var( ) = m

High variance of the error in the CAPM model. Small number of surveyed periods.

A high frequency of the error type I occurrence reflects the problem of limited access to information, which causes a lack of sufficient
3

R M , t = E ( R M ,t ) + t

37

evidence to reject the null hypothesis leading the researcher to the conclusion that the CAPM model is true. The error type II arises when the statistical test rejects the null hypothesis and results in accepting CAPM model when in fact it is not true. It is because rejecting the null:
H 0 : E 1,t = 0

from the cross-sectional regression:

2

R P ,t = 0 , t + 1, t P

2 ,t

P + 3 , t S e , P + p ,t

in favour of the hypothesis:

H 1 : E 1,t > 0

model CAPM is considered true, although E 1,t E (RM ,t RF ,t ) , which means, that in the reality CAPM is a false theory. Hence, the statistical rejection of the null hypothesis in this case is not unequivocal evidence that the alternative hypothesis is true. Finally, KS suggest an alternative test, in which the null hypothesis that the CAPM model is true takes the following form:
HA0 : E ( 0,t + 1,t rm,t ) = 0

And the formula for the t-test:

A t ( A ) = t CAPM

0 + 1 rm (rm ) / T

38

where T is a number of observations. Applying this test KS conclude that the CAPM model is true. Most of the latest tests of the CAPM model refer to the empirical verification of the sophisticated derivatives of the standard model (Jagannathan et al. 1995; Campbell R. Harvey's research papers http://www.duke.edu/~charvey/research.htm), which is far beyond the scope of this thesis. The above presented analysis of a standard CAPM model does not allow to unequivocally state if the theory truly reflects the financial reality. Even when rejecting the model using a proxy for the market, because of a highly theoretical definition of a market portfolio, there is no possibility of testing the theory. Nevertheless, the CAPM gained the acceptance of the financial practitioners such as: portfolio managers, investment advisors or financial analysts. The popularity of the model results from its simplicity resulting from linear relationship based on only one factor (Javed 2000).

2.2 Empirical Studies on APT

As the most universal group of tests, the early tests of the multiple factor generating returns are briefly discussed. These studies motivated researchers to consider other than only beta and risk free rate factors that might explain assets returns. The empirical investigation of the APT theory statistical significance should be considered together with its method of creation. The method of estimation of factors and coefficients influences the tests results.

2.2.1 Investigation on variables influencing returns

The possibility that expected returns are generated by multiple factors was recognized over twenty years ago. The early empirical studies

39

were carried out by Brennan who concluded that the return generating process has to be described by at least two factors. Furthermore, Rosenberg and Marathe searching for the presence of components that have an impact on assets returns shown that there are many factors influencing market portfolio. Moreover, studies of Langetieg, Lee and Vinso, Mayers evidence that there is more than only one factor in the returns generating model (Roll and Ross, 1980). There were other researchers investigating variables that were likely to influence asset return. Chen, Roll and Ross in their research published in 1986 suggested four-factor model and then tested it. (Francis, 2000). Measures of unexpected changes in the following variables were suggested in their paper: 1. Inflation- as it has impact on discount rate and future cashflows for investors 2. Interest rates term structure- the differences between short and long term bonds influencing the value of future liabilities compared to liabilities due within shorter period of time. 3. Risk premium- the difference in low- and high-grade corporate bonds approximates the reaction of market to risk. 4. Industrial production- the differences in industrial production have an impact on investment opportunities and the real value of cashflows. This study revealed that there is a significant relationship between these macroeconomic variables and factors estimated statistically in the previous Ross and Roll analysis. valuation is perfectly correct. Their research was continued by Burmeister and McElroy. They implemented a model that generates returns using five factors (Elton and Gruber 1998) Nevertheless, there is no evidence that the suggested selection of variables that influence assets

40

1. The risk of not paying liabilities 2. Premium rewarding long term investments 3. Deflation 4. Change in expected level of sale The fifth variable represents all unobservable variables that are estimated on the basis of residuals of diversified portfolios regressed against four others. The first variable was measured by the difference in long term rates of governmental bonds and long term corporate bonds interest rate plus five percent. The second was approximated by the difference between long term rates of governmental bonds and one month treasury bonds. The third one was described by the difference between the expected inflation rate at the beginning of each month and the real monthly inflation rate The first four factors explained 25 percent of the returns variability and all five described from 30 to 50 percent depending on particular portfolios. Thus that is the next study confirming that the return variables. Their later studies introduced three generating process accounts for more than one factor including unobservable unobservable factors instead of only one. According to Elton and Gruber (1998) this survey is one of the strongest empirical evidences showing that multifactor models are useful in explaining returns. The variable set that was tested in these studies was selected arbitrary; hence it should not be treated as the only one that explains returns correctly. Nonetheless, the analyses can give an idea which variables may influence returns and therefore should not be neglected by future researchers.

41

The mentioned studies tried to define factors that influence returns on the basis of economic theory. Researchers defined factors that are likely to explain assets returns. Despite of the fact that these studies did not create one selection of macroeconomic factors generating returns, their results shown that there is more that one factor significant in the return generating process.

2.2.2 Approaches to APT model estimation

This section analyses empirical studies concerning APT in relation to their methods of estimation. The following researches were carried out using two different approaches to model implementation and testing. There are three general approaches to the estimation of coefficients applied in empirical studies. The first technique allows for simultaneous statistical estimation of factors and beta coefficients. The second one defines factors or coefficients a priori.

2.2.2.1 Statistical estimation of betas and factors

There are empirical studies that use this method. Factor analysis is usually applied in order to estimate factors and their coefficients simultaneously. Further details of this method are presented in details in empirical part of this study. This section summarizes findings of example tests carried out on the basis of this method. One of the first APT tests applying this technique was carried out by Roll and Ross (1980). They surveyed 1260 stocks quoted on the New York Stock Exchange grouped alphabetically into 42 groups. The maximum likelihood analysis was performed in order to estimate factors and factor loadings (coefficients). Then, the factor loadings estimates were applied to explain the cross-sectional variation of

42

individual estimated expected returns. Finally, the estimates from the cross-sectional model were used in order to calculate the significance of the risk premia associated with each factor. The APT reflects the reality if there are one or more significant risk coefficients that significantly differ from zero. The results of this test show that there are no more than four significant risk premia coefficients. Cho, Elton and Gruber carried out a similar analysis as Roll and Ross did but they examined a newer data set. More than four significant factors were found (Elton Gruber, 1998).

2.2.2.2 Portfolio method of factor estimation

The next group of arbitrary methods that can be used in APT models estimation assumes that factors having an impact on returns are reflected in portfolios. These portfolios are defined on the basis of investors expectations and macroeconomic factors that are likely to influence returns. This method was applied by Fama and French in 1993 and discussed in details in section 2.1.3.2 of this paper. Their approach is arbitrary as the portfolio grouping is subjective, but it confirms that returns can be explained by more than single-factor model.

2.2.2.3 Betas arbitrary choice

Sharp (Elton and Gruber, 1998) carried out a research defining beta coefficients arbitrary; hence the APT model could be implemented quite easily. Having betas defined, the model could be created by regressing returns against betas.

43

The sample consisted of monthly 2197 stocks returns analyzed over 1931-1979. Sharp assumed that equilibrium returns are influenced by arbitrary selected variables such as: 1. Beta of assets measured with relation to S&P index 2. Dividend payout 3. Firms size measured by capitalization 4. Beta estimated against long term governmental bonds 5. Historical alpha parameter (the intercept of regression function estimated on abnormal returns of securities and of market index S&P) Furthermore, the industry specific variables were analyzed as well. Taking into account the economics theory, beta is expected to influence return positively as low-grade assets should generate higher returns in equilibrium. The impact of dividend payout is expected to be positive as well, as increasing dividend is likely to be interpreted as a signal of increasing expected future cashflows. The big firm size as approximation of company liquidity would influence the return negatively. If the beta measured against bonds is significant, the abnormals would be sensitive to interest rates and exchange rates. The alpha significance implies that autocorrelation of residuals in CAPM occurred; hence there is more than one factor that influences returns. The empirical results confirmed that the outcomes, expected on the basis of the economics and all variables, were significant. The determination coefficient of the model explaining returns related only to market beta amounted to 0.037. When the model includes beta, dividend payout, firm size, beta on bonds and alpha intercept the value of that coefficient increased to 0.079. Moreover, model implemented on the basis of all analyzed variables explained over ten percent of the return analyzed.

44

Creation of Sharp model included arbitrary chosen variables but it showed that there was more than one significant variable explaining equilibrium returns. Furthermore, the research showed that it was possible to find arbitrary significant factors reflecting economic relationships.

2.3 APT contra CAPM

A lot of empirical studies investigate the question, if APT is a better model than CAPM. They usually confirm that APT overperforms CAPM. Reinganum (1981) carried out an empirical research that scrutinized whether the arbitrage pricing model can account for the differences in average returns between small and large firms traded on American Stock Exchanges. Reinganum assumed that APT would be better in explaining returns than CAPM as it explains the CAPM anomalies. Thus, the firm size effect was analyzed. The research was carried out within the estimation period of fourteen years that is since 1964 to 1978. Furthermore, the sample was being changed for each year. The number of firms examined ranges from 1457 in 1963 to over 2500 in the mid 70s. To estimate factor loadings, factor analysis was introduced. The test results indicate that APT fails statistical verification. Portfolios constructed of small firms earn on average 20 percent more than large firms portfolios. However, the research results should be taken with caution as the Reinganum analysis tested a few hypotheses simultaneously. Thus there is no certainty which of them have failed. For example the process generating returns might not have been linear, the firm-specific variance might not be diversified or the arbitrage opportunity might

45

subsist on the market. Therefore, the reason of APT failure was not discovered. Chen (1983) analysed daily returns during the 1963-1978 period. First, the APT model was implemented and tested. Betas were computed with market proxies such as: the S&P 500 index, the value weighted stock index of the equally weighted stocks. The cross-sectional regression of average stock returns was applied according to both market equilibrium models. The significance level of the first risk factor was the highest, and it was concluded that the first factor is related to market portfolio. Furthermore, the hypothesis of constant expected return across assets was rejected. Therefore, the model explains expected returns across assets. The next test allowed for comparison of APT with CAPM as models explaining the expected returns. Chen used the following regression:

ri = w r

i , APT

+ (1 w) r i ,CAPM + ei

The past return on security i was related to weighted average of returns calculated according to both market models. Estimated returns were always bigger than 0.9. Therefore it can be concluded that APT performed better than CAPM. The last test carried out by Chan was based on residuals generated by both models. Residual estimates equations should follow white noise for well-estimated models. The CAPM model did not follow a random walk. The APT explained a part of residuals generated by CAPM but APT residuals were not explained by CAPM. Therefore, it might be concluded that CAPM faced a misspecification problem.

46

One of the latest APT tests was carried out by Haugen (2000). He investigated which model CAPM or APT predicts returns better. Returns over the same time period 1980 - 1999 and over the same stock population (the largest 3,500 companies in the United States) were analyzed. CAPM was estimated by regression of each stock return against the S&P 500 return and then recalculating betas each month. Then stocks were ranked by betas and divided into deciles. Tests results concluded that the payoff and risk were negatively related on the stock market. Then APT was implemented. It included the following macroeconomic factors: 1. The monthly return on Treasury bills 2. The difference in the monthly return on long- and short- term Treasury bills 3. The difference in the monthly return on the Treasury bonds and low-grade corporate bonds of the same maturity 4. The monthly change in the consumer price index 5. The monthly change in industrial production 6. The beginning-of-month dividend-to-price ratio for the S&P 500 The model was constructed by regression of stock returns against these six factors. The APT appeared to predict return better than CAPM although the negative risk premia for some of the examined stocks occurred. Connnor and Korajczyk carried out the APT test applying the Principal Components Analysis to find the additional returns on small companies stocks in January. They concluded that, based on weighted index, developed APT explains the returns to such firms better than CAPM (Elton and Gruber 1998).

47

However, Gultekin and Gultekin (1987) came to a completely different conclusion concerning APT and the January effect. Their study analyses the impact of the return stock seasonality on the empirical tests of APT. The results show that the APT model can explain riskreturn relation in January only independently on the size of the group tested. If the January returns are excluded from the sample, there is no significant relationship between expected stock returns and the risk measures predicted by APT.

There are empirical studies confirming that arbitrage pricing theory is a better model for returns predictons than the capital asset pricing one. This finding is not surprising as there are so many research papers confirming that one-factor model fails, and that the return of an asset is generated by the multiple factors process. However, some empirical studies reject APT as well. Arbitrage pricing theory is not ideal in explaining asset returns. Nevertheless, it usually overperforms CAPM in empirical verification.

2.4 Empirical evidences in Poland

The basis of empirical studies concerning market equilibrium models in Poland is extremely poor right now. The most important reason for that situation is the fact that Warsaw Stock Exchange is still in early stages of its development. Furthermore, it is a question whether this market is efficient enough to implement and test CAPM or APT.

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2.4.1 Tests of market efficiency

Nowadays, first studies on market efficiency on WSE are being carried out. The issue of market efficiency was investigated by Szyszka (2003). Some of his findings are relevant to research carried out in this paper. The efficiency of WSE was investigated in two subperiods first to October 1994 and the second from October 1994 to October 1999 as in the first subperiod stocks were quoted less than five times a week. First, Szyszka concluded that in the first years of WSE even the weak efficiency was not present. This finding was based on test of correlation of daily returns and then series test. However, due to data availability only 14 companies were examined. There was a significant positive correlation between returns and historical returns from one to five sessions. Nonparametric tests confirmed these results. The second subperiod brought different conclusions. Instead of 14, 29 companies stocks were examined. 16 firms out of 29 had returns significantly correlated with historical returns. Furthermore, the correlation for annual subperiods generated insignificant coefficients. Significant correlation coefficients between returns within time series imply that stock prices do not follow random walk. Coefficients were high in early stages of WSE development when stocks were not quoted daily. The correlation of returns for Universal mounted to 0.44 these days. This example is usually presented as a proof of market inefficiency these days. After 1999 the correlation coefficients were lower and not all of them were significant. Szyszka study indicates that the development of the Warsaw Stock Exchange goes along with better efficiency. There was not sufficient empirical evidence that allowed the rejection of the weak form of efficiency.

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2.4.2 Multifactor models on Warsaw Stock Exchange

Czekaj et al. (2001) analyzing WSE discovered that multifactor model could have been implemented in order to explain returns. They examined a sample of 44 stocks in 1995 and 119 stocks in 2000. Weekly rates of return were analyzed. Stocks were divided into decile portfolios that were recalculated and updated each quarter. Portfolios were grouped according to four characteristics. The first one was based on portfolios created on the basis of company capitalization, the second on Price to Book Value ratio (P/BV), third one on the Price to Earnings ratio (P/E) and the last grouping reflected betas estimated against index WIG. Market premium on portfolios was estimated and its significance was verified statistically. There was a monotonic relation between average rate of return and average capitalization of companies with yearly premium. The highest decile portfolios had premium of over six percent with comparison to WIG and for low decile companies that premium accounted for 11.8 percent. Therefore the choice of portfolio of stocks characterized by higher capitalization might create value. Thus choosing lower capitalization portfolio, losses can be expected. Therefore, it was suggested that beta and capitalization are significant risk measures and they might be introduced as factors in market equilibrium models. Tests based on P/E portfolios discovered that premium on low and high-decile portfolios is negative and lower for high decile portfolios. Thus, investments in low decile portfolios should generate gains. According to these results P/E ratio explains rates of return on portfolios and therefore it can be employed into factor model. Portfolios grouped according to their P/BV ratio revealed that there is a U-shaped relationship between returns generated on decile portfolios.

50

It can be concluded that company capitalization and Price to Earnings ratio are better estimates of expected returns than beta calculated according to CAPM. Therefore, it might be expected that multifactor model for WSE would work better than CAPM. However, the methodology of beta estimation was not presented in details in this study and it might suffer from methodological mistakes. Thus, it is hard to say if these two factors overperformed beta when explaining rates of return. The first attempt of applying Arbitrage Pricing Theory to Polish market was made by Rubaszek (2002). He surveyed 73 monthly observations from 1994- 2000 period. The APT model was created using factor analysis with maximum likelihood factoring (MLF) method. The research was carried out on five portfolios grouped according to company capitalization. Variables concerning investment environment and the value of companies listed were introduced: 1. Warsaw Stock Exchange Index (WIG) 2. World markets indices (DAX Xetra, NASDAQ, DJ, Standard& Poor 500) 3. CRB Spot Rate (Commodity Research Bureau Index) 4. Term structure of interest rates 5. Prices (Consumer Price Index, Production Price Index) 6. Aggregated money supply 7. Exchange rates (Polish Zloty against German Mark and US Dollar) 8. Industrial Production 9. Unemployment Rate On the basis of these variables (26 together) two significant factors were created. The first one was correlated with the return on WIG. Therefore, it can represent the economic environment in Poland. The second one relates strongly to WIG as well to NASDAQ, PPI and

51

money supply. Moreover, Chow test of factor coefficients stability revealed that these coefficients were unstable during the estimation period. The findings should be taken with caution, as the study was conducted on the sample of only 38 companies. Besides, the examined period of six years included quotations from the time of Russian crises that strongly destabilized Warsaw Stock Exchange. Furthermore, more explicit results could be obtained if weekly returns were used instead of monthly. It is possible that there are academic papers concerning CAPM or APT. However, they were not published and could not be referred to in this paper (as Msc and PhD dissertations are available only for PhD students). All the discussed studies analyzed very small samples from 14 (Szyszka, 2003) to 119 (Czekaj et al., 2001) securities. That was due to availability of data as it was usually not possible to find more companies traded at the same time. This limitation concerned also estimation period that could not be longer. Findings based on such samples are very weak. It is impossible to compare results presented in the literature, as they all concern different issues and employ completely different methodologies. However, they may be the basis for future studies on market equilibrium models. Szyszkas (2003) findings concerning market efficiency that is getting better constantly encourage researchers to create and to test market models. Furthermore, Czekaj et al. (2001) postulates that multifactor models might perform better than model based only on market beta. Positive results on arbitrage pricing theory model obtained by Rubaszek (2002) should rather be taken with caution.

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CHAPTER III Data Description

In this chapter a description of the data used in both empirical tests of CAPM and APT on the Polish market will be presented. The core discussion will be preceded by the debate about the length of estimation period, data frequency and the choice of the proxy for the market portfolio. Data analysed was found in Datastream and Reuter, basis and cover the period from November 1998 up to the end of 2002.

3.1 Data Choice

Before tests of empirical validity of both models will be conducted, it is crucial to consider a few issues, which are not specified by the theory. Decisions, which are to be taken by the researcher, regard the choice of: 1. A proxy of the market portfolio 2. Length of the estimation period 3. The frequency of the returns

3.1.1 Choice of the proxy for the market portfolio

In practice, capital market index is the most commonly used, however, there are no such indices that can truly reflect the market portfolio. Market indices are usually related to the returns on shares or returns on the debt instruments. In USA the most popular index is S&P 500,

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which takes into account only 500 of thousands of shares quoted on the US markets. The problem becomes more complex when one includes the fact that with a globalisation and free capital flows most investors have a global access to investment opportunities. Domodaran (1999) on the example of Disney company showed that the value of estimated beta depends heavily on the choice of index against which returns were regressed:
Table 3.1 Beta estimated for different indices Index Dow 30 S&P 500 NYSE Composite Wilshire 5000 MS Capital Index
st

Estimated Beta* 0.99 1.13 1.14 1.05 1.06

st

* estimated on the monthly data from 1 of. January 1993 to 31 of December 1997 Source: http://pages.stern.nyu.edu/~adamodar/pdfiles/eqnotes/discrate2.pdf

The index, which includes the highest number of shares and is value weighted average, which means that it takes into account the companies capitalisation, should provide better estimates. This is the reason for the S&P 500 popularity, which although does not include as many companies as NYSE or Wilshire 5000, makes up on its competitiveness because it is weighted. Furthermore, inclusion of the unweighted index in this study might be inappropriate for three reasons. First, the application of the unweighted index is in contradiction to the classical CAPM theory, that empirical verification is the aim of this study. Following the formal derivation of the mode in equilibrium, the share of each asset in the portfolio will be proportional to its share in the market portfolio:

RM = Ri xX i
i =1

Where:

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Xi =

Market value of the asseti Market value of all assets

Second, the correlation between unweighted index and returns on shares would be miscalculated as Polish capital market is dominated by a few companies. This problem is partially solved by regulation, which set a maximum share of a single company or industry in the indices. Finally, all indices quoted on the GPW (Warsaw Stock Exchange) are value weighted indices. This suggests that practitioners apply weighted index as a proper tool in the capital market analysis. Furthermore, for some small, segmented capital markets local index should be applied, because it describes better the financial reality.

3.1.2 Length of estimation period

According to Kozicki and Shen (2002) most of financial institutions use two- up to five-year period for beta estimation purpose. Damodaran (1999) on the example of Dinsey shows, that beta is time-varying coefficient and the choice of the estimation period influences considerably its value:
Table 3.2 Beta estimated for different estimation periods Estimation period 3 years 5 years 7 years 10 years Estimated Beta* 1.04 1.13 1.09 1.18
st st

* estimated on the monthly data from 1 January 1993 to 31 December 1997 using S&P 500 index as a market proxy Source: http://pages.stern.nyu.edu/~adamodar/pdfiles/eqnotes/discrate2.pdf

There is no consensus between academics regarding the length of estimation period. Bartholdy and Peare (BP) provide evidences that are in favour of five- year period, when estimating expected returns based

55

on CAPM. However, Daves et al. (2000) strongly suggest that an estimation period of three years captures most of the maximum reduction in the standard error of estimated beta from a one-year estimation period to an eight-year estimation period. Taking decision about an estimation period a kind of trade off should be consider. The longer the estimation period, the more observations are collected for the regression, which increases the quality of estimates, as standard error of beta estimates is smaller. On the other hand, the longer the estimation period, the more time-varying characteristics of the firm might be subjected to changes. These could be for example a change of the industry, in which the company was primary active, diversification or change of the financial leverage ratio. Thus, the beta estimated over longer estimation periods is more likely to be biased. Therefore, for blue chip companies longer estimation period should be better. However, for the companies that recently were restructured, were a target of an acquisition, merged with other firm, changed the industry or financial leverage, shorter period should be more accurate.

3.1.3 Observation frequency

The last decision that can affect the value of estimated beta is the frequency of the data used. The most often frequencies are: daily, weekly, monthly, quarterly or yearly. The example of Disney shows the difference of estimated beta with relation to the frequency of the observations:

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Table 1.3 Beta estimated for different indices frequencies of the observations

Frequency of the observations Daily Weekly Monthly Quarterly Yearly

Estimated Beta* 1.33 1.38 1.33 0.44 0.77

st

* estimated on the monthly data from 1 January 1993 to 31st December 1997 using S&P 500 index as a market proxy Source: http://pages.stern.nyu.edu/~adamodar/pdfiles/eqnotes/discrate2.pdf

BP (2002) found the opposite tendency. Applying Standard and Poors index the average beta for daily returns of 0.77 increased up to 1.10 when monthly returns were used. BP argue that the best estimates are achieved by applying data with monthly frequency. This result is once again in contradiction to Daves et al. (2000) that conclude the financial manager should always select daily returns because daily returns result in the smallest standard error of beta or greatest precision of beta estimates. Applying greater frequency increases the number of the observations in the regression, but at the cost of the quality of data, especially if shares analysed are not traded at the frequency applied. This problem exists not only because of the lack of daily quotations, but might be a problem even with shares traded on a daily basis. This is because the moments of sale/purchase are not synchronised with index movements. For example if on a particular day shares of a single company are for the last time traded at 14.30,, the index value might be still changing till 16.00. This will influence the correlation between the share and the index.

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3.2 Characteristics of data used for CAPM and APT tests

Since relatively short history of capital market in Poland and its rather small significance in the first years of existence4, data used for the test is from the period after the Russian crisis (August 1998). This is because the Russian crisis significantly influenced Polish economy and capital market. It would be impossible to build a representative sample containing companies traded on the WSE before and after the crisis. There are three most important reasons that can be summarised as follows. First, the short history of the capital market in Poland (12 years) causes that there were not many companies quoted before the crisis. Till the end of 1995 there were less than 30 companies listed and till the end of 1997 (half a year before the crisis) there were around 80 companies listed. Furthermore, many companies went bankrupt. Hence the sample would include only a part of companies listed on the stock exchange before the crisis. Moreover, the crisis affected almost all companies causing either a changed the primary industry or diversification. With no doubt the crisis altered the correlation with the market index. Although there are techniques that could deal with the crisis problem (like introducing a binary dummy variable for the period after the crisis had begun), because of the above mentioned reasons, this would improve the quality of the study only slightly.

Even now the role of the capital market as a source of capital is rather small.

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Therefore the first observations are from November 1998, as since then market has recovered gaining stability, and end up with the year 2002. As the estimation period is relatively short, to ensure necessary number of degrees of freedom, observations can be either of weekly or of a daily frequency. As previously described, one can give reasons in favour of shorter or longer frequency. However, for the purpose of this study the shorter possible frequency is chosen and therefore weekly data are going to be used. The reason for this decision is to avoid noise in data analyzed, which occurs when longer frequency applied.

3.2.1 Characteristics of data used for CAPM test

There are three types of primary variables used in the CAPM test: 1. Returns on Shares 2. Warsaw Market Index (WIG) 3. Risk Free Rate

3.2.1.1 Returns on Shares

From all 209 (http://www.gpw.com.pl/xml/spolki/listaspolek_baza.xml) of firms quoted on the Warsaw Stock Exchange only these, quoted on a daily basis are considered. There were three criteria for exclusion of the companies in the sample: 1) The companys equity has not been quoted on the WSE since November 1998. The aim of the selection process is to create a sample that would be constant over time. 2) The company went bankrupt over the estimation period. The same reasoning as in the previous point.

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3) The companys equity had gaps in quotations over the estimation period. Including shares quoted infrequently would cause estimation bias. 4) The companys equity is quoted in foreign currency. Including shares denominated in foreign currency would impose the necessity of simultaneous adjustments to the variable exchange rate. Excluding these kinds of shares should not influence the result, as there are only two companies on the market, which denominate their assets in foreign currency. A reason mentioned in point one was the most important for exclusion from the sample. Over 70 firms currently quoted on the WSE had to be excluded because of not being listed since November 1998. After precise selection process only returns of 100 companies are examined in the study. The chosen shares are rather liquid since during the period of two years particular shares had a few, single or double observation gaps in a row. Therefore, the number of gaps in quotations, which is a proxy for liquidity, is less then five percent of all observations for the single company, which allows for conclusion that shares in the sample can be assumed to be liquid. Thanks to this selection process the sample is constant over the estimation period.

The variable was constructed in the following way:

Rt =

Pr icet Pr icet 1 Pr icet 1

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3.2.1.2 Warsaw Market Index (WIG)

WIG is chosen as a proxy for the market portfolio. When accounted, price changes of all companies quoted are considered. As discussed in chapter 1.1.1 WIG is an index weighted with the market value of the single firm, hence the impact of the particular company on its value is directly proportional to the company capitalisation. Such a construction of the index results in the fact that the change in its value reflects changes in the total value of shares included in the portfolios of all investors. From the beginning of the second quarter of the Next year 1994 the impact of one company on the index was limited to 10 percent of the value of the all shares portfolio. changes, from the beginning of the second quarter of the 1995, restricted the share of single industries in the index to 30 percent and introduced the rule that the basis for defining impact of the single company on the WIG is the number of the shares introduced to active trade not just the registered number of shares. The basis date for WIG is 16 April 1991 the date of the first session of Warsaw Stock Exchange and its basis value was 1000. WIG is accounted at the end of each session and published with an accuracy of 0.1 basis point. The formula for the index calculation is (www.gpw.com.pl):

WIG (t ) =

M (t ) *1000 M (0) * K (t )

where: M(t) 91) K(t) - adjustment coefficient for session t capitalisation of index portfolio on session t M(0) - capitalisation of index portfolio on the base date (16 April

61

Thus, the variable was calculated according to the formula:

dWIGt =

WIGt WIGt 1 WIGt 1

3.2.1.3 Risk Free Rate

A common proxy for the risk free rate are government bonds. In this study five-year government bond is chosen. Although shorter, onemonth bonds are recommended as the best proxy for the risk free rate, since in the practice the probability of their default is zero, it appeared impossible to obtain their quotations on the secondary market. The oldest, available and accessible five-year government bond was issued on 2nd February of 2000 and is marked with a sign PS0205. To calculate the variable the following formula was applied:

dRFt =

RFt RFt 1 RFt 1

3.2.2 Variables used for APT test

Arbitrage Pricing Theory test is implemented and tested on the following set of variables: 1. Stocks returns 2. WIG 3. Risk Free Rate 4. S&P 500 5. Polish Zloty (PLN) Exchange Rate (against USD). 6. International Price of Gold

62

Therefore the APT model in comparison to CAPM will include three additional variables.

3.2.2.1 S&P 500

The impact of international markets on the value of assets in Poland was considered. The American index was found the most influential, as it has a strong impact on the world economy. The economic results of events such as Great Depression and Terrorist Attack of September 11 were immediately transferred overseas and expectations of the daily investors moods were reflected on the WSE. The S&P 500 Indexs weekly quotations were chosen as a proxy of general condition of American economy. It is calculated using a base-weighted aggregate technique. This method implies that the level of the index reflects the total market value of all 500 component stocks relative to a particular base period (www.cftech.com/BrainBank/FINANCE/SandPIndexCalc.html - 40k). As the APT will be based on the stock returns thus variables in absolute values should not be employed. Thus, the following variable was constructed:

dS & Pt =

S & Pt S & Pt 1 S & Pt 1

3.2.2.2 Polish Zloty (PLN) Exchange Rate

Many Polish companies are indebted in foreign currencies

(http://www.nbp.pl/statystyka/czasowe/zadluz.html).

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Thus, if the Polish Zloty exchange rate against USD depreciates, the country overall indebtedness will increase. On the other hand, the PLN depreciation is reflected in improvements of competitiveness of Polish export goods, as lower relative price makes them more attractive for foreign buyers. In this situation, Polish companies stock prices would be likely to go up. The following variable is analyzed:

dPLN t =

PLN t PLN t 1 PLN t 1

Where PLN t is the Polish Zloty exchange rate denominated in US Dollars at time t. Moreover, due to the fact that exchange rate was employed, a variable delivering information on price level, was introduced. Macroeconomics theory states that exchange rate is a price of domestic currency for foreign investors and that the inflation rate is its domestic price. According to Purchasing Power Parity (PPP) theory there is a relationship between the level of prices of domestic and foreign market. PPP is an equilibrium condition in the market of tradable goods and forms a basic building block for several models of the exchange rate based on economic fundamentals. In essence, PPP states that it should be possible to buy the same collection of goods and services in any economy for the same amount of home currency. There are two different interpretations of PPP: absolute and relative. Empirical evidences usually support the relative version of PPP. In this interpretation, the changes in exchange rates are related to changes in the relative prices. Empirical findings confirm that exchange rate may diverge from PPP, but will tend to return to PPP over time. Proponents

64

of the theory argue that PPP is a long run determinant of the exchange rate, but it does not hold in a short one. Manzur research showed that PPP could not be rejected over a long run. Furthermore, it is revealed that PPP holds well for countries with high inflation relative to trading partners. The inflation rate in Poland was high in comparison to its trading partners (McKenzie, 2002). Assuming that PPP holds in Poland, the variable presenting relative exchange rate of the Polish Zloty delivers information on a long-term price level as well.

3.2.2.3 International Price of Gold

The international gold price is introduced to the potential variable set used for APT tests. Carruths et al study of 1998 analysed the possibility that movements in the real price of gold reflect uncertainty in financial and other traded commodity markets. The research explored UK industrial and commercial companies (ICC). The investigation of this issue indicates that price of gold can enhance the explanation of investment spending by the ICC sector. The size of the relationship between investment and gold price movements is small but significant. Carruths et al (1998) results obtained for UK market suggest important and significant effects for both real profits and the real gold price in both the short and the long-run. Therefore, this research assumes that the gold price is an indirect proxy for aggregated investment uncertainty. As a measure of uncertainty, this variable has the advantage that it has a global dimension and might therefore be considered as exogenous. Since gold is usually regarded as a low-risk hedge, movements in its price ought to reveal important information about market sentiment vis vis

65

other asset returns. Furthermore, gold is highly inelastic in supply. Its price movements are expected to reflect changes in demand. Thus, in contrast to other price series, gold price movements are expected to reflect more closely the demand-driven substitution for other assets (Carruth et al, 1998). The following variable is employed in the primary data set:

dGOLDt =

GOLDt GOLDt 1 GOLDt 1

where dGOLDt is a price of gold measured in USD at week t.

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CHAPTER IV Empirical Test of CAPM

In this chapter test of the CAPM model on the Polish market will be carried out. The methodology applied is based on the Black, Jensen and Scholes (1972) with some adjustments described below. The test is performed on the Microsoft econometric software: Eviews 4.1. Ordinary Least Squares was applied as the estimation method.

4.1 Calculation procedure

In this section methodology of the CAPM test will be presented. Further, reasons for grouping shares in portfolios will be discussed and finally time-varying risk free rate and its implications will be commented on.

4.1.1 CAPM test methodology

The methodology of the test that is conducted in the next section is primary based on a technique developed by Black, Jensen and Scholes (1972). BJS technique is applied as it deals with the estimation bias (discussed in the point 3.1.1) to some extent. This method is a two-stage-regression test, which allows for testing the model not only for a single company, but for the whole market as well. The two-stageregression BJS methodology (discussed in chapter 2.1.1.2) is still a mainframe for the researchers. Despite the fact that there are many adjustments to the BJS technique in this paper, they were justified by

67

the availability of data on the Polish capital market. There are many differences resulting from this fact. First, the estimation period for beta coefficient calculation is much shorter then in BJS studies. In order to provide the same number of observations their frequency was increased from monthly to weekly. Hence, betas of the companies in the first sub-period will be estimated using weekly returns over thirteen and a half months to assure the number of observations at least equal the number used by BJS. The first estimation sub-period starts on 12th of November 1998 and lasts to 30th of December 1999. This gives exactly 60 observations. BJS used as well 60 observations to estimate the value of an individual company betas, because they applied five year period with monthly frequency (5x12). Second, betas, unlike in the BJS studies, are estimated not on the basis of CAPM, but the market model (zero-beta model). The differences between the implied techniques do not affect significantly the results of the test, as an individual companies betas are required only to form the portfolios. Therefore, the exact values of CAPM betas are not crucial at this stage, as they are only needed to rank the companies with growing systematic risk. In this context the same results would be obtained with CAPM model. Unlike in BJS studies, CAPM model was not used to rank the shares. It is because there is no publicly available information about risk free rate before year 2000. Due to the application of the market model, the number of observations in the CAPM testing phase could be significantly increased, as the observations used after portfolios are formed derive from the year 2000 onwards, which date is determined by the availability of the government bonds quotations. Finally, because the history of the capital market in Poland is relatively short, the test is conducted over the five-year period, which is significantly shorter than in the BJS study (35 years).

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Except for the mentioned differences in the estimation period, the testing procedure is the same as in the BJS study and will be described further in this chapter. All shares used in the study are grouped increasingly with respect to their beta coefficients and then divided into ten groups that form ten portfolios. Therefore, the first portfolio is composed of ten shares characterised by the lowest correlation coefficients with the market, the second one is formed of companies which were in the second decile of sorted shares. This is continued till the tenth portfolio, which includes last ten shares with the highest value of beta coefficients. The procedure of beta estimation, shares sorting and finally classification of companies to the portfolios is repeated twice more. This enables to increase the elasticity of the model, as the companies, particularly in countries like Poland, fluctuate in their relation to the market index. Unlike in BJS study, yearly updating of beta values should significantly raise the quality of obtained results. In each of the following two sub-periods, the estimation interval is lengthened up to one and a half year, which gives 78 observations per sub-period. On the basis of the estimated betas for individual shares in the subperiod November 1998 December 1999, ten portfolios composed of ten shares each will be formed. In the year 2000 for each portfolio weekly rates of returns R p ,t will be calculated, which will provide 52 observations. Next, in the sub-period from 8th June 1999 to 28th December 2000, once again betas of all 100 previously chosen shares are estimated. Using these values ten new portfolios will be created in the same way as the previous portfolios and for the year 2001 their weekly returns are to be worked out. This calculations will give additional 52 observations. For the last time, this procedure is repeated for the sub-period from 13th June 2000 27th December 2001, for

69

which the betas are estimated and the portfolios for the year 2002 are formed. All in, 156 observations for each portfolio will be obtained. These portfolios will be used for further analysis that is CAPM regression in time series. The regression will be run on the weekly market risk premiums (weekly returns on the WIG index decreased by the weekly returns on the government bonds risk free rate) against the weekly portfolio risk premiums (weekly returns on each portfolio reduced by the weekly returns on the government bonds risk free rate) within the estimation period January 2000 December 2002. The following estimated equation will be applied:
R p ,t R F ,t = p + p ( R M ,t R F ,t ) + t

Therefore, ten betas for each portfolio p are calculated, as well as the average rate of returns of every single portfolio R p for the researched period of three years. These results are used in the cross-sectional regression:

Rp = 0 + 1 p + p

If model CAPM is true for the Polish market, the estimated coefficient

0 should equal the risk free rate for standard version of CAPM or the
lowest borrowing rate in case of Black CAPM. The coefficient 1 defines the price of the market risk, hence its value should be significantly positive. It might seem that the sample of 10 observations used when estimating above parameters is far too small and the number of thresholds might indicate that the t-tests are not powerful. However, BJS conducted their tests on the sample of the same size and FM (1973) used the sample of 20 portfolios. This part of their study has never been criticised in later papers.

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Furthermore, cross-sectional analysis will be broadened by the two additional factors taken into consideration by FM. The first one is the residual variance Se p of the time-series regression, in which the weekly returns on the portfolios are dependent variables. Residual variance is a proxy for the non-systematic risk. The second additional variable is squared value of portfolio beta 2 p . This variable is added to check if there is any non-linearity in the relationship between portfolio returns premiums and market risk premium. The non-linearity is assumed to be parabolic, as the most often expected form. Both supplementary independent variables are added to the model separately, so there are three types of final cross-sectional equations to be tested: 1. R
= + 1 +

2. R p = 0 + 1 p + 3 2 p + p 3. R p = 0 + 1 p + 3 Se p + p

Since variables 2 p and Se p do not indicate that there is any correlation, there is no need to include them in one model simultaneously. The creation of separate models for any new variable will improve the quality of obtained results, as for the same number of degrees of freedom there are fewer parameters to be estimated. The method of estimation used for all regressions is Ordinary Least Squares. Both tested models (CAPM and APT) are linear and according to Gauss-Markov theorem OLS estimators are best linear unbiased estimators (Wooldridge 2000) and. There are, however, many other techniques the most common of which is General Method of Moments and models with autoregressive conditional heteroskedasticity.

71

The methodology presented above is the best one that could be applied on the Polish market. Despite relatively short estimation period, the necessary number of degrees of freedom is provided for the tests to assure the high power of the conducted tests. The market index is weighted, lack of this idex characteristic, was the main virtue of the BJS studies. Furthermore, unlike in BJS studies, there are two additional factors used, which might give the first insight missing information. into any possibly

4.1.2 Portfolio grouping

The main problem associated with empirical test of CAPM model is the bias of estimated coefficients in the second stage of tests - sectional regression. For thos reason shares are grouped in portfolios and the test is not conducted on the variables represented by single companies. The bias is always present when two-stage testing procedure is implemented. It is a result of applying beta estimated in the time-series regression, as an independent variable in crosssectional regression. Since the parameter always will be estimated with an error, it is obvious that independent variable in the second, crosssection regression will be burdened with an error. As a consequence, the parameter in the cross-section regression determining the price of the market risk will be estimated with a bias. This problem can be presented more formally (Larsson 2002): Time-series regression Cross-sectional regression
Ri ,t = i + bi RM ,t + i ,t Ri = 0 + 1 P + P

Where bi is the estimator of beta and it takes the form of:

bi = i + i

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Where i is estimation error with zero mean and zero covariance with

i and i . This estimated coefficient becomes an independent variable

in the second equation. Hence, the estimated parameter 1 takes the following form:

 cov(Ri , bi ) , 1 = (bi ) 2

 cov( 1 i + i , i + i ) , 1 = 2 ( i + i )
2

 1 = 1

2 i

+ 2i

The value of the fraction is lower, hence 1 is a biased downward. On the other hand the estimator 0 will be biased upward, hence higher than the true parameter of the population. Using an estimated beta instead of its true value in the cross-sectional regression, bias downward the estimated parameter 1 . Although grouping shares in portfolios does not eliminate completely the problem, it does limit its significance. This bias is present in both stages of the CAPM tests. In the subsequent years the same problem is faced by FM and FF (Pasquariello 1999).

4.1.3 Risk free rate variability

In the conducted test, unlike in the standard CAPM model, the risk free rate does not have a constant value. This approach makes the model much more real, as one of the feature of the Polish economy is the time-varying interest rate, even in short term. This variability is a result

73

of a continuous and gradual decrease in the rate of inflation from 252.2 percent in 1990 down to projected 0.6 percent in the year 20035. The other factor influencing the level of the risk free rate is the monetary policy. Its guidelines are to cut down the interest rate for the last few years in order to stimulate the economic growth. As the risk free rate becomes a new independent variable, the model changes its form from:
R p , t = R F + p ( R M ,t R F ) + t

to
R p ,t R F ,t = p + p ( R M ,t R F ,t ) + t

where the constant RF becomes a variable RF,t, which when moved on the other side of the equation, creates a model where the dependent variable is the risk premium for the portfolio/shares R p ,t RF ,t and the independent variable premium for the market risk RM ,t RF ,t . As mentioned before, this technique is adapted only in the time-series regression of the portfolios.

4.2 Empirical test of the CAPM

In this section a detailed test of CAPM model is presented. The first phase of the test is time-series regression. Estimated beta parameters of all ten portfolios are the result of the first phase. These parameters become independent variables in the second stage, which is crosssectional regression of averaged returns against betas. The outcome of this regression will allow for assessment if the model is statistically significant on the Polish market.
5

http://bossa.pl/rynki/inflacja.html

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4.2.1 Time-series regression

On the basis of estimated betas for 100 companies ten portfolios were formed for that the average weekly returns were calculated6 and then betas of each portfolio were computed7. Results summary is presented in the table below:
Table No 4.1: Beta and their t-statistics values for all portfolios Portfolio Beta t-statistics 1 0.304299 4.123798 2 0.326055 4.015498 3 0.473718 7.621019 4 0.278166 3.386901 5 0.3174 4.461146 6 0.230514 3.972888 7 0.569277 9.358641 8 0.574836 6.589265 9 0.599535 9.005915 10 1.074353 12.02110 Source: Own calculations

The results shown in Table 4.1 indicate that all betas are statistically significant and different from zero. High values of the t-statistics allow for making this conclusion even at the significance level of =0.01. On the other hand, from the further analysis of the results, unlike expected, values of the betas do not increase with portfolio number. In spite of the applied technique of yearly portfolio sorting, betas of the shares forming the portfolios must indicate high variability and instability. Since in a simple linear regression t-statistics of the estimated parameter describes the quality of the model, it can be concluded that it is high in all of the cases. However, doubts are raised when analysing the coefficients of determination of each regression presented in table 4.2:

6 7

Appendix No 1 results of all time-series regressions of average weekly returns of the portfolios against weekly returns on the WIG index are presented in appendix No 2

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Table

No

4.2:

The

coefficients

of

determination

of

the

regression

R p ,t R F ,t = p + p ( R M ,t R F ,t ) + t
Portfolio R 1 0.101827 2 0.097061 3 0.279123 4 0.071041 5 0.117137 6 0.095207 7 0.368645 8 0.306541 9 0.350949 10 0.609768 Source: Own calculations
2

Low values of R2 for the portfolios 1, 2 and 4 - 6 suggest that there might be some other variables describing the premium R p ,t RF ,t better, than premium for the market risk RM ,t RF ,t . Results for the portfolios 5 and 7-10 are satisfactory, as the financial econometric practice allows for recognising the CAPM model as a good one, because it makes possible to explain the arbitrary determined 30 percent of the financial reality. The 10th portfolio has a particularly good outcome with the coefficient of determination of above 60 percent. The possible reasons of such a good result are discussed on the basis of the tests presented below. Before the results of the time-series regression are used in the next stage of the study, the tests on the residuals of estimated models should be run in order to determine the quality of estimated parameters. Tests on the normal distribution, heteroskedasticity and autocorrelation are conducted with the level of significance =0.058. Table 4.3 contains the summary of the results:

Detailed results of all tests in Appendix No 3

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Table No 4.3: Summary of results of the tests on the normal distribution, heteroskedasticity and autocorrelation of the residuals form regression

R p ,t R F ,t = p + p ( R M ,t R F ,t ) + t

Portfolio 1 2 3 4 5 6 7 8 9 10

Normal Distribution Non-existing Non-existing Non-existing Non-existing Non-existing Non-existing Non-existing Non-existing Non-existing Non-existing

Autocorrelation Non-existing Non-existing Non-existing Existing AR(2) Existing AR(1) Non-existing Non-existing Non-existing Non-existing Existing - AR(1)

Heteroskedasticity Non-existing Non-existing Non-existing Non-existing Non-existing Non-existing Non-existing Existing - ( RM ,t RF ,t ) 2 Non-existing Existing - ( RM ,t RF ,t ) 2

Source: Own calculations

The non-existence of normal distribution leads to the serious consequences, because the value of t-statistics can not be considered true. This conclusion results from the fact that t-test is based on the normal distribution. However, if there are around 25-30 observations for each estimated parameter, Central Limit Theorem can be implied and conclude that the distribution of residuals is aiming to have normal distribution. As time-series regressions are run on 152 observations and there are two parameters estimated p and p , the above theory can be applied. At this point it should be added that most of the financial data does not have features of normal distribution and daily returns even if the number of observations tend to infinity, will never be approximated to normal distribution (Fama 1976). The existence of autocorrelation is associated with serious

consequences for the quality of the estimated model. Correlation of the residuals leads to the higher values of t-statistics, as the variance of the estimated parameters should be higher. As a result, the estimated parameters will not be efficient. Autocorrelation is a cause of the higher coefficient of determination value as well, an example of which might

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be R2 for the portfolio number ten. Test for autocorrelation was conducted with four lags because four weekly returns create approximately one month period. In seven out of ten tested models autocorrelation is not a problem and although it exists in portfolios four, five and ten, it is very low. To solve the problem of autocorrelation additional terms AR (1) or AR (2) are added to the estimated equations. The test for the heteroskedasticity of residuals is the last one. Its presence does not allow for trusting the t-statistics, because timevarying variance can lead to contrary conclusions on the significance of the estimated parameters. Heteroskedasticity in the above models was virtually not existing, except for the models for portfolios eighth and ten. These results are not constant with expectations, as the most of financial data time-series are characterised by variable variance. It was impossible to remove heteroskedasticity in order to achieve efficient estimators of the parameters in the models for portfolio eight and ten. Therefore, the Newey-West technique is applied to OLS estimation. In all models, beta was a statistically significant variable and due to the sufficient number of observations, the tests were of a high statistical power. However, the coefficients of determination are relatively low. This fact allows to assume that there are some missing independent variables.

4.2.2 Cross-sectional regression

The subsequent phase of the CAPM test is cross-sectional regression. It is based on results obtained in the previous stage. Both standard errors of regression and beta coefficients in the table four include changes caused by applying techniques dealing with autocorrelation and heteroskedasticity9. This data will be used to estimate the final

Appendix No 4

78

model and test the hypothesis, which will provide arguments rejecting or supporting the CAPM theory.
Table No 4.4: Data used in cross-sectional regression Portfolio Average

Rp

Standard error of regression 0.02904 0.031955 0.024462 0.031476 0.026856 0,022834 0.023939 0.027782 0.026199 0.026474

Beta 0.304299 0.326055 0.473718 0.319304 0.271354 0.230514 0.569277 0.574836 0.599535 1.092972

1 -0.00263 2 -0.00531 3 0.001207 4 -0.00033 5 0.000165 6 0.002446 7 -0.00596 8 -0.00215 9 -0.00094 10 -0.00405 Source: Own calculations

The standard version of the CAPM model is the first to be tested:

Rp = 0 + 1 p + p
where according to the classical tests the value of the parameter 0 should equal the average weekly risk free rate or higher in case of Black CAPM and 1 should be statistically bigger then zero. The results are presented in Table 4.5:
Table No 4.5: Results of the cross-sectional regression: R p

= 0 + 1 p + p

Dependent Variable: SREDNIA Method: Least Squares Date: 04/28/03 Time: 11:27 Sample: 1 10 Included observations: 10 Variable Coefficient Std. Error t-Statistic C 0.000429 0.001851 0.231727 BETA -0.004588 0.003461 -1.325568 R-squared 0.180087 Mean dependent var Adjusted R-squared 0.077598 S.D. dependent var S.E. of regression 0.002665 Akaike info criterion Sum squared resid 5.68E-05 Schwarz criterion Log likelihood 46.20008 F-statistic Durbin-Watson stat 2.321095 Prob(F-statistic) Source: Own calculations

Prob. 0.8226 0.2216 -0.001756 0.002775 -8.840017 -8.779500 1.757130 0.221584

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Ho: 0 =0 the parameter 0 is statistically insignificant. H1: 0 0 the parameter 0 is statistically significant. At the level of significance =0.05 the P-value of the t-statistics equals 0.8226 and leads to a conclusion that there is no sufficient evidence to reject Ho, hence the parameter 0 is statistically insignificant. Ho: 1 =0 variable p does not affect R p H1: 1 0 variable p does affect R p

At the level of significance =0.05 the P-value of the t-statistics equals 0.2216 and leads to a conclusion that there is no sufficient evidence to reject Ho, hence variable p does not affect average portfolio returns.

The results of classical tests indicate that the CAPM theory does not hold on the Polish market. The conclusion does not change even if testing procedure developed by Kozicki and Shen (2002) is applied:

HA0 : E ( 0 + 1 rm ) = 0 , the CAPM model holds HA1 : E ( 0 + 1 rm ) 0 , the CAPM model does not hold
A t ( A ) = t CAPM

0 + 1 rm 0.000429 0.004588 (-0.00157) = = 20.465 (rm ) / T 0.00094/ 156

At the level of significance =0.05 the t-statistics equals 20.465 and leads to a conclusion that there is sufficient evidence to reject Ho in favour of HA1 . The CAPM model does not hold.

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Graphical results of the regression presented in diagram 4.1 and 4.2 support the statistics:
Diagram No 4.1: Graphical results of the regression of the average returns on portfolios against their betas as independent variable.
S R E D N IA vs . B E T A .00 4 .00 2 .00 0 SREDNIA -.00 2 -.00 4 -.00 6 -.00 8 0 .2 0 .3 0.4 0.5 0 .6 0 .7 0.8 0.9 1 .0 1 .1 BETA

Source: Own calculations Diagram No 4.2: Actual, residual and fitted graph from the model

Rp = 0 + 1 p + p
.004 .002 .000 -.002 -.004 .004 .002 .000 -.002 -.004 -.006 1 2 3 4 5 6 Actual 7 8 9 10 -.006 -.008

Residual

Fitted

Source: Own calculations

In order to be assured of the correctness of obtained results tests of the residual values are conducted:

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1. Distribution of the residuals graphically and statistically is presented in Diagram 4.3:

Diagram No 4.3: Histogram of residual values from the model: R p
3 .2 2 .8 2 .4 2 .0 1 .6 1 .2 0 .8 0 .4 0 .0 S eries : R es id u als S am p le 1 1 0 O b s ervation s 1 0 M ean M ed ian M axim u m M in im u m S td . D ev. S kew n es s K u rtos is J arq u e-B era P rob ab ility -0 .0 0 4 -0 .0 0 2 0 .0 0 0 0 .0 0 2 0 .0 0 4 -5 .6 4 E -1 9 0 .0 0 0 5 0 5 0 .0 0 3 0 6 3 -0 .0 0 4 2 4 6 0 .0 0 2 5 1 6 -0 .5 5 3 0 9 5 2 .1 6 7 4 6 4 0 .7 9 8 6 5 5 0 .6 7 0 7 7 1

= 0 + 1 p + p

Source: Own calculations

Ho: p have normal distribution H1: p have not normal distribution At the level of significance =0.05 the P-value of the 2 statistics equals 0.670771 and leads to a conclusion that there is no sufficient evidence to reject Ho, hence the residuals p have normal distribution.

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2. Heteroskedasticity

The

outcome of

the

test for the

heteroskedasticity is presented in Table 4.6

Table No 4.6: Results of the test on the heteroskedasticity of the residuals from the model R p

= 0 + 1 p + p
0.701627 0.617895

White Heteroskedasticity Test: F-statistic 0.372913 Probability Obs*R-squared 0.962875 Probability Test Equation:Dependent Variable: RESID^2 Method: Least Squares Sample: 1 10 Included observations: 10 Variable Coefficient Std. Error t-Statistic C 4.62E-06 1.18E-05 0.390724 BETA 1.04E-05 4.35E-05 0.239174 BETA^2 -1.37E-05 3.33E-05 -0.410860 R-squared 0.096288 Mean dependent var Adjusted R-squared -0.161916 S.D. dependent var S.E. of regression 7.00E-06 Akaike info criterion Sum squared resid 3.43E-10 Schwarz criterion Log likelihood 106.2970 F-statistic Durbin-Watson stat 1.737492 Prob(F-statistic) Source: Own calculations

Prob. 0.7076 0.8178 0.6935 5.70E-06 6.49E-06 -20.65941 -20.56863 0.372913 0.701627

Ho: the variance of p is constant H1: the variance of p is not constant At the level of significance =0.05 the P-value of the 2 statistics equals 0.617895 and leads to a conclusion that there is no sufficient evidence to reject Ho, hence the variance of residuals p is constant.

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3. Autocorrelation Outcome of the test for the autocorrelation of the residuals is presented in Table 4.7:
Table No 4.7: Results of the test on the autocorrelation of residuals in model

Rp = 0 + 1 p + p
Breusch-Godfrey Serial Correlation LM Test: F-statistic 0.256624 Probability Obs*R-squared 0.353641 Probability Test Equation: Dependent Variable: RESID Method: Least Squares Date: 04/28/03 Time: 11:32 Presample missing value lagged residuals set to zero. Variable Coefficient Std. Error t-Statistic C -3.76E-05 0.001945 -0.019332 BETA 5.79E-05 0.003636 0.015925 RESID(-1) -0.188663 0.372425 -0.506581 R-squared 0.035364 Mean dependent var Adjusted R-squared -0.240246 S.D. dependent var S.E. of regression 0.002799 Akaike info criterion Sum squared resid 5.48E-05 Schwarz criterion Log likelihood 46.38011 F-statistic Durbin-Watson stat 2.034878 Prob(F-statistic) Source: Own calculations 0.628012 0.552059

Prob. 0.9851 0.9877 0.6280 3.79E-19 0.002513 -8.676021 -8.585246 0.128312 0.881601

Ho: errors are independent H1: errors are autocorrelated At the level of significance =0,05 the P-value of the Lagrange Multiplier with one lag statistics equals 0.552 and leads to a conclusion that there is no sufficient evidence to reject Ho, hence the errors are independent As the regression is built on the cross-section data, the achieved results are consistent with expectations. The hypothesis concerning the statistical significance of the variables

2 p and Se p will be tested by adopting the testing procedure for

omitted variables.

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Table 4.8 contains the results:

Table No 4.8: Results of the test for omitted variable Omitted Variables: BETA^2 F-statistic Log likelihood ratio 0.222555 0.312986

2p
0.651451 0.575853

Probability Probability

Test Equation: Dependent Variable: SREDNIA Method: Least Squares Date: 04/28/03 Time: 11:36 Sample: 1 10 Included observations: 10 Variable Coefficient C 0.002419 BETA -0.012390 BETA^2 0.006030 R-squared 0.205351 Adjusted R-squared -0.021691 S.E. of regression 0.002805 Sum squared resid 5.51E-05 Log likelihood 46.35658 Durbin-Watson stat 2.362831 Source: Own calculations

Std. Error t-Statistic 0.004647 0.520605 0.016934 -0.731650 0.012781 0.471758 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.6187 0.4881 0.6515 -0.001756 0.002775 -8.671315 -8.580540 0.904463 0.447314

H0: omitted variable 2 p is statistically insignificant H1: omitted variable 2 p is statistically significant At the level of significance =0.05 the P-value of the F-statistics equals 0.651451and leads to the conclusion that there is no sufficient evidence to reject Ho, hence the omitted variable 2 p is statistically insignificant. The hypothesis of the nonlinear relationship between average returns and betas is therefore rejected. Applying the same procedure, the hypothesis of the statistical significance of the second added variable - residual variance is rejected as well, which is presented in the Table 4.9:

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Table No 4.9 Results of the test for omitted variable Omitted Variables: SE F-statistic Log likelihood ratio 1.940882 2.447241

Se p
0.206213 0.117732

Probability Probability

Test Equation: Dependent Variable: SREDNIA Method: Least Squares Date: 04/28/03 Time: 11:37 Sample: 1 10 Included observations: 10 Variable Coefficient C 0.011490 BETA -0.005493 SE -0.392221 R-squared 0.358073 Adjusted R-squared 0.174665 S.E. of regression 0.002521 Sum squared resid 4.45E-05 Log likelihood 47.42370 Durbin-Watson stat 2.036590 Source: Own calculations

Std. Error t-Statistic 0.008130 1.413221 0.003338 -1.645715 0.281534 -1.393155 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.2005 0.1438 0.2062 -0.001756 0.002775 -8.884741 -8.793965 1.952334 0.211933

H0: omitted variable Se p is statistically insignificant H1: omitted variable Se p is statistically significant

At the level of significance =0.05 the P-value of the F-statistics equals

0.206213

and leads to a conclusion that there is no sufficient evidence to

reject Ho, hence the omitted variable Se p is statistically insignificant. Thus, the residual variance has no impact on the value of the expected return of the portfolio. Results of the CAPM test conducted on the Polish market suggest that the model does not hold in the Polish economy. All presented variables appeared to be statistically insignificant. The overall conclusion is that there is no statistically significant relation between expected average returns and beta as a market risk measure of the individual portfolios.

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CHAPTER V APT Estimation and Tests

Due to the fact that APT theory defines only asset valuation structure without defining economic or company characteristics that influence rates of returns, APT test presented in this chapter is only one of many versions that can be developed for the Polish market.

5.1 Methodology
Methodology that is going to be applied in the empirical research is presented briefly in this section. As there are different methods of factor estimation, the choice of factor analysis in comparison to portfolio and macroeconomic factors theories is discussed.

5.1.1 Estimation procedure

In order to implement and test the APT model (assuming that firm specific risk is diversified) the equation presented in the second chapter needs to be estimated. That is:

Ri = RF + ik k
j =1

The ik can be found with the use of the following formula:

Ri = a i + ik I k + i
k =1

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The last equation shows that ik can be calculated either after or simultaneously with factors I k estimation. Therefore, the first step of APT model estimation is to specify factors that influence returns assuming that the theoretical assumptions are met. After calculation of factors their coefficients should be estimated for each individual security using regression. Instead of returns on securities they are to be regressed against portfolios. Assuming that the Law of Large Numbers holds, this would allow for diversification of the firm specific risk. The last step will be the estimation of the risk premiums for all factors. It would be done applying the cross-sectional regression between the time-series of the returns on portfolios. Finally, the estimated model is going to be statistically verified with Chow and Lagrange Multiplier tests. The next sections of this chapter present the estimation procedure in details introducing the empirical results that were obtained.

5.1.2 Methods of testing and Estimation

As mentioned in chapter two there are three general approaches to factor estimation: 1. macroeconomic factors 2. portfolios based on company characteristics 3. statistical choice of factor proxies such as factor analysis

The first technique defines factors on the basis of macroeconomic theory. This approach chooses arbitrary several economic variables as

88

proxies of factors explaining asset returns. The most important advantage of this approach is that it names factors. This characteristic is quite useful for corporate managers, as it presents how their company returns relate directly to individual macroeconomic factors. However, this method is strongly disadvantaged. It is also difficult to identify the unexpected changes in variables that are factor proxies (Grinblatt and Titman, 1998). Furthermore, this technique might result in neglecting of some potentially important non-quantifiable factors. Taking into account that Polish economy might be strongly influenced by political uncertainty, factors defined arbitrary and limited only to a few variables might not catch the political risk at all. The portfolio method of factor estimation includes intuitional choice of variables as well. According to this technique, factors are estimated on the basis of firm characteristics. This method assumes that risk premium ( k ) associated with the firm characteristic (for example firm size, dividends or earnings ratio etc.) represents compensation for that specific type of factor risk and therefore for portfolios constructed of assets described by the characteristics (Elton and Gruber 1998). Elton and Gruber (1998) suggest that this approach will give better factor proxies than other methods if covariances change over time. Furthermore, this method might overperform macroeconomic factor method because these factors are able to catch unpredicted macroeconomic changes, as they are based on stock returns that are unpredictable as well. The only disadvantage of this method is that if there is no link between return premiums and factor sensitivities, the approach picks out mispriced portfolios (Grinblatt and Titman, 1998). This drawback might significantly influence the asset returns on the Polish market. The empirical basis of empirical studies on Polish market is extremely poor as discussed in Chapter II. Thus, it might be very difficult to look intuitively for firm characteristics that are likely to generate factors in Poland.

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Finally, factors might be estimated statistically using for example factor analysis. If covariances between stocks do not change over time, this method generates exactly desired factors. However, this technique does not name factors and therefore is less useful for corporate managers. Even though, when testing the theory on a whole capital market, factors interpretation is not so important, as the technique will show whether returns are generated by some factors and therefore answer the question if APT holds in Poland. Furthermore, unless there are hidden factors that are created on the basis of a few macroeconomic variables, the methodology will estimate factors based on individual macroeconomic variables giving similar model as macroeconomic factors technique. Moreover, macroeconomic variables are likely to be correlated with each other. If macroeconomic variables are likely to autocorrelate, factor analysis could create statistically significant model. Political risk that is of crucial importance in Poland might be for instance the hidden variable. Therefore, factor analysis might be a good technique of the factors estimation. The portfolio method might be a good alternative but it seems to be too intuitive. If there were more studies on that topic, they might give an idea of company characteristics that should be included in the model. It might be inappropriate to examine the same factors as those, which were analysed when implementing APT in the United States. For example dividend payout ratio is not likely to be a significant factor in Poland. Polish investors do not pay attention to the fact that company pays dividends or not. The number of companies paying dividends is substantially decreasing as it is presented in Table 5.1.

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Table 5.1 Companies paying dividends in Poland Year 1999 2000 2001 2002 Source: own calculations Number of companies paying dividends 61 49 38 14

The reason for that situation might be that dividends are taxied at 15 percent when other capital market gains are tax free. Furthermore, Polish companies pay the dividends rather accidentally that is usually less frequent than once a year. Therefore, it is hard to state if they have a dividend policy at all. Moreover, there were no studies analysing the impact of earnings etc. on stock prices. Thus it would be difficult to assume that this company characteristic may influence the stock prices or not. As there were no empirical researches that might give an idea on which characteristics can be factor proxies, the portfolio method will not be applied. However, after better understanding of processes and relationships on the WSE, this method could be implemented. Taking into account advantages and disadvantages of the three techniques discussed above, factor analysis is going to be applied as the most appropriate for Polish capital market.

5.1.3 Factor Analysis overview

Factor Analysis was presented for this time in Spearmans article of 1904 (Rubaszek, 2002). He carried out a survey on unobservable factors influencing tests results of the high school students.

91

This statistical technique is used to uncover the latent structure (dimensions) of a set of variables. It reduces attribute space from a larger number of variables to a smaller number of factors and as such is a "non-dependent" procedure. Moreover, factor analysis generates observed raw indicator variables and the factors or latent variables which explain the variance in these variables as good as possible. The I k are called here factors and ik factor loadings (for example Rszkiewicz, 1998).

5.1.3.1 Factor Analysis formal model

This section is based on papers of Rszkiewicz (1998), Rubaszek (2002) and Electronic Textbook StatSoft (2003). Assuming that there are N observable variables in the sample, the observation matrix is as follows:

x11 x X = 12 ... x1T

x 21 x 22 ... x 2T

... x N 1 ... x N 2 ... ... ... x NT

T N

where xit is a value of i-th variable observed at time t = 1,2,,T. Assume that vector X (Ti ) t (T means here transposed matrix) is distributed in N- dimensions, where N ( ; ) . Factor analysis assumes that all variables are a function of common factors and idiosyncratic factor.
X i = f (I1 , I 2 ,..., I k ) + i

There are three requirements that need to be met in factor analysis.

92

1. Uncorrelated thus orthogonal factors:

cov(I j , I l ) = 0

where j l . 2. Uncorrelated unique variance:

cov( i , j ) = 0

where i j 3. Factors are not correlated with the unique variance:

cov(I j , i ) = 0 .

The most popular approach that was employed in this paper, assumes that there is a lineal relationship between variables and factors. Therefore, the factor analysis model can be formulated as follows:

X it = i1 I 1 + i 2 I 2 + .... + ik I k + i
If a model meets the requirements presented above, the following equation is true:

2 2 2 i2 = i2 1 + i 2 + ... + ik + = ij + j =1

ij = i1 j1 + ... + ik jk
where:

93

i2 - the variance of variable X i ij - the covariance of variables X i and X j

j =1

2 ij

- common variance - unique variance

The greater the impact of common variance in comparison to unique variance is, the better the factor analysis.

5.2 Factors estimation- empirical results

The empirical findings and detailed calculation procedure are presented in this section.

5.2.1 Variables analyzed

In order to perform factor analysis certain requirements should be met concerning the number of variables and cases examined and so called sampling adequacy.

5.2.1.2 Suboptimization
The rule that "The more variables, the better factor analysis" may not be appropriate, if there is a chance of suboptimal factor solutions ("bloated factors"). Too many too similar items will camouflage true basic factors, leading to suboptimal solutions. To avoid suboptimization, it should be started with a small set of the soundest items that represent the range of the factors. Data employed in this research are expected to convey the information content that is not too analogous. Therefore, it is assumed that the data selection, applied in this study, will eliminate the feasibility of suboptimization.

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5.2.1.2 Number of cases

The selection of variables is based not only on their economic meaning. There is a required number of cases that need to be examined in factor analysis. However, methodologists differ in this issue (Garson): 1. Rule of 10. There should be at least 10 cases for each item in the instrument that is being used. 2. Rule of 100: The number of subjects should be the larger of 5 times the number of variables, or 100. Even more subjects are needed when communalities are low and/or few variables load on each factor. 3. Rule of 150: At least 150 - 300 cases, more toward the 150 end when there are a few highly correlated variables. 4. Significance rule. There should be 51 more cases than the number of variables, to support chi-square testing 152 cases for each of five variables were examined in this study. This is in accordance to almost all rules that were suggested by methodologists. Therefore, the sample employed is assumed to be large enough to deliver interpretable factors.

5.2.1.3 Sampling adequacy

There are statistical requirements related to variables used in factor analysis (Rszkiewicz, 2002). Sampling adequacy predicts if data is likely to factor well on the basis of correlation and partial correlation. In order to measure sampling adequacy the Kaiser-Meyer-Olkin (KMO) statistics was employed. KMO can be applied, to assess which variables need to be excluded from the model because they are too multicollinear.

95

There is a KMO statistic for each individual variable as well. KMO overall statistic is a sum of individual statistics. The value of KMO varies from 0 to 1.0. There is a rule that the KMO overall should amount to 0.5 or bigger to proceed with factor analysis. If it does not, the indicator variables with the lowest individual KMO statistic values should be excluded from the sample, until KMO overall rises above 0.5.

In order to compute KMO overall the following formula is used:

KMO =

r
j i i j j i i j

2 ij

rij2 + aij2
j i i j

where rij is an element of the correlation matrix R and a ij is a partial correlation coefficient between variable i and j estimated when others variables do not influence the results of the correlation. The numerator is the sum of squared correlations of all variables in the analysis (except the 1.0 that implies self-correlations of variables). The denominator is the same sum plus the sum of squared partial correlations of each variable with each variable. According to the theory the partial correlation should not be very large if separate factors are anticipated to emerge from factor analysis. The variable set that meets the KMO test was computed using SPSS for Windows software. First the anti-image matrices were computed (see table one Appendix No 5). They contain the negative partial covariances and correlations that can give an indication of correlations that are not due to the common factors. The diagonal elements on the

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Anti-image correlation matrix are the KMO individual statistics for each variable. The overall KMO amounts to 0.4909951087217. Therefore, factor analysis should not be conducted on this sample. The KMO statistics of individual variable are presented below (Diagram 5.1.)
Diagram: 5.1.KMO statistics five variables

Individual KMO Statistics

0,54 KMO estimates 0,52 0,5 0,48 0,46 0,44 WIG risk free GOLD Variables exchange rate S&P

Source: own calculations

To improve the overall KMO the return on S&P500 was excluded from the sample as the variable with the lowest KMO value. Anti-image matrices are presented in appendix No 5 (table 2).

After exclusion of this variable the estimation of the statistic increased to the level of 0.5411158754155. Thus, the sample is assessed to be good enough to perform factor analysis. The final sample employed in the study consists of the following variables: WIG, RF, GOLD and EX.

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5.2.2 Number of factors

There are three best known strategies of the statistical selection of the right number of factors such as variance explained, Kaiser rule of eigenvalues and Cattell criterion. First strategy uses the first n factors that explain 80 percent (or some other arbitrary percentage) of the variance. This rule of thumb is a middle ground between the two below ones (Rszkiewicz, 1998). The second one uses only the factors whose eigenvalues10 are at or above the mean eigenvalue (the Kaiser rule). This is the strictest rule of the three and may cause using too few factors. Finally, the third one applies a scree plot. It is a plot in which the x axis represents the factors arranged in a way that they would be descending eigenvalue and the y axis is the value of the eigenvalues. This plot will demonstrate a sharp decrease leveling off to a flat tail as each consecutive component's eigenvalue explains less and less of the variances. The Cattell rule is to choose all factors prior to where the plot levels off. Nevertheless, this rule is very arbitrary. Picking the "elbow" can be prejudiced because of the fact that the curve has multiple elbows or it is a smooth curve. Therefore, it is feasible that the researcher may be tempted to set the cut-off at the number of factors according to the more desirable outcomes. Furthermore, the criterion tends to result in more factors than the Kaiser criterion. In practice, an additional important aspect is the extent to which a solution is interpretable. Therefore, generally several solutions with more or less factors are examined. Then the best one that makes the model most logical is analyzed.

10

Eigenvalues are a variances extracted by the factors ( Rszkiewicz, 1998).

98

5.2.2.1 Kaiser rule

First, Kaiser criterion was applied. Estimated eigenvalues are presented in Table 5.1:
Table 5.1: Eigenvalues for different number of factors Factor 1 2 3 4 Eigenvalue 1.288 1.034 0.882 0.796

Source: own calculations

The eigenvalues of two factors were bigger than average. Thus, two factors were extracted. However, the components of these factors imply that the first factor is correlated strongly with the risk free rate. The second factor is correlated strongly with WIG. These findings are presented in Table 5.2:
Table 5.2: Factor Loadings matrix for two factors extracted Variable WIG RF GOLD EX F1 -0.156 0.720 0.654 0.563 F2 0.872 0.112 -0.282 0.425

Source: own calculations

Therefore, APT created in this way would be very similar to CAPM. Since Capital Asset Pricing Model was tested in previous chapter, there is no point in creating a similar model.

99

5.2.2.2 Cattell rule

The scree plot method (Diagram 5.2 ) brings similar results. However, this criterion allows for arbitrary choice of two or three factors as the Cattell rule indicates. The choice of two factors would create model very similar to CAPM, thus three factors would be selected.
Diagram 5.2 Scree Plot
S c r e e P lo t
1,4

1,3

1,2

1,1

1,0

,9

Eig en v a lu e

,8

,7 1 2 3 4

Plot

C o m p o n en t N u m b er

Source: own calculations

If three factors are extracted, the curve is still descending and not flat. Therefore, the extraction of three factors is in accordance with Cattell rule.

5.2.2.3 Variance criterion

The criterion of variance explained by the individual factors indicates that three factors explain over 80 percent of the cumulative variance.

100

Table 5.3 presents the percentage of variance explained by each factor and the cumulative percentage of variance explained. For example it states that two factors explain over 50 percent of the variance and three explain 80.1 percent.
Table 5.3. Eigenvalues and the total variance three factors extracted Factor % of variance explained 1 32.20 2 25.84 3 22.04 4 19.89 Source: own calculations Cumulative % 32.20 58.05 80.10 100.00

5.2.3 Factoring methods

There are different methods of extracting factors from a dataset. The most popular are Maximum Likelihood, Principal Factor Analysis and Principal Component Analysis.

5.2.3.1 Maximum Likelihood Factoring

The maximum likelihood estimators used to be applied in studies that tested APT. This methodology was employed for example in studies carried out by Roll and Ross (1980) and Rubaszek (2002). However, the maximum likelihood method should not be applied in this paper. If it is employed, the model would fail. The ratio of variables to estimated factors is of the value that makes the model insignificant. Bartlett Statistic is usually used to check if the estimated factors are good enough in explaining the variance-covariance matrix. The Bartletts test uses the 2 statistics with the number of the degrees of freedom: v = [(N-K)(N-K)-N-K]

101

The number of thresholds would be negative in this research, if the maximum likelihood methodology applied. As there are four analyzed variables and three common factors were decided to be extracted. If N = 4 and K = 3, there is a negative number of degrees of freedom that is v = -3. Due to the negative number of degrees of freedom, the results of factor analysis should be interpreted with caution. Therefore, it was decided to proceed with a different factoring method. For one or two factors the model would be significant but it would be similar to CAPM as the two first factors depend strongly on market index and risk free rate.

5.2.3.2 PCA versus PFA

The Principal Components Analysis was introduced by Hoteling (Rszkiewicz, 1998). It assumes that k-dimensional variable may be transformed into p-dimensional one where p is not bigger than k. Due to that transformation a new selection of variables is created. The Principal Component Analysis reflects both, common and unique variance of the variables, and may be seen as a variance-focused approach that seeks to reproduce both, the total variable variance with all components and the correlations. This approach seeks such a linear combination of variables that the maximum variance is extracted from the variables. The variance is then removed and a second linear combination, which explains the maximum proportion of the remaining variance, is looked for. Principal Factor Analysis also called principal axis factoring, PAF, alias common factor analysis, Principal Factor Analysis is a form of factor analysis which seeks the smallest number of factors. It can account for

102

the common variance (correlation) of a set of variables, whereas the more common Principal Components Analysis in its full form seeks the set of factors which can account for all the common and unique (specific plus error) variance in a set of variables. PCA establishes the factors that can account for the total (unique and common) variance in a selection of variables. It is an appropriate approach for creating a typology of variables or reducing attribute space. PCA is appropriate for most social science research purposes and is the most often used form of factor analysis. PFA determines the least number of factors that can account for the common variance in a set of variables. This is suitable for determining the dimensionality of a set of variables, such as a set of items in a scale, explicitly to test whether one factor can account for the bulk of the common variance in the set. Thus, PCA can also be used to test dimensionality. PFA has the drawback that it can produce negative eigenvalues, which are meaningless. The principal components analysis, as usually applied in social sciences and commonly known was assessed as a suitable one for this study.

5.2.3.3 PCA results

The correlations between variables and the three created factors are presented in table 5.4. These correlations are also called factor loadings.

103

Table 3.4: Factors loadings- three factors extracted Variable RF GOLD WIG EX F1 0.720 0.654 -0.156 0.563 F2 0.112 -0.282 0.872 0.425 F3 0.172 0.477 0.449 -0.650

Source: Own calculations

It seems that the first factor is generally more correlated with variables than the second and the third one. This could be expected because the factors are extracted sequentially and will account for less and less variance overall. Moreover, there is a strong correlation between the first factor and the risk free rate, the second factor is correlated strongly with the variable based on WIG and the last factor with the exchange rate. The performed analysis enabled to reduce the number of variables from initially five to finally three factors (components). Reduction in the number of variables is quite useful when explaining reality. If there are more than two variables, a "space" is defined, as two variables define a plane. Therefore, if the number of variables is reduced to three factors, a three- dimensional scatterplot (Diagram 5.3) can be plotted.

104

Diagram 5.3: Component Plot

1,0

wig

,5

exchange rate

risk free

Component 2

0,0

gold

-,5

1,0

,5

0,0

Component 1

-,5

-,5

0,0

,5

1,0

Component 3

Source: own calculations

The diagram presents three new factors that were based on variables that are correlated with them. Moreover, to calculate the value of factors that would be applied in further APT testing, factor scores coefficients were estimated. Factor scores coefficient matrix (Table 5.5.) presents the coefficients by which variables are multiplied to obtain factor scores.
Table No 5.5: Factor Scores Coefficients Variables WIG RF GOLD EX F1 -0.121 0.559 0.508 0.437 F2 0.844 0.108 -0.273 0.410 F3 0.510 0.195 0.541 -0.737

Source: own calculations.

105

Factor scores are also called component scores. There are different alternative methods for calculating the factor scores such as regression, Bartlett, or Anderson-Rubin. The regression method was employed as the most popular one. Finally, three factors were estimated as the final solution of factor analysis. In order to check the models quality the Bartletts test is employed. It indicates that these results should be treated with caution, as the significance level is very high that is nine percent. Thus, estimated factors deliver reliable information only if such a liberal significance level is assumed.

5.3 Time-series regression

On the basis of estimated betas for 100 companies ten portfolios were formed the same way as for the CAPM test were formed. For each of ten portfolios the average weekly returns were calculated11. Then, the coefficients and the t-statistics for all three factors for each portfolio were computed12, summary of which is presented in the Table 5.6:
Table No 5.6: Factors coefficients and their t-statistics values for all portfolios

R p ,t = 0 + 1 F1,t + 2 F2,t + 3 F3,t + t

Portfolio

t-stat

2
0.385412 0.304808 0.569930 0.343685 0.363908 0.344764 0.601654 0.556596 0.641715 1.017440

t-stat 3.356710 2.471697 5.962446 2.717870 3.369192 3.878438 6.513072 5.065011 6.292173 9.216588

3
-0.123005 -0.078523 -0.047475 -0.114360 -0.184273 -0.224909 -0.056357 -0.013661 -0.096088 0.317883

t-stat -0.806169 -0.479159 -0.373755 -0.680549 -1.283841 -1.903958 -0.459098 -0.093549 -0.708995 2.166932

1 2 3 4 5 6 7 8 9 10

-0.025368 -0.153133 -0.267580 -1.503911 0.134705 0.018577 0.139012 0.025362 -0.286785 -1.840305 -0.287014 -0.03681 -0.313953 -2.355602 -0.580418 -3.660831 -0.446433 -3.033983 -0.649553 -4.078258 Source: Own calculations
11 12

Appendix No 1 results of all time-series regressions of average weekly returns of the portfolios against weekly returns on the WIG index are presented in appendix No 6

106

The results from Table 5.6 indicate that only second factor was statistically significant at =0.05. The two other factors F1 and F3 in most cases were not significantly different from zero at the same level of significance. F1 was statistically insignificant for the first six portfolios and the same conclusion must be made about F3 for portfolios 1-9. Very low p-values of F-statistics indicate that although the two out of three variables explain the average weekly returns on portfolios, all models are considered to be of a high quality. At the level of significance =0.05 there is statistically sufficient evidence to reject the null hypothesis of joint insignificance of the estimated parameters. The results are summarised in the Table 5.7:
Table No 5.7: P-value for the F-test on the joint significance of the model

R p ,t = 0 + 1 F1,t + 2 F2,t + 3 F3,t + t

Portfolio

1 2 3 4 5 6 7 8 9 10

P-value of f-test 0.003036 0.018271 0.000000 0.026342 0.002079 0.001842 0.000000 0.000000 0.000000 0.000000

Source: Own calculations

As in CAPM model tested in this paper, doubts are raised when analysing the coefficients of determination of each regression, which are presented in Table 5.8:

107

Table

R p ,t = 0 + 1 F1,t + 2 F2,t + 3 F3,t + t

2

No

5.8:

The

coefficients

of

determination

of

regression

Portfolio

R 1 0.089397 2 0.065345 3 0.277215 4 0.060287 5 0.094334 6 0.095900 7 0.327815 8 0.277328 9 0.314343 10 0.597561 Source: Own calculations

The portfolios which achieved low values of R2 in the test of CAPM achieve them here too. It suggests that the variables are strongly dominated by the same factor as in CAPM test. Indeed, it might be true, because two out of four factors are repeated in both studies: Polish market index WIG and proxy for the risk free rate. The suspicions are confirmed by the correlation matrix between the three factors and variables representing risk free rate and market index, displayed in the Table 5.9:

Table No 5.9: The Correlation matrix between factors, risk free rate, WIG index F1 F2 F3 RF WIG 1.000000 0.004317 -0.129932 0.531905 -0.297325 F2 0.004317 1.000000 F3 -0.129932 0.643287 RF 0.531905 0.092447 WIG -0.297325 0.948004 Source: Own calculations 0.643287 0.092447 0.948004 1.000000 0.075375 0.712005 0.075375 1.000000 -0.012807 0.712005 -0.012807 1.000000

There is a high correlation between F2 and WIG that is likely to be the reason for its statistical significance and similar values of R2. High correlation between F2 and F3 is the most probable reason for its insignificance.

108

The next step in the statistical verification is a test for redundant variables. The test is for the joint insignificance of F1 and F3. It is designed in the manner that any of the significant variables would be detected. The F-test was used and P-values are presented in Table 5.1013: Ho: 1 = 3 =0 variables F1 and F3 do not affect R p ,t H1: Either or both 1 and 3 equal 0, either or both F1 and F3 affect R p ,t The tests are conducted at the level of significance =0.05
Table No 5.10: The P-value of F-test on the redundant variables F1 and F3 from regression R p ,t = 0 + 1 F1,t + 2 F2 ,t + 3 F3,t + t P-value of F-test 0.723008 1 0.317730 2 0.913652 3 0.767099 4 0.117426 5 0.166690 6 0.065548 7 0.001426 8 0.011318 9 0.000009 10 Source: Own calculations Portfolio

The null hypothesis can not be rejected for most of the models, namely for portfolios 1 - 7. Further tests show that in the case of portfolios 8 10 the F1 is significant, whereas F3 remains insignificant for portfolios 8 - 9. Before factors F1 and F3 will be rejected, tests on residuals are conducted. Tests on the normal distribution, heteroskedasticity and autocorrelation are conducted with the level of significance =0.05. The results are displayed in Table 5.1114:

13 14

Detailed results in Appendix No 7 Detailed results in appendix No 8

109

Table No 5.11: Summary of results of the tests on the normal distribution, heteroskedasticity and autocorrelation of the residuals form regression

R p ,t = 0 + 1 F1,t + 2 F2,t + 3 F3,t + t

Portfolio Normal Distribution 1 Non-existing 2 Non-existing 3 Non-existing 4 Non-existing 5 Non-existing 6 Non-existing 7 Non-existing 8 Non-existing 9 Non-existing 10 Non-existing Source: Own calculations

Autocorrelation Non-existing Existing AR(2) Non-existing Existing AR(2) Existing AR(1) Non-existing Non-existing Non-existing Non-existing Existing AR(1)

Heteroskedasticity Non-existing Non-existing Existing (F2^2) Non-existing Non-existing Non-existing Non-existing Existing Non-existing Non-existing

All

consequences

related

to

the

lack

of

normal

distribution,

heteroskedasticity and autocorrelation were described in the previous chapter. Distribution is assumed to tend to be normal, problems arising from heteroskedasticity are reduced by applying Newey-West technique and finally autocorrelation is solved by adding to the estimated equations terms AR(1) or AR(2), if needed. In order to solve autocorrelation problem term AR(1) was added to equations 5 and 10. Similarly, AR(2) was inserted to models for portfolios 2 and 4. Application of Newey-West technique to the models 3 and 8 assures that the estimates are efficient15. The changes made to the models are effective enough to reconsider the results:
Table No 5.12: factors coefficients and their p-values for t-statistics after including changes: R p ,t = 0 + 1 F1,t + 2 F2 ,t + 3 F3,t + t Portfolio 1 2 3 4 5 6 7 8 9 10

p-value

p-value 0.0010 0.0002 0.0000 0.0023 0.0024 0.0002 0.0000 0.0001 0.0000 0.0000

3
-0,123005 -0.240978 -0.047475 -0.076247 -0.144080 -0.224909 -0.056357 -0.013661 -0.096088 0.405940

p-value 0.4214 0.1577 0.7234 0.6635 0.2931 0.0589 0.6468 0.9459 0.4794 0.0038

AR-terms

p-value

-0,025368 0.8785 0.385412 -0.441216 0.0214 0.443532 0.018577 0.9096 0.569930 -0.004101 0.9832 0.370791 -0.183777 0.2171 0.309504 -0.03681 0.7745 0.344764 -0.313953 0.0198 0.601654 -0.580418 0.0025 0.556596 -0.446433 0.0029 0.641715 -0.624755 0.0000 0.996932 Source: Own calculations

No changes -0.292197 0.0005 Newey-West technique -0.245680 0.0028 -0.255977 0.0017 No changes No changes Newey-West technique No changes -0.282885 0.0005

15

The final version of all corrected three-factor models in appendix No 9

110

According to the results the variable F3 is redundant, since it remains significant only for one portfolio. These results are coherent with previously obtained. It is still inconclusive factor F1 should be included in the next stage, as it is significant for a half of the models. The decision will be based on the Schwarz Criterion. All ten regressions are re-estimated for one independent factor F2 and alternatively for two independent factors F1 and F2. Models are re-estimated in order to choose between one or two factors for further analysis and to find the best estimates for the next stage of the testing procedure. Hence, if only one factor is examined to find its best value any bias that may occur while estimating should be reduced. This bias is definitely caused by redundant variables. Before the coefficients and their P-values for both versions are presented16, summary of residual tests in both models are depicted in Tables 5.13 and 5.1417:
Table No 5.13: Summary of results of the tests on the normal distribution, heteroskedasticity and autocorrelation of the residuals form regression

R p ,t = 0 + 2 F2,t + t

Portfolio Normal Distribution 1 Non-existing 2 Non-existing 3 Non-existing 4 Non-existing 5 Non-existing 6 Non-existing 7 Non-existing 8 Non-existing 9 Non-existing 10 Non-existing Source: Own calculations

Autocorrelation Non-existing Non-existing Non-existing Existing AR(2) Existing AR(1) Non-existing Non-existing Non-existing Non-existing Existing AR(1)

Heteroskedasticity Non-existing Non-existing Existing (F2^2) Non-existing Non-existing Non-existing Non-existing Existing Non-existing Non-existing

16

Results of the time-series regressions of two factor models and one-factor models in Appendix No 10 and 11 respectively 17 Detailed results of residuals tests in Appendix No 12 for two-factor model and No 13 for one-factor model

111

Table No 5.14: Summary of results of the tests on the normal distribution, heteroskedasticity and autocorrelation of the residuals form regression

R p ,t = 0 + 1 F1,t + 2 F2,t + t

Portfolio Normal Distribution 1 Non-existing 2 Non-existing 3 Non-existing 4 Non-existing 5 Non-existing 6 Non-existing 7 Non-existing 8 Non-existing 9 Non-existing 10 Non-existing Source: Own calculations

Autocorrelation Non-existing Existing AR(2) Non-existing Existing AR(2) Existing AR(1) Non-existing Non-existing Non-existing Non-existing Existing AR(1)

Heteroskedasticity Non-existing Non-existing Existing (F2^2) Non-existing Non-existing Non-existing Non-existing Existing Non-existing Non-existing

Analysing the above tables, it can be concluded that both kinds of models face the same problems with residuals for the same portfolios. Coefficients estimated after application of the procedure that improves the models quality, are presented in Table 5.15 and 5.1618:

Table No 5.15:

R p ,t

2 coefficient and its P-value for t-statistics = 0 + 2 F2,t + t 2

0,325300 0,265853 0,546794 0,336301 0,235964 0,234874 0,573414 0,548586 0,593772 1,171754 P-value 0.0003 0.0053 0.0000 0.0002 0.0018 0.0007 0.0000 0.0000 0.0000 0.0000

Portfolio

1 2 3 4 5 6 7 8 9 10

Source: Own calculations

18

Results of all regressions for one- and two-factor models after adjusting for residuals are in the Appendixes No 14 and 15 respectively

112

Table No 5.16:

R p ,t

1 and 2 coefficients and their P-value for t-statistics = 0 + 1 F1,t + 2 F2,t + t 1

-0,002219 -0,349877 0,027512 0,020165 -0,158216 0,005516 -0,303347 -0,577847 -0,428349 -0,690301 P-value 0.9892 0.0571 0.8583 0.9136 0.2791 0.9655 0.0219 0.0031 0.0036 0.0000

Portfolio

2
0,325305 0,327616 0,546731 0,336209 0,239777 0,234861 0,574115 0,549921 0,594761 1,186652

P-value 0.0003 0.0002 0.0000 0.0002 0.0016 0.0007 0.0000 0.0000 0.0000 0.0000

1 2 3 4 5 6 7 8 9 10

Source: Own calculations

Comparing results from Tables 5.6 and 5.12 the values of the coefficient 2 are the smallest for the one-factor model, whereas their tstatistics are the highest for the two-factor model. Hence, it still remains inconclusive if variable F1 should be included in further studies. In order to make decision which of the two models: R p ,t = 0 + 2 F2,t + t or
R p ,t = 0 + 1 F1,t + 2 F2,t + t , is better Schwarz Criterion (SBC) is

applied. The comparison is based on the models after adjusting for residuals. The lower value of the SBC indicates better model:
Table No 5.17: Comparison of the one-factor model two-factor model

R p ,t = 0 + 2 F2,t + t with

R p ,t = 0 + 1 F1,t + 2 F2,t + t .

Comparison method: Schwarz Criterion Portfolio Schwarz Criterion value for Schwarz Criterion value for two one factor model factors model -4.197212 -4.164162 -4.043250 -4.039216 -4.567012 -4.534237 -4.027585 -3.994260 -4.379106 -4.353943 -4.689233 -4.656194 -4.602078 -4.599729 -4.256219 -4.200778 -4.402179 -4.378062 -4.266619 -4.167651

1 2 3 4 5 6 7 8 9 10

Source: Own calculations

113

For models 7 - 10 SBC is lower in two-factor model, which can be attributed to the statistical significance of the variable F1. Although for portfolios 1 6 one-factor model is slightly better, once again the results cannot definitely indicate superior model. In conclusion, F3 was not statistically significant in nine out of ten models. Furthermore, despite some problems with residuals, after their correction the conclusions cannot be changed. As there is no final conclusion achieved concerning F1, the cross-sectional tests are run with and without F1. The only significant variable even at the level of significance =0.01 is F2, which shows high correlation with the weekly return on the WIG index. In both one- and two-factor models, the coefficient of determination remains close to or below the values obtained for three-factor models, which was expected. It may suggest that some variables are missing and therefore model is likely to be not fully specified.

5.4 Cross-sectional regression

The subsequent phase of the APT test is the same as for CAPM model, namely cross-sectional regression based on the data obtained in the previous stage. Observations from the Table 3.18 will be used to estimate the final model and test the hypothesis, which will provide arguments rejecting or supporting this version of APT model. As in the previous chapter the conclusion about the significance of the factor F1 was not achieved, there are two sets of data used in cross-sectional study.

114

Table No 5.18: Data used in cross-sectional regression Portfolio Average 1 -0,00263 2 -0,00531 3 0,001207 4 -0,00033 5 0,000165 6 0,002446 7 -0,00596 8 -0,00215 9 -0,00094 10 -0,00405 Source: Own calculations

Rp

from onefactor model 0,325300 0,265853 0,546794 0,336301 0,235964 0,234874 0,573414 0,548586 0,593772 1,171754

from twofactor model -0,002219 -0,349877 0,027512 0,020165 -0,158216 0,005516 -0,303347 -0,577847 -0,428349 -0,690301

from twofactor model 0,325305 0,327616 0,546731 0,336209 0,239777 0,234861 0,574115 0,549921 0,594761 1,186652

For the one-factor model the estimated equation takes the form of:

R p = 0 + 1 2, p + p

and for the two-factor model:

R p = 0 + 1 1, p + 2 2, p + p

where according to the theory the coefficients should be statistically bigger then zero. The results for the one-factor model are presented in Table 5.19:

Table No 5.19: Results of the cross-sectional regression:

R p = 0 + 1 2, p + p

Dependent Variable: AVERAGE Method: Least Squares Date: 04/27/03 Time: 17:34 Sample: 1 10 Included observations: 10 Variable Coefficient Std. Error t-Statistic C -5.81E-05 0.001791 -0.032416 2 -0.003513 0.003241 -1.083982 R-squared 0.128067 Mean dependent var Adjusted R-squared 0.019075 S.D. dependent var S.E. of regression 0.002749 Akaike info criterion Sum squared resid 6.04E-05 Schwarz criterion Log likelihood 45.89251 F-statistic Durbin-Watson stat 2.380740 Prob(F-statistic) Source: Own calculations

Prob. 0.9749 0.3100 -0.001756 0.002775 -8.778503 -8.717986 1.175017 0.309957

115

Ho: 0 =0 the parameter 0 is statistically insignificant H1: 0 0 the parameter 0 is statistically significant At the level of significance =0.05 the P-value of the t-statistics equals 0.9749 and leads to a conclusion that there is no sufficient evidence to reject Ho, hence the parameter 0 is statistically insignificant. Ho: 1 =0 variable 2 does not affect R p H1: 1 0 variable 2 does affect R p

At the level of significance =0.05 the P-value of the t-statistics equals 0.31 and leads to a conclusion that there is no sufficient evidence to reject Ho, hence the variable 2 does not affect average portfolio returns. As in the simple linear regression t-statistics of the estimated parameter reflects the overall quality of the model, its value of 1.083982 indicates its insignificance. The graphical explanation of the regression in diagrams 5.4 and 5.5 supports the statistical results:
Diagram No 5.4: Graphical result of the regression of the average returns on portfolios against 2 variable.
AVERAGE vs. V2 .004 .002 .000 AVERAGE -.002 -.004 -.006 -.008 0.2

0.4

0.6 V2

0.8

1.0

1.2

Source: Own calculations

116

Diagram

No

5.5:

Actual,

residual

and

fitted

graph

from

the

model

R p = 0 + 1 2, p + p
.004 .002 .000 -.002 -.004 .004 .002 .000 -.002 -.004 -.006 1 2 3 4 5 6 Actual 7 8 9 10 -.006 -.008

Residual

Fitted

Source: Own calculations

In order to be assured of the correctness of obtained results tests of the residual values are conducted: 4. Distribution of the residuals graphically and statistically is presented in Diagram 5.6:
Diagram No 5.6: Histogram of residual values from the model:

R p = 0 + 1 2, p + p
5 Series: Residuals Sample 1 10 O bservations 10 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -0.0025 0.0000 0.0025 0.0050 2.40E-19 0.000517 0.003329 -0.004316 0.002592 -0.465285 2.214968 0.617598 0.734328

0 -0.0050

Source: Own calculations

117

Ho: p have normal distribution H1: p have not normal distribution At the level of significance =0.05 the P-value of the 2-statistics equals 0.7343 and leads to a conclusion that there is no sufficient evidence to reject Ho, hence the residuals p have normal distribution.

5. Heteroskedasticity

the

outcome

of

the

test

for

the

heteroskedasticity is presented in Table 5.20

Table No 5.20: Results of the test on the heteroskedasticity of the residuals from the model R p

= 0 + 1 2, p + p
Probability Probability 0.708892 0.626180

White Heteroskedasticity Test: F-statistic 0.361530 Obs*R-squared 0.936235 Test Equation: Dependent Variable: RESID^2 Method: Least Squares Date: 04/27/03 Time: 17:50 Sample: 1 10 Included observations: 10 Variable Coefficient C 7.89E-06 2 -6.74E-07 2^2 -4.98E-06 R-squared 0.093623 Adjusted R-squared -0.165341 S.E. of regression 7.58E-06 Sum squared resid 4.02E-10 Log likelihood 105.4923 Durbin-Watson stat 2.010468 Source: Own calculations

Std. Error t-Statistic 1.09E-05 0.721636 3.88E-05 -0.017365 2.78E-05 -0.178848 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.4939 0.9866 0.8631 6.04E-06 7.02E-06 -20.49847 -20.40769 0.361530 0.708892

Ho: the variance of p is constant H1: the variance of p is not constant At the level of significance =0.05 the P-value of the 2-statistics equals 0.626180 and leads to a conclusion that there is no sufficient evidence to reject Ho, hence the variance of residuals p is constant.

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6. Autocorrelation Outcome of the test on the autocorrelation of the residuals is displayed in Table 5.21.
Table No 5.21: Results of the test on the autocorrelation of residuals in model

R p = 0 + 1 2, p + p
Breusch-Godfrey Serial Correlation LM Test: F-statistic 0.314934 Probability Obs*R-squared 0.430535 Probability Test Equation: Dependent Variable: RESID Method: Least Squares Date: 04/27/03 Time: 17:57 Presample missing value lagged residuals set to zero. Variable Coefficient Std. Error t-Statistic C 6.37E-06 0.001873 0.003403 2 -1.84E-05 0.003389 -0.005419 RESID(-1) -0.207531 0.369805 -0.561190 R-squared 0.043054 Mean dependent var Adjusted R-squared -0.230360 S.D. dependent var S.E. of regression 0.002875 Akaike info criterion Sum squared resid 5.78E-05 Schwarz criterion Log likelihood 46.11255 F-statistic Durbin-Watson stat 2.062926 Prob(F-statistic) Source: Own calculations

0.592171 0.511726

Prob. 0.9974 0.9958 0.5922 2.40E-19 0.002592 -8.622511 -8.531735 0.157467 0.857249

Ho: errors are independent H1: errors are autocorrelated At the level of significance =0.05 the P-value of the Lagrange Multiplier with one lag statistics equals 0.511726 and leads to a conclusion that there is no sufficient evidence to reject Ho, hence errors are independent. As the regression is built on the cross-section data the achieved results are consistent with expectations. The overall conclusion is that the one factor model does not explain much and is statistically inappropriate. T-statistic for 2 coefficient indicates that this variable does not explain the variance of average returns on portfolios. Although the sample is relatively small, the tests are of high statistical power as no problems with residuals are uncovered.

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The two-factor model was tested as an alternative. As previously, its coefficients from time-series regression are now regressed as independent variables against average returns on portfolios. The results are presented in Table 5.22.
Table No 5.22: Results of the cross-sectional regression:

R p = 0 + 1 1, p + 2 2, p + p
Dependent Variable: AVERAGE Method: Least Squares Date: 04/27/03 Time: 18:01 Sample: 1 10 Included observations: 10 Variable Coefficient Std. Error t-Statistic C -0.000428 0.001751 -0.244250 1 0.006457 0.004706 1.372128 2 0.000525 0.004420 0.118878 R-squared 0.334514 Mean dependent var Adjusted R-squared 0.144375 S.D. dependent var S.E. of regression 0.002567 Akaike info criterion Sum squared resid 4.61E-05 Schwarz criterion Log likelihood 47.24349 F-statistic Durbin-Watson stat 2.164912 Prob(F-statistic) Source: Own calculations

Prob. 0.8140 0.2124 0.9087 -0.001756 0.002775 -8.848697 -8.757921 1.759311 0.240429

To test the significance of the estimated parameters, t-statistics is applied: Ho: 0 =0 the parameter 0 is statistically insignificant H1: 0 0 the parameter 0 is statistically significant At the level of significance =0.05 the P-value of the t-statistics equals 0.8140 and leads to a conclusion that there is no sufficient evidence to reject Ho, hence the parameter 0 is statistically insignificant. Ho: 1 =0 variable 1 does not affect R p H1: 1 0 variable 1 does affect R p

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At the level of significance =0.05 the P-value of the t-statistics equals 0.2124 and leads to a conclusion that there is no sufficient evidence to reject Ho, hence variable 1 does not affect average portfolio returns. Ho: 2 =0 variable 2 does not affect R p H1: 2 0 variable 2 does affect R p

At the level of significance =0.05 the P-value of the t-statistics equals 0.9087 and leads to a conclusion that there is no sufficient evidence to reject Ho, hence variable 2 does not affect average portfolio returns. The general quality of the model is poor, as expected: Ho: 1 = 2 = 0 the model is miss-specified H1: Either or both of 1 and 2 0 At the level of significance =0.05 the P-value of the F-statistics equals 0.2404 and leads to a conclusion that there is no sufficient evidence to reject Ho, the model is miss-specified. Graphical results in Diagram 5.7 support the hypothesis of the model insignificance:

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Diagram No 5.7: Actual, residual and fitted graph from the model
.0 0 4 .0 0 2 .0 0 0 -.0 0 2 .0 0 4 .0 0 2 .0 0 0 -.0 0 2 -.0 0 4 1 2 3 4 5 6 A c tu al 7 8 F itted 9 10 -.0 0 4 -.0 0 6 -.0 0 8

R es id u al

Source: Own calculations

In order to be assured of the correctness of obtained results tests of the residual values are conducted: 1. Residuals distribution is presented graphically and statistically in Diagram 5.8:
Diagram No 5.8: Histogram of residual values from the model:

R p = 0 + 1 1, p + 2 2, p + p
5 Series: R esiduals Sample 1 10 O bservations 10 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -0.002 0.000 0.002 7.86E-20 0.000689 0.002715 -0.003874 0.002264 -0.564016 1.885116 1.048092 0.592120

0 -0.004

Source: Own calculations

Ho: p have normal distribution H1: p have not normal distribution

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At the level of significance =0.05 the P-value of the 2-statistics equals 0.5921 and leads to a conclusion that there is no sufficient evidence to reject Ho, the residuals p have normal distribution.

2. Heteroskedasticity

the

outcome

of

the

test

for

the

heteroskedasticity is presented in Table 5.23

Table No 5.23: Results of the test on the heteroskedasticity of the residuals from the model

R p = 0 + 1 1, p + 2 2, p + p
White Heteroskedasticity Test: F-statistic 0.937605 Obs*R-squared 4.285988 Test Equation: Dependent Variable: RESID^2 Method: Least Squares Date: 04/27/03 Time: 18:19 Sample: 1 10 Included observations: 10 Variable Coefficient C 1.63E-06 1 -3.61E-05 1^2 -7.01E-05 2 5.41E-06 2^2 3.47E-07 R-squared 0.428599 Adjusted R-squared -0.028522 S.E. of regression 4.64E-06 Sum squared resid 1.08E-10 Log likelihood 112.0849 Durbin-Watson stat 1.501012 Source: Own calculations Probability Probability 0.511254 0.368683

Std. Error t-Statistic 7.20E-06 0.227156 2.24E-05 -1.613891 4.55E-05 -1.539498 2.60E-05 0.207639 1.92E-05 0.018091 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.8293 0.1675 0.1843 0.8437 0.9863 4.61E-06 4.57E-06 -21.41697 -21.26568 0.937605 0.511254

Ho: the variance of p is constant H1: the variance of p is not constant

At the level of significance =0.05 the P-value of the 2-statistics equals 0.3686 and leads to a conclusion that there is no sufficient evidence to reject Ho, hence the variance of residuals p is constant.

3. Autocorrelation the outcome of the test on the autocorrelation of the residuals is presented in Table 5.24:

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Table No 5.24: Results of the test on the autocorrelation of residuals in model

R p = 0 + 1 1, p + 2 2, p + p
Breusch-Godfrey Serial Correlation LM Test: F-statistic 0.142565 Probability Obs*R-squared 0.232093 Probability Test Equation: Dependent Variable: RESID Method: Least Squares Date: 04/27/03 Time: 18:21 Presample missing value lagged residuals set to zero. Variable Coefficient Std. Error t-Statistic C -0.000188 0.001935 -0.097376 1 0.000519 0.005208 0.099610 2 0.000636 0.005010 0.126872 RESID(-1) -0.161865 0.428692 -0.377578 R-squared 0.023209 Mean dependent var Adjusted R-squared -0.465186 S.D. dependent var S.E. of regression 0.002740 Akaike info criterion Sum squared resid 4.51E-05 Schwarz criterion Log likelihood 47.36090 F-statistic Durbin-Watson stat 1.915817 Prob(F-statistic) Source: Own calculations 0.718740 0.629976

Prob. 0.9256 0.9239 0.9032 0.7187 7.86E-20 0.002264 -8.672180 -8.551146 0.047522 0.984958

Ho: errors are independent H1: errors are autocorrelated At the level of significance =0.05 the P-value of the Lagrange Multiplier with one lag statistics equals 0.62998 and leads to a conclusion that there is no sufficient evidence to reject Ho, hence errors are independent. As the regression is built on the cross-section data the achieved results are consistent with expectations. None of the APT model versions presented in this paper works on Polish market. All tested factors appeared not to be statistically significant. The overall conclusion after testing classical CAPM and APT models is that classical capital market equilibrium models do not work on the Warsaw Stock Exchange. Discussion on the possible reasons for the market equilibrium models failure is carried out in the next chapter.

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CHAPTER VI Possible Reasons for CAPM and APT Failure

The validity of both models: standard version CAPM as well as proposed version of APT is rejected. The aim of this chapter is to point out the possible explanations for the failure of both models. Furthermore, in this chapter improvements that could be applied in order to deliver more reliable results will be discussed. There is a number of reasons why the models can not be applied to Polish market. Each of these reasons will be a subject of detailed discussion: 1. Instability of companies betas even in short term 2. Inappropriate portfolio grouping on the beta basis 3. Market inefficiency and liquidity o Individual investor impact on the asset price o Small volume low liquidity o Autocorrelation 4. Weighted index capital dominance of a few companies 5. Generally low significance of the market as a source of capital 6. Shortcomings of APT factor analysis 7. Short estimation period

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6. 1 Beta instability
In the CAPM case, time-series models of the portfolios are stable over the estimation period. For the arbitrary chosen time that is on 4th July 2002 applying Chow Breakpoint Test only for two out of ten models: seventh and tenth for which the null hypothesis about the stability of estimated parameters can not be rejected even at a very high level of significance19. The results are presented in Table 6.1:
Table No 6.1: Results of the model stability test Chow Breakpoint Test: 7/04/2002 Estimated model: R p ,t R F ,t = p + p ( RM ,t R F ,t ) Portfolio P-Value 1 0,543011 2 0,298215 3 0,331163 4 0,507972 5 0,738408 6 0,598632 7 0,000184 8 0,371525 9 0,240888 10 0,022043 Source: Own calculations

Problems, however, emerge much earlier, in the first stage and were associated with beta estimation for the individual shares, which afterwards form the portfolios. Betas estimated for the shares in the period subsequent to forming portfolios are different from the betas of the same shares in the period when these shares are prescribed to the particular portfolios. This is a cause of inconsistency within a group. It leads to results, which are in contradiction to the expectations, for example: portfolio, which at the forming phase was in the sixth decile based on its relation to the market risk, after estimation appeared to have the lowest beta, which would be expected for the portfolio containing first decile of shares. Although CAPM model does not impose the requirement of constant beta of an asset, such a high variability makes it impossible to find a true relation between beta and average returns. Table 6.2 should clarify the magnitude of the problem:
19

Appendix No 16

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Table No 6.2: Differences in shares betas composing fourth portfolio before and after it is formed. Beta estimated for the period Beta estimated for the period from from 13. July 2000 to 27. 3. January 2002 to 26. December 2002 December 2001 OCEAN SA 0.29048631 0.713788012 STALPRODKUT 0.304070251 0.461836357 BUDOPOL0.305519608 -0.403168579 WROCLAW WISTIL 0.306052531 0.033646917 OBORNIKI 0.314800398 0.046852433 HANDLOWY 0.320958834 0.494068836 FORTE 0.329261567 -0.042074626 EKODROB 0.330939013 0.43268908 DEBICA 0.335007843 0.478581477 FORTIS BANK 0.337494666 0.188541371 POLSKA Source: Own calculations

Instability of stock betas in long term is a natural order resulting from either business or economic cycle. This time-varying characteristic of beta can result from the thee following reasons:

Investments in new projects, mergers and acquisitions as well as industry diversification. Change in financial leverage, not only by increasing or decreasing debt, but by paying out dividends and buying back shares.

Company growth, reflecting the change in the structure of operational costs influence the beta value.

However, high variability of beta coefficient in short term implies that the relation between beta of the portfolio and beta of the previous period estimated for the particular shares will be sustained.

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6. 2 Inappropriate portfolio grouping APT case

The other source of problems might be the basis caused by wrong portfolios grouping. As in the case of CAPM test there is not much choice, as most of the empirical studies use portfolios formed on the basis of increasing correlation with market risk, there is no reason to do so for APT model. This is because this model does not assume the necessity of close relation to the one particular factor, which is to be market index. Therefore, the time-series regressions are conducted once again for portfolios formed by alphabetically sorted shares. As the logic suggests sorting procedure is applied only once. Forming portfolios on the alphabetical basis assures that shares included in portfolios are chosen randomly. The results are presented in Table 6.320:
Table No 6.3: factors coefficients and P-values of t-statistics for all portfolios R p ,t = 0 + 1 F1,t + 2 F2,t + 3 F3,t + t , portfolios formed alphabetically. Portfolio

P-value

2
-0.027823 0.015397 0.098606 -0.089273 0.075355 0.080018 -0.067171 -0.065707 0.046841 -0.028143

P-value 0.8838 0.9061 0.3211 0.5552 0.4372 0.4463 0.6092 0.5942 0.7321 0.8459

3
0.178185 0.175062 0.060672 0.204282 0.162521 0.200052 0.150678 0.156367 0.308565 0.217079

P-value 0.1610 0.3137 0.6455 0.3102 0.2081 0.1529 0.3885 0.3406 0.0912 0.2601

1 -0.020109 0.0920 2 0.078409 0.6773 3 0.014168 0.9212 4 0.078000 0.7208 5 0.123644 0.3771 6 -0.102236 0.4999 7 -0.268465 0.1579 8 -0.105581 0.5530 9 -0.061129 0.7568 10 0.135191 0.5177 Source: Own calculations

Analysis of Table 6.3 suggests that none of the factors is statistically significant for all portfolios. High power of the t-test is ensured by nonexistence of the errors disturbances21:

20 21

detailed estimation output in Appendix No 17 Detailed results of the residuals tests in Appendix No 18

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Table No 6.4: Summary of results of the tests on the normal distribution, heteroskedasticity and autocorrelation of the residuals form regression R p ,t = 0 + 1 F1,t + 2 F2,t + 3 F3,t + t , portfolios formed alphabetically. Portfolio Normal Distribution 1 Non-existing 2 Non-existing 3 Existing 4 Non-existing 5 Existing 6 Non-existing 7 Non-existing 8 Non-existing 9 Existing 10 Non-existing Source: Own calculations Autocorrelation Non-existing Non-existing Non-existing Non-existing Non-existing Non-existing Non-existing Non-existing Non-existing Non-existing Heteroskedasticity Non-existing Non-existing Existing Non-existing Non-existing Existing Non-existing Non-existing Non-existing Non-existing

The

conclusion

cannot

be

changed

after

correction

of

the

heteroskedasticity in models three and six22. The results support the hypothesis that none of the factors presented in APT model is statistically significant. There is no relation between these factors and average returns.

6. 3 Market inefficiency and liquidity

Market efficiency is one of the assumptions underlying capital market equilibrium models. There is a number of conditions that must be satisfied for the market to be efficient, some of which are discussed in the first chapter of this paper. Market is considered efficient, if the prices rationally reflect all available information. However, Polish capital market has features indicating its inefficiency, which might be a cause for the models failure. Three sources of inefficiency are detected and shortly discussed. Efficient market is liquid, which means that all investors can buy and sell any amount of shares any time. Therefore, investors funds for
22

Estimation output for the models after correction in Appendix No 19

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trading purposes should not be locked in, because an asset is illiquid. Difficulty in trading on a stock exchange causes mispricing, as the value of the share is determined by other factors then available information (Damodaran 2001). The liquidities of the stocks traded on the Warsaw Stock Exchange are relatively low. High-capitalisation companies are traded most often whereas frequent gaps in quotation of many small companies indicate the low liquidity of their shares. Low liquidity of the Polish capital market is supported by the low volume of the trade, which is on average merely 150mln23 USD daily and in the last months around 150mln PLN ( 39.5mln USD)24. This is very little when comparing with average daily trading on NYSE 41,3 billion USD25. On a randomly chosen day that is 31st March 2002 the volume of trade on the WSE reached approximately 27mln USD, of which close to 7 mln USD is accounted for Bank Pekao S.A. and almost 7 mln USD is a turnover for TP S.A a Polish Telecommunication company stocks. Both companies are included in WIG 20, twenty biggest firms listed on the Warsaw Stock Exchange. Small volume of trade may result in other source of market inefficiency, namely the impact of a particular investor on a stock price. Under efficient market assumption none of individual trader is able to affect the price. Although since the beginning of the second quarter 1994 impact of one company on the index was limited to 10 percent of the value of the general shares portfolio. For such a small market turnover as on the Warsaw Stock Exchange liquidation of one big investors positions can disturb the equilibrium significantly.

23 24

http://www.igte.com.pl/Biuletyny/Biuletyn_002_2002/8_4.htm average exchange rate on 05.05.2003, https://www.bm.bphpbk.pl/pieniadz/kalkulator/ 25 Ibidem

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6. 4 Value weighted index and capital dominance of a few companies

Unlike in JBS studies, the index used, WIG, is a weighted index, hence its value depends on the market capitalisation of any individual company listed on the Warsaw Stock Exchange. A capital dominance of a few biggest companies is a feature of the Polish market, which is presented in Table 6.5:
Table No 6.5: Capital share in market portfolio of ten biggest companies State on 5. May 2003 Company Capital share in a market portfolio in % TPSA 10,71 PKNORLEN 10,51 PEKAO 9,28 BPHPBK 6,76 KGHM 6,09 PROKOM 4,23 SWIECIE 3,25 AGORA 2,97 STOMIL 2,85 BZWBK 2,85 59,5 Source: http://www.gpw.com.pl/xml/dane/indeksy/wig.xml

A capital dominance of a few biggest companies might be a source of additional problems, as the relationship built in CAPM model and partially in the proposed version of APT model becomes close to the relation between a return on an individual stock and a few dominating companies. This is in contradiction to the theory, which implies the relationship with well diversified portfolio. This effect increases on its significance, if the overall trade volume is relatively small. The problem of low volume of trade was discussed in previous section. Furthermore, assuming that the weighted average beta equals one and betas of the dominating companies are bigger than one, majority of listed companies on the stock exchange, will have betas lower than one. Such situation occurred in this study. Big and stable companies

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have relatively high betas with comparison to small, risky firms, betas of which are relatively low.

6. 5 Low significance of the market as a source of capital

The importance of the Warsaw Stock Exchange as a source of capital is still relatively small. Its current capitalisation of the companies shares is roughly 28 bln USD. Polish capital market is very small when comparing with NYSE with its capitalization of 14 900 mld USD. This comparison stresses rather marginal importance of WSE. For example the number of listed shares on NYSE is 258626 and it is only one of a few capital markets in USA. Furthermore, Warsaw Stock Exchange does not fulfil a definition of a market portfolio. Stocks of publicly listed companies in Poland reflect only a small part of investment opportunities. For example the debt market is much bigger with its 38 bln USD27. Furthermore, Polish investors do not have to invest only in Poland as they have global access to investment opportunities in Western countries. On the other hand, as most of the investments in Poland are made by foreign capital, it might be concluded that Warsaw Stock Exchange serves only for a diversification for international investors. In such situation investment horizon becomes much wider than the region of Poland.

6. 6 Shortcomings of APT factor analysis

APT significance should be assessed simultaneously with the estimation methodology used to create this model. Factor analysis is a method that allows for identification of factors simultaneously with the
26 27

http://www.igte.com.pl/Biuletyny/Biuletyn_002_2002/8_4.htm state at the end of 2002, http://www.rk.pl/fua/fundacja/dzialalnosc/vii.asp

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estimation of coefficients influencing the returns on individual stocks (Elton and Gruber, 1998). The fact that the estimated model did not support the arbitrage pricing theory, can result from biases of the estimation technique applied. Factor analysis has disadvantages that may influence APT tests. First of all, ik are biased thus k are significant only asymptotically. Furthermore, these parameters can be rescaled arbitrary (for example multiplied by two). Third, the researcher cannot be sure if factors were obtained in the right rank. Therefore, the analysis of different samples may bring different results. That may lead to the situation that first factor in first study may be a second one in the next research. Nevertheless, the most important disadvantage of factor analysis is the complexity of mathematical calculations that need to be carried out. This difficulty made researchers introduce simplifications. Therefore, the study usually employs a limited sample of securities. Portfolio aggregation is likely to generate information losses, as the results will describe only a small sample of returns leaving the most risky assets beyond the model. Chen (1981) presented a technique that enables APT testing with a large number of securities. However, this methodology was criticized by Dryhmes, Friend and Gultekin (Elton, Gruber, 1998). They concluded that the number of significant factors depends on the sample size. Thus, the more securities in portfolio, the bigger the number of significant results. Their research revealed that there are three significant factors for groups of 15 securities and seven factors for groups of 60 securities. The portfolios analyzed in this paper consisted of ten securities, thus the results obtained may not be reliable. According to Dryhmes et al the portfolios created are expected to neglect the covariance between securities included in different groups. Furthermore, factors for one portfolio are likely to differ from factors estimated for another. In order to improve the APT model a bigger number of securities should be grouped.

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6.7 Diversification of the firm-specific risk

Arbitrage pricing model tested in this research assumed that firmspecific risk is diversified, as portfolios of stocks were tested, instead of individual shares. However, portfolios consisted of only ten shares and therefore this assumption might not be met in all groups of stocks. There are big companies in Poland, whose business activities, influence other firms. Any scandals associated with these companies might have a significant impact on Polish market. Therefore, it would be difficult to diversify firm-specific risk of such a company. For example PKN Orlen, Polish gas producer and retailer, has a great impact on a whole industry because of its monopolistic position. However, this company is well known for corporate scandals. Its former president Mr. Modrzejewski was arrested and dismissed because of revealing secret information. As a result of that it was possible to buy shares of one of the companies at competitive price. The information about the arresting of that executive caused a drop in stock prices of seven percent. Furthermore, Orlen incumbent president Mr. Wrbel is accused of collusion while bargaining. Moreover, his advisors are accused of manipulation with stock prices (Indulski and Koczot, 2003). Due to that scandals companys investors are exposed to additional uncertainty. However, the problem is that this firm has a very strong impact on other companies and incidents of that kind could influence test results as well. Moreover, corporate scandals take place in other companies as well. For example Drosed (Mielczarek, 1999) stocks prices were manipulated as well. It is questionable if the risk of such mispricing can be fully diversified when grouping stocks into portfolios.

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6.8 Small number of variables

Moreover, the factor analysis that was carried out may not explain the reality well enough because there were only five variables introduced. More variables especially these delivering different information are expected to improve the model. There were no variables on income (for example GDP), no variables linking Polish economy directly to European markets or no information on industrial production. The application of such data is likely to improve created APT model. Furthermore, it would be advantageous to employ variables that could describe political risk in Poland. This risk is reflected to a certain extent in the exchange rate as political uncertainty results usually in the PLN depreciation. That is because foreign investors take their capital back, when they find political situation in Poland uncertain. There are no empirical studies confirming this hypothesis but there is some evidence that suggests this opinion. For example rotation on crucial positions in Polish government, especially those directly linked to Ministry of Finance was deterring foreign investors from investments on the WSE. Such situation occurred when the government of the incumbent Prime Minister Leszek Miller or former Minister of Finance Grzegorz Koodko was expected to resign (http://waluty.onet.pl/731083.wiadomoci.html, http://waluty.onet.pl/732360.wiadomoci.html). However, political risk can also refer to unexpected changes of legislation that may influence investors or certain industries. Assuming that markets are efficient these law modifications should be discounted by investors and included in stock prices. Nevertheless, the legislation process is sometimes not as clear as it should be.

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For example capital gains on stock prices will be taxied in 2004. Despite the fact that the new tax rate will be charged next year, investors are not sure what the tax rate will be. Internet chats with Minister of Finance representatives were their source of information. Having no access to more reliable information and therefore being not able to estimate their future net profits, they might try to make gains as soon as possible. Such strategy would result in making investors less rational (Brycki, 2003). The inclusion of more variables could describe better the political risk in Poland and therefore the constructed model would perform better. However, implementing such variables might cause additional problems as it would be difficult to quantify such measures. Factor analysis creating unobservable variables could include political risk factors to some extent but introducing for example binary variables describing changes in law or in the government could improve the model even more.

6.9 Short estimation period

The last possible reason for the failures of the examined models might be short estimation period and a small number of shares included in the study. Because of the problems resulting from the low liquidity data of a monthly frequency might be better as it would give more averaged returns. On the other hand, short estimation period does not allow for using monthly rates of return, as the number of observations would be far too small and as a consequence the insufficient number of degrees of freedom would be obtained. The trade off problem, between the number of observations (degrees of freedom) and the size of the sample of companies included, is caused by the short history of Warsaw Stock Exchange. Most of the studies were conducted on the markets with long history and therefore without such a limitation.

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References:

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APPENDIXES
Appendix No 1 Data used in time series regression

Data

risk free

Index

Portfolio Portfolio Portfolio Portfolio Portfolio Portfolio Portfolio Portfolio Portfolio Portfolio 1 2 3 4 5 6 7 8 9 10
0,01145 0,04853 0,05663 0,03858 0,07741 0,00245 0,15550 0,01016 0,07398 0,01537 0,05104 0,02911 0,09903 0,00450 0,04829 0,00525 -0,03765 0,00581 0,00800 0,03332 0,00142 -0,02278 -0,03027 0,00312 -0,04835 -0,02507

00-02-03 0,00205 0,03710 0,02705 00-02-17 0,01462 0,00885 0,02632

00-02-10 0,02727 0,03245 0,03306 -0,01353 0,09737

0,03648 -0,02809 -0,01709 0,00235 0,04269 0,07189 0,00132 0,04552

00-02-24 -0,01614 0,07890 -0,04848 -0,05462 0,06219 -0,05864 -0,04085 -0,07287 0,01338 -0,07148 -0,00136 00-03-02 0,00117 -0,02833 -0,02107 0,01265 00-03-09 0,00410 -0,00425 0,04999 00-03-16 -0,02564 -0,00279 0,02951 00-03-30 -0,02219 -0,00437 0,00703 0,07290 0,01146 0,04437 -0,01320 -0,00691 -0,01431 0,05919 0,00607 0,08715 0,00966 0,01165 0,02898 0,06061 0,11437 0,00791

0,00444 -0,03236 0,03422 -0,01866 -0,00221 -0,02647 0,02253

00-03-23 -0,00263 0,00509 -0,02468 -0,01010 -0,00779 0,04188 -0,00140 0,07125

0,01642 -0,00187 -0,03068 -0,01064 -0,01047 -0,01465 0,02157 -0,00746 -0,01924 0,01242 0,02397 0,01415 0,02409 0,00375 -0,03294 -0,00253 -0,00705 0,01135 0,00454 0,01383 0,03482 0,07653 0,00336 0,00916 0,00729 0,00877 0,00923 -0,03093 0,01734 0,00444 0,01207 0,00499

00-04-06 0,00515 -0,05941 -0,01729 -0,04605 -0,04286 -0,00756 -0,02167 -0,00559 -0,04959 0,01147 -0,04191 -0,03546 00-04-13 -0,00940 -0,00977 -0,00035 0,01427 00-04-20 -0,01256 -0,06738 -0,01788 -0,03772 -0,06705 0,00138 -0,01999 0,00248 -0,04815 -0,04995 -0,02798 -0,05414 00-04-27 0,01422 0,01104 -0,00261 -0,01497 0,00762 00-05-04 -0,01415 0,01890 0,00504 0,01341 0,02582 -0,02413 0,00488 -0,01262 0,00512 -0,01091 0,00400 0,01433 0,00246 0,01463 0,02846 0,04317 0,02587 0,03185 0,00354 -0,02231 0,00018 -0,02683 0,00847

00-05-11 -0,00437 -0,01804 -0,03084 -0,02060 0,01393 -0,01721 0,00209 -0,01393 0,01145 00-05-18 -0,01128 0,03443 -0,00765 0,04419 -0,01211 0,02643 00-06-01 0,02084 0,05024 0,03022 -0,01633 0,03217 00-06-15 -0,00735 -0,00926 0,04532 00-06-29 -0,01341 0,01520 0,00311 0,05349 0,01687 0,02674 0,02381 0,03935 -0,00648 0,02930 0,01963 0,01672 0,03667 0,00456 0,06165 0,01151

00-05-25 0,01584 -0,06428 -0,02622 -0,04240 0,04340 -0,01946 -0,06597 -0,04398 -0,05709 -0,03226 -0,04143 -0,06971 00-06-08 -0,00269 0,01455 -0,01499 -0,00480 -0,00116 -0,00238 -0,03418 -0,01424 -0,01032 -0,01940 -0,00879 -0,02247 0,01128 -0,00269 0,00577 -0,01876 0,03176 0,00348 0,02169 0,02657 0,02280 0,01664 00-06-22 0,01235 -0,00615 -0,00352 -0,02623 -0,01754 -0,02519 0,00886 -0,01278 0,00481 00-07-06 -0,00062 -0,01590 0,01939 -0,01016 -0,00126 0,02668 00-07-13 -0,02165 -0,00051 0,01843 -0,00270 0,00611 00-07-20 0,00860 0,02084 -0,00285 0,00804 -0,01203 0,02608 0,02329 0,03826 0,00362 0,01282

0,00958 -0,00502 -0,00344 0,02260 -0,01329 0,00454 -0,01968 -0,00900 -0,00625 0,02469 -0,00009 0,02379

0,00571 -0,00747 -0,00258 0,03192 -0,01844

00-07-27 0,00777 -0,02826 0,00608 -0,05699 -0,01406 -0,00856 0,18051 -0,00733 -0,01731 0,00053 00-08-10 0,00422 0,01053 0,01463 0,03121 0,03081 0,01730 0,06909 0,03244 0,02344 0,04371

00-08-03 0,00199 -0,02597 -0,02021 -0,05946 -0,00541 0,00726 -0,07056 0,02047 -0,05260 0,01513 -0,04095 -0,03037 00-08-17 -0,01051 -0,03219 -0,01107 0,00539 -0,01593 -0,02270 -0,02232 -0,00870 -0,04546 -0,01081 -0,00996 -0,01696 00-08-24 -0,01562 -0,01063 -0,02357 -0,01896 -0,00064 0,00380 -0,03258 -0,00215 0,01563 -0,02186 -0,00732 00-08-31 -0,00888 0,00867 -0,00344 0,00840 0,01266 0,00941 -0,00212 -0,00855 -0,00131 -0,01671 0,02106

00-09-07 -0,01665 -0,00789 -0,00803 -0,02643 -0,01329 -0,00603 -0,00688 -0,02079 0,00167 -0,01674 -0,00851 -0,01236 00-09-14 0,00859 0,00043 0,00599 -0,03939 -0,02464 0,01577 -0,02890 -0,00217 -0,02821 -0,02011 -0,00204 00-09-21 0,00633 -0,02349 -0,00505 -0,06308 -0,02483 0,03067 0,04186 -0,00323 0,00466 -0,04101 -0,04564 -0,04094 -0,00517 0,03891 -0,02355 0,03802

00-09-28 0,01219 -0,06032 -0,00982 -0,06454 -0,06491 -0,07691 -0,07561 -0,01897 -0,03337 -0,05265 -0,07212 -0,04312 00-10-05 0,00380 -0,02129 -0,03890 0,12518 -0,01448 -0,00143 0,03274 -0,02382 0,01073 -0,00146 0,00505 00-10-19 0,01010 0,03385 -0,00050 -0,08101 0,04462 -0,02410 -0,01940 0,01769 -0,02413 0,00678 -0,03474 00-10-26 0,00750 0,01856 0,03456 00-11-02 0,00868 -0,00904 0,02743 0,04375 0,04120 0,01346 0,05031 0,06601 0,02720 0,00292 -0,00458 0,03881 -0,00787 0,04109 0,00073 0,00318 0,00974 0,04272 0,05560 00-10-12 0,00000 -0,06694 -0,02641 0,01868 -0,08507 -0,01037 -0,03479 -0,04582 -0,04401 -0,07829 -0,04747 -0,07068

00-11-09 0,01476 0,04386 -0,01342 -0,00891 0,04370 -0,03665 0,01067 00-11-23 0,01010 0,00786 -0,01383 0,00435 00-11-30 0,01634 -0,00373 -0,00811 0,00022

0,02994 -0,00364 0,00257 -0,02653 -0,00247 -0,00281 0,02587 0,02773 0,04659

00-11-16 0,02061 -0,02771 -0,02378 -0,00981 -0,01390 -0,03144 -0,00606 -0,00211 -0,03983 -0,04258 -0,00782 -0,00581 0,02232 -0,00556 -0,00863 0,01790 -0,02005 -0,01280 0,01168 0,02196 0,00165 0,01924 -0,01758 -0,01426 -0,00593 0,00202 0,01487 -0,01719 0,00974 0,01945 -0,00479 0,01739

00-12-07 -0,00856 0,02590 -0,00349 -0,01150 -0,02001 -0,02552 -0,04699 -0,02745 0,01236 00-12-14 -0,00817 0,05752 -0,01389 -0,03121 0,05508 -0,02934 0,00019

144

Data

risk free

Index

Portfolio Portfolio Portfolio Portfolio Portfolio Portfolio Portfolio Portfolio Portfolio Portfolio 1 2 3 4 5 6 7 8 9 10
0,01267 0,04054 0,01097 0,02154 0,00804 0,02723 -0,01357 -0,01915 -0,01245 0,01847 0,03528 0,03444 0,01447 0,02102 -0,03331 0,01605 0,00757 0,00397 0,01249 0,03852 0,02174 0,02104 0,00640

00-12-21 0,01588 -0,01293 -0,01319 -0,00187 -0,01259 0,01804 00-12-28 -0,00984 0,02645 -0,00346 0,07132 01-01-04 0,01275 -0,00183 0,08131 0,00494

0,01717 -0,02469 0,05824

01-01-11 0,00104 -0,05440 -0,03024 0,00147 -0,03195 -0,01034 -0,01365 -0,01518 -0,03421 -0,01359 -0,04926 -0,06735 01-01-18 0,00311 0,01174 -0,04480 0,01478 -0,02637 -0,02742 -0,02187 0,01222 -0,01403 0,01854 -0,03990 01-01-25 -0,01553 0,01502 0,00583 -0,01737 0,01549 01-02-01 0,00409 0,01635 0,02441 0,01312 0,00971 -0,01771 -0,00198 0,02666 0,01729 0,01994 -0,00958 0,02479 0,01017 -0,00117 0,00815 -0,03341 0,01868

01-02-08 -0,00465 -0,04545 -0,06873 -0,03291 -0,03452 -0,04346 -0,01229 -0,04322 -0,03928 -0,01734 -0,03317 -0,08122 01-02-15 0,00701 0,00123 -0,01421 0,01043 -0,01357 -0,01863 -0,00145 -0,00812 -0,01146 -0,00987 -0,02127 01-02-22 -0,00638 -0,07068 -0,01151 -0,01681 -0,03323 -0,03047 -0,06559 -0,00715 -0,04303 -0,04855 -0,01261 -0,08301 01-03-01 0,00117 -0,04291 -0,03871 -0,00514 -0,00975 -0,03005 -0,02163 0,00108 -0,03355 -0,01842 -0,01446 -0,05567 01-03-08 -0,00233 0,01985 -0,03512 -0,04447 -0,05693 -0,01925 -0,00854 -0,01110 -0,00200 -0,01105 0,00903 01-03-22 0,00819 0,00813 0,07078 01-04-05 -0,01159 -0,01520 0,00213 0,05681 0,04142 0,02060 0,00314 0,00878 0,00509 0,02767 0,00547 0,03982 0,00381 0,00511 0,01555 0,00874 0,00968 0,00295 0,04070 0,04366 0,01774 0,04792 0,05430 0,04576 0,02472 0,01007 -0,03400 0,01130 0,01080 0,07768 0,03072 -0,00072 -0,01289 0,00033 0,04310 -0,06493 01-03-15 0,00000 -0,05572 -0,06957 -0,05318 -0,09424 -0,00080 -0,03959 -0,07721 -0,05913 -0,06323 -0,02828 -0,09171 01-03-29 0,00116 0,00422 0,00424 -0,01863 0,01997 01-04-12 0,00586 0,05441 -0,01978 -0,00536 0,01450 01-04-19 0,00000 0,02785 -0,01970 0,01544 01-04-26 -0,00932 -0,00233 -0,03487 -0,01730 0,07071

0,02759 -0,00561 0,01451

0,00094 -0,02078 0,00003

0,00551 -0,00301 -0,01281

0,01291 -0,00045 0,01677

0,01359 -0,00222 -0,00388 0,00612 0,01945 -0,00033 0,01092 0,00142 -0,03124 0,00182 0,01334 0,02276

01-05-03 -0,00471 -0,02149 -0,03390 -0,00282 0,00296 -0,00043 -0,00402 0,00359 01-05-17 0,01063 -0,00101 -0,04086 0,00575

01-05-10 0,00059 -0,01707 -0,03612 -0,04471 -0,03090 -0,01847 -0,02411 -0,00292 -0,01877 -0,00758 -0,01951 -0,03062 0,03302 -0,00893 -0,01162 0,00416 -0,02199 0,00064 0,02751 0,01539 0,00367 01-05-24 -0,00584 0,04956 -0,01392 -0,01447 0,00839 -0,00306 0,00456 01-06-07 0,00471 -0,04176 -0,03587 0,00588

01-05-31 -0,00176 -0,00451 -0,00027 -0,07263 -0,00407 -0,00432 -0,03969 -0,01383 0,00140 -0,00926 -0,01161 -0,01843 0,02435 -0,02211 0,00238 -0,01306 -0,02202 -0,00971 0,00877 01-06-14 0,00352 -0,02888 -0,03333 0,00078 -0,02432 -0,03534 -0,03220 -0,00378 -0,06547 -0,04287 -0,03479 -0,03407 01-06-21 -0,00759 -0,02467 -0,02295 -0,02927 -0,00127 -0,01683 -0,01424 -0,03022 -0,04066 -0,00336 -0,00685 -0,02311 01-06-28 -0,01236 -0,01258 0,00326 -0,02864 0,00891 0,01088 0,01282 -0,02706 0,00668 -0,01338 -0,00718 -0,01230 0,05333 01-07-05 0,01669 -0,04657 -0,04006 -0,01295 -0,04286 -0,01945 -0,01959 -0,00104 -0,05446 -0,06923 -0,00753 -0,06937 01-07-12 0,00586 0,00458 -0,02233 -0,02458 -0,00080 -0,02823 -0,00102 -0,01197 -0,00052 0,08248 -0,01587 01-07-19 0,00350 0,00189 -0,02417 0,00670 -0,02152 -0,00755 -0,01994 -0,01631 -0,02746 -0,05347 -0,00272 -0,06157 01-07-26 0,00000 -0,02769 0,00333 -0,01504 -0,02630 -0,04086 -0,01559 -0,02401 -0,02479 -0,02849 -0,03847 -0,02435 01-08-02 -0,01394 0,01136 0,00883 0,06406 0,04509 0,01497 0,01146 -0,00643 0,02949 0,04560 -0,00922 0,04280 01-08-09 0,01178 -0,05030 0,02255 -0,00183 -0,04277 -0,01094 -0,02502 -0,01851 -0,00392 -0,02636 -0,01056 -0,04464 01-08-16 0,00698 -0,02988 -0,03497 0,00611 0,00190 -0,00167 -0,00931 -0,04325 -0,02852 -0,01265 -0,02712 -0,01151 0,02165 0,00881 -0,00577 0,03385 0,01003 0,00904 0,02685 0,02174 -0,01673 0,01748 -0,00922 0,00465 0,04502 0,01171 0,03884 0,02863 01-08-23 0,00578 0,02435 0,00058 -0,01952 0,00462 01-09-06 0,01082 0,03800 -0,00392 -0,02251 0,02726 01-09-20 0,01403 -0,04040 -0,01124 0,04980

01-08-30 0,00920 0,01832 0,04310 -0,01847 -0,00282 0,03422

0,01394 -0,00747 -0,00754 0,00736

01-09-13 0,00394 -0,04455 -0,01071 -0,07282 -0,03046 -0,03592 -0,02266 -0,00087 -0,05332 -0,03202 -0,02507 -0,06171 0,00266 -0,00651 0,04154 -0,01265 -0,02299 -0,03188 -0,04519 -0,06412 0,00390 0,01261 0,02339 0,05329 0,01177 0,01490 -0,03991 -0,00243 -0,01614 0,06083 0,05187 0,03132 0,01031 0,02646 0,01396 0,02212 0,00467 0,01072 0,15063 0,04647 0,02358 0,01510 0,00015 0,07348 0,00208 0,00125 0,02642 0,00960 0,05465 0,11039 01-09-27 0,01162 -0,02484 -0,00817 -0,01444 -0,00696 -0,00053 0,00959 -0,06518 -0,02585 0,01235 -0,00010 -0,03621 01-10-04 0,00274 -0,00570 -0,02222 -0,02455 -0,01398 0,00135 01-10-11 0,01037 0,09440 0,10149 0,00124 0,01981 0,00844 0,01620 0,02643 0,02926 0,02315 0,04858 0,00829 0,01533 01-10-18 0,01836 0,01320 -0,03187 0,01486 01-10-25 -0,00212 0,03431 -0,04269 0,01738 01-11-01 0,01700 0,02174 0,00053 01-11-15 -0,00626 0,05305 0,02483 0,00092 0,05910 0,00559 -0,01145 0,03473

0,03903 -0,00956 0,02500 0,03832 0,00754 0,00686 0,02644

0,00329 -0,00914 -0,03341 0,03949

01-11-08 0,00104 0,00630 0,02826 -0,00124 -0,01905 -0,01089 0,02732 -0,00656 0,00719

0,02091 -0,01433

01-11-22 0,01261 -0,01885 0,08495 -0,01740 -0,00526 -0,01569 -0,02742 0,02532 -0,00555 -0,00884 -0,01525 -0,05862 01-11-29 -0,00674 -0,01174 -0,02282 -0,03655 0,01422 01-12-06 0,00888 0,01659 0,01905 0,00280 -0,04044 -0,01541 0,01062 -0,03025 -0,05208 0,01315 -0,01721 0,03147 -0,01076 0,03792 0,00099 0,01993 0,03027 0,03188 0,01681 0,00154 -0,04042 0,01140 0,05851 0,00402 0,03209 0,04359 0,07460 0,05699 0,00469 -0,01058 0,00416 0,02670 0,05375

01-12-13 0,00000 -0,02647 -0,05801 0,00369 -0,02481 -0,04245 0,01422 -0,01697 -0,03957 -0,03221 -0,03486 -0,10250 01-12-20 0,00414 -0,01023 0,01134 -0,02430 0,02160 01-12-27 0,00928 -0,00441 0,01096 02-01-03 0,00613 0,06273 0,00869 02-01-10 0,00203 0,06230 0,00220 0,02802 0,00000 0,03213 -0,00385 0,00654 0,01676 -0,02575 0,01042 -0,01554 -0,04257

0,00410 -0,01286 -0,01173 0,00501

145

Data

risk free

Index

Portfolio Portfolio Portfolio Portfolio Portfolio Portfolio Portfolio Portfolio Portfolio Portfolio 1 2 3 4 5 6 7 8 9 10
0,00484 -0,03361 0,01323 0,00393 0,02960 0,00360 0,06212 -0,00475 0,02116 0,01808 0,01677 -0,03234 -0,00046 0,01035 0,00162

02-01-17 0,00395 0,02554 -0,02632 0,00760 -0,01836 0,02728 -0,01718 0,00926 02-01-24 -0,00959 0,01441 0,04305 -0,00541 -0,02081 0,01940 02-01-31 -0,00958 -0,00637 0,00095 0,01083 -0,03013 0,00924

0,00090 -0,00701 -0,08403

02-02-07 0,00309 -0,04636 -0,01579 -0,00980 -0,01638 0,00142 -0,01956 -0,04647 -0,00129 0,01791 -0,03527 02-02-14 0,00205 0,00381 -0,00619 -0,04738 -0,00438 -0,00291 -0,00307 -0,01648 0,00411 -0,01449 0,00523 02-02-21 0,00102 -0,01981 0,01975 02-02-28 0,00409 0,01372 0,02478 0,00882 0,04916

0,00423 -0,01301 -0,01194 -0,01545 -0,00797 -0,01677 -0,01011 -0,02664 0,00145 -0,00113 -0,00032 -0,00001 -0,00006 -0,00368 -0,00257 -0,00781 0,00446 -0,00179 0,02440 -0,00364 0,02409 0,00762 -0,01893 -0,00528 -0,02676 -0,01490 -0,01934 -0,03120 0,00863 -0,04162 0,02473 -0,00206 -0,00578 -0,00441 0,01283 -0,01174 0,07283 -0,01158 -0,00194 0,02853 0,01420 0,07036 0,00746 0,02087 0,00285 -0,04240 0,03300 0,08730 0,02754 0,00605 -0,02485

02-03-07 0,00102 0,01100 -0,00194 -0,00251 -0,00463 -0,01982 0,00013 02-03-14 -0,00203 -0,01312 -0,02449 -0,05144 0,00681

02-03-21 0,00000 -0,01751 -0,04020 -0,01404 -0,00869 -0,03007 0,00371 -0,01995 -0,05778 0,00169 -0,03772 -0,03929 02-03-28 0,00000 0,00329 -0,00168 -0,01086 -0,00504 0,00919 02-04-11 0,00203 0,02915 -0,02076 0,00251 02-04-18 -0,00152 -0,00918 0,05454 02-04-04 0,00306 -0,01747 -0,02254 -0,03989 0,00961 -0,00360 -0,00051 0,03326 -0,04413 -0,07574 -0,02604 -0,03090 0,03923 -0,04527 0,00458 0,00891 -0,01549 0,01977 0,02571 -0,00912 -0,01412 -0,01075 -0,05262 -0,03682 0,01547 0,01345 0,02023

02-04-25 0,00000 -0,00222 0,02385 -0,00852 -0,00829 0,01959 -0,00502 -0,01398 -0,00815 0,00526 02-05-02 0,00254 -0,00236 -0,01333 0,00219 0,01715 -0,01803 0,00996 0,05355 0,02678 0,02793

02-05-09 -0,00051 -0,00333 -0,02921 -0,01652 -0,02686 -0,01932 -0,04721 -0,01918 -0,01827 -0,01337 -0,04377 -0,00840 02-05-16 0,00608 0,03613 -0,02367 -0,01931 0,04249 02-05-23 0,00000 0,00958 0,04633 0,00261 -0,00004 0,09625 0,01471 0,02867 0,00221 -0,02057 0,02289 0,01118 -0,00231 -0,01111 -0,02561 -0,01446 0,00322

02-05-30 0,00957 0,00587 0,01071 -0,00063 -0,01059 0,00503

02-06-06 0,00000 -0,00148 -0,01352 -0,01471 -0,00126 0,00943 -0,03023 -0,01856 0,00131

02-06-13 0,00649 -0,01444 -0,03569 0,02336 -0,00937 -0,02115 -0,00087 -0,00992 -0,00828 -0,00416 -0,03339 -0,01941 02-06-20 0,00248 -0,03928 0,05162 -0,03549 0,00419 -0,03354 -0,00858 0,00274 -0,02187 -0,02415 -0,05400 -0,03404 02-06-27 -0,00346 -0,02780 -0,04022 -0,03008 0,02838 -0,04391 -0,01216 -0,02116 -0,00155 -0,01704 -0,04978 -0,02310 02-07-04 0,00050 -0,04232 0,01819 -0,00192 -0,01025 -0,03036 -0,00225 -0,00492 -0,02886 -0,02097 -0,03995 -0,05478 02-07-11 0,00000 -0,00609 -0,01413 -0,02032 -0,01133 -0,02187 0,01554 -0,00641 0,01514 -0,03585 0,00268 -0,02147 02-07-18 0,00000 -0,01026 0,02872 -0,05065 -0,00943 -0,01441 -0,00672 -0,01549 -0,03320 -0,01661 -0,00391 -0,03247 02-07-25 0,00794 -0,07541 -0,02670 -0,05608 -0,03557 -0,01592 -0,00507 -0,02363 -0,04332 -0,06771 -0,10683 -0,12595 02-08-01 -0,00098 0,04056 -0,01573 0,00393 -0,00710 -0,00311 0,02313 -0,02270 0,01563 -0,00878 0,01524 02-08-08 0,00197 -0,02815 0,00688 0,00128 -0,00569 0,00413 0,00551 0,06355 0,00849 -0,01585 0,00800 0,01983 0,04115 0,05481 0,03091 02-08-15 0,00197 0,01464 -0,01855 -0,02836 -0,00014 0,23537 -0,02500 -0,01941 -0,01349 0,02152 02-08-22 0,00294 0,03245 -0,01253 -0,00194 -0,00694 -0,05957 -0,00698 0,01266 -0,01166 0,03117 02-08-29 0,00440 -0,00438 0,00660 -0,01453 0,01690 -0,09465 0,01756 -0,00328 -0,03849 0,00267 02-09-05 0,00097 -0,03769 0,01950 -0,03345 0,00088 02-09-12 0,00389 0,03193 0,05254 -0,01395 -0,00149 0,01307 -0,01446 -0,00443 -0,06709 0,03933 0,05336 -0,03069 0,01226 -0,00478 -0,02469 0,08439 0,00012

0,03832 -0,02683 0,00103 -0,02277 -0,01583 -0,04882 -0,13317

02-09-19 0,00145 -0,01067 -0,06309 -0,01759 -0,01355 0,00649 -0,00054 -0,02609 0,00871 -0,01404 0,00726

02-09-26 -0,00097 -0,00003 0,00230 -0,02767 0,00040 -0,00530 0,01045 -0,01131 -0,02991 0,01445 -0,00626 -0,02367 02-10-03 0,00194 -0,01343 -0,01317 -0,00822 -0,00665 -0,06881 -0,01093 -0,03862 -0,03751 -0,04391 -0,01680 -0,06281 02-10-10 0,00338 0,00238 -0,04571 -0,01357 -0,03220 0,00244 02-10-17 0,00530 0,04138 0,09096 02-10-31 0,00764 0,02649 0,03308 02-11-07 0,00047 -0,02323 0,01384 02-11-21 -0,00284 0,03645 0,01554 0,03946 0,00857 0,00276 0,01025 -0,01628 -0,00857 0,02823 0,01300 0,01261 0,03305 0,00389 0,04827 0,04408 -0,00328 0,04929 -0,02039 0,01744 0,03151 0,01362 0,01609 -0,02890 0,01535 0,00397 -0,01601 -0,00380 -0,01609 -0,03484 0,04331 0,04906 0,03517 0,01607 0,00595 0,01734 0,04282 0,01259 0,00058 0,02034 0,01295 0,02539 0,00611 0,01712 0,00550 0,00074

02-10-24 0,00384 0,02257 -0,03232 0,02304 -0,00624 0,01737 -0,00822 0,01203 -0,00802 0,00226 0,04493 -0,00725 0,06091 -0,00734 0,00057 0,04095

02-11-14 0,00237 0,01309 0,01900 -0,00394 0,01331 02-11-28 0,00190 0,02628 -0,00093 -0,01353 0,02897 02-12-05 -0,00378 0,00510 0,00666 -0,01513 0,02174 02-12-12 -0,00237 -0,02536 0,03029 -0,04215 0,00771

0,01533 -0,02299 0,01126 -0,00156 0,00437 0,01945 0,02221 0,01170 0,00944

0,00851 -0,03117 0,01867 -0,00822 -0,02969 -0,00241 0,01317 0,01640 -0,03165 -0,03621 0,02429

0,01332 -0,03061 -0,03411 0,01150

02-12-19 0,00714 -0,02723 -0,00611 -0,08219 0,01146 -0,00519 -0,01550 -0,01589 0,01558 -0,09521 -0,02507 -0,05488 02-12-26 -0,00284 0,01121 -0,00490 0,01883 -0,00649 0,01755 0,02487 -0,01643 -0,00088 -0,00070 0,01328

146

Appendix No 2 Results of the time-series regression R p ,t R F ,t = p + p ( RM ,t R F ,t ) + t

Portfolio 1
Dependent Variable: P1-RF Method: Least Squares Date: 03/27/03 Time: 16:55 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C -0.003279 INDEX-RF 0.304299 R-squared 0.101827 Adjusted R-squared 0.095839 S.E. of regression 0.029040 Sum squared resid 0.126497 Log likelihood 323.2688 Durbin-Watson stat 2.171409

Std. Error t-Statistic 0.002367 -1.385033 0.073791 4.123798 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.1681 0.0001 -0.004246 0.030540 -4.227221 -4.187433 17.00571 0.000062

Portfolio 2
Dependent Variable: P2-RF Method: Least Squares Date: 03/27/03 Time: 16:56 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C -0.005885 INDEX-RF 0.326055 R-squared 0.097061 Adjusted R-squared 0.091042 S.E. of regression 0.031955 Sum squared resid 0.153172 Log likelihood 308.7272 Durbin-Watson stat 2.120784

Std. Error t-Statistic 0.002605 -2.259168 0.081199 4.015498 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.0253 0.0001 -0.006922 0.033517 -4.035885 -3.996097 16.12422 0.000093

Portfolio 3
Dependent Variable: P3-RF Method: Least Squares Date: 03/27/03 Time: 16:56 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C 0.001101 INDEX-RF 0.473718 R-squared 0.279123 Adjusted R-squared 0.274317 S.E. of regression 0.024462 Sum squared resid 0.089761 Log likelihood 349.3423 Durbin-Watson stat 1.731651

Std. Error t-Statistic 0.001994 0.551929 0.062159 7.621019 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.5818 0.0000 -0.000406 0.028716 -4.570293 -4.530506 58.07993 0.000000

147

Portfolio 4
Dependent Variable: P4-RF Method: Least Squares Date: 03/27/03 Time: 16:57 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C -0.001054 INDEX-RF 0.278166 R-squared 0.071041 Adjusted R-squared 0.064848 S.E. of regression 0.032322 Sum squared resid 0.156703 Log likelihood 306.9947 Durbin-Watson stat 2.087148

Std. Error t-Statistic 0.002635 -0.400190 0.082130 3.386901 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.6896 0.0009 -0.001939 0.033424 -4.013088 -3.973300 11.47110 0.000903

Portfolio 5
Dependent Variable: P5-RF Method: Least Squares Date: 03/27/03 Time: 16:57 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C -0.000439 INDEX-RF 0.317400 R-squared 0.117137 Adjusted R-squared 0.111251 S.E. of regression 0.028000 Sum squared resid 0.117597 Log likelihood 328.8139 Durbin-Watson stat 2.421461

Std. Error t-Statistic 0.002282 -0.192162 0.071148 4.461146 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.8479 0.0000 -0.001448 0.029700 -4.300183 -4.260396 19.90183 0.000016

Portfolio 6
Dependent Variable: P6-RF Method: Least Squares Date: 03/27/03 Time: 16:58 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C -0.004437 INDEX-RF 0.230514 R-squared 0.095207 Adjusted R-squared 0.089175 S.E. of regression 0.022834 Sum squared resid 0.078209 Log likelihood 359.8126 Durbin-Watson stat 1.997001

Std. Error t-Statistic 0.001861 -2.384044 0.058022 3.972888 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.0184 0.0001 -0.005170 0.023926 -4.708060 -4.668272 15.78384 0.000110

Portfolio 7
Dependent Variable: P7-RF Method: Least Squares Date: 03/27/03 Time: 16:59 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C -0.005762 INDEX-RF 0.569277 R-squared 0.368645 Adjusted R-squared 0.364436 S.E. of regression 0.023939 Sum squared resid 0.085960 Log likelihood 352.6307 Durbin-Watson stat 1.931419

Std. Error t-Statistic 0.001951 -2.952685 0.060829 9.358641 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.0037 0.0000 -0.007572 0.030028 -4.613562 -4.573774 87.58416 0.000000

148

Portfolio 8
Dependent Variable: P8-RF Method: Least Squares Date: 03/29/03 Time: 09:19 Sample: 2/03/2000 12/26/2002 Included observations: 152 Newey-West HAC Standard Errors & Covariance (lag truncation=4) Variable Coefficient Std. Error t-Statistic C -0.001938 0.002322 -0.834632 INDEX-RF 0.574836 0.087238 6.589265 R-squared 0.306541 Mean dependent var Adjusted R-squared 0.301918 S.D. dependent var S.E. of regression 0.027782 Akaike info criterion Sum squared resid 0.115772 Schwarz criterion Log likelihood 330.0025 F-statistic Durbin-Watson stat 2.203549 Prob(F-statistic)

Prob. 0.4053 0.0000 -0.003766 0.033251 -4.315822 -4.276034 66.30699 0.000000

Portfolio 9
Dependent Variable: P9-RF Method: Least Squares Date: 03/27/03 Time: 16:59 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C -0.000650 INDEX-RF 0.599535 R-squared 0.350949 Adjusted R-squared 0.346622 S.E. of regression 0.026199 Sum squared resid 0.102955 Log likelihood 338.9195 Durbin-Watson stat 1.984412

Std. Error t-Statistic 0.002136 -0.304417 0.066571 9.005915 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.7612 0.0000 -0.002557 0.032411 -4.433151 -4.393363 81.10651 0.000000

Portfolio 10
Dependent Variable: P10-RF Method: Least Squares Date: 03/29/03 Time: 09:23 Sample: 2/03/2000 12/26/2002 Included observations: 152 Newey-West HAC Standard Errors & Covariance (lag truncation=4) Variable Coefficient Std. Error t-Statistic C -0.002250 0.001736 -1.296261 INDEX-RF 1.074353 0.089372 12.02110 R-squared 0.609768 Mean dependent var Adjusted R-squared 0.607166 S.D. dependent var S.E. of regression 0.027617 Akaike info criterion Sum squared resid 0.114403 Schwarz criterion Log likelihood 330.9067 F-statistic Durbin-Watson stat 2.454092 Prob(F-statistic)

Prob. 0.1969 0.0000 -0.005667 0.044062 -4.327719 -4.287932 234.3862 0.000000

149

Appendix No 3 Results of the residual tests on the model R p ,t R F ,t = p + p ( R M ,t R F ,t ) + t 1. Autocorrelation Ho: errors are independent H1: errors are autocorrelated Level of significance =0.05 LaGrange Multiplier with four lags test statistics Portfolio 1
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 1.128388 5.692802 Probability Probability 0.347986 0.337267

Portfolio 2
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 1.775369 8.768572 Probability Probability 0.121467 0.118659

Portfolio 3
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 0.996668 5.050346 Probability Probability 0.422018 0.409767

Portfolio 4
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 2.903403 11.19998 Probability Probability 0.023887 0.024406

Portfolio 5
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 3.027994 11.64378 Probability Probability 0.019604 0.020206

Portfolio 6
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 0.366132 1.509573 Probability Probability 0.832440 0.824944

150

Portfolio 7
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 0.491548 2.019794 Probability Probability 0.741941 0.732118

Portfolio 8
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 2.159478 8.490560 Probability Probability 0.076447 0.075174

Portfolio 9
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 0.279893 1.156712 Probability Probability 0.890621 0.885173

Portfolio 10
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 2.724382 10.55736 Probability Probability 0.031695 0.032016

2. Heteroskedasticity Ho: the variance of t is constant H1: the variance of t is not constant Level of significance =0.05 2 test statistics Portfolio 1
White Heteroskedasticity Test: F-statistic Obs*R-squared 1.460309 2.922143 Probability Probability 0.235468 0.231988

Portfolio 2
White Heteroskedasticity Test: F-statistic Obs*R-squared 0.401893 0.815569 Probability Probability 0.669776 0.665122

151

Portfolio 3
White Heteroskedasticity Test: F-statistic Obs*R-squared 3.064364 6.005121 Probability Probability 0.049637 0.059660

Portfolio 4
White Heteroskedasticity Test: F-statistic Obs*R-squared 0.287009 0.583329 Probability Probability 0.750919 0.747019

Portfolio 5
White Heteroskedasticity Test: F-statistic Obs*R-squared 0.892155 1.798696 Probability Probability 0.411949 0.406835

Portfolio 6
White Heteroskedasticity Test: F-statistic Obs*R-squared 2.079087 4.126730 Probability Probability 0.128657 0.127026

Portfolio 7
White Heteroskedasticity Test: F-statistic Obs*R-squared 1.359293 2.723628 Probability Probability 0.260008 0.256196

Portfolio 8
White Heteroskedasticity Test: F-statistic Obs*R-squared 6.645796 12.44872 Probability Probability 0.001719 0.001981

Portfolio 9
White Heteroskedasticity Test: F-statistic Obs*R-squared 0.207854 0.422898 Probability Probability 0.812561 0.809411

Portfolio 10
White Heteroskedasticity Test: F-statistic Obs*R-squared 3.107630 6.086512 Probability Probability 0.047617 0.047679

152

3. Distribution of the residuals graphically and statistically Ho: t have normal distribution H1: t have not normal distribution Level of significance =0.05 2 test statistics

Portfolio 1
16 Series: Residuals Sample 2/03/2000 12/26/2002 O bservations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -0.05 0.00 0.05 -2.16E-18 -0.002911 0.085191 -0.057977 0.028944 0.552016 3.211695 8.003443 0.018284

12

Portfolio 2
30 25 20 15 10 5 0 -0.10 Series: Residuals Sample 2/03/2000 12/26/2002 O bservations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -0.05 0.00 0.05 0.10 3.65E-19 -0.002456 0.135440 -0.092975 0.031849 0.529423 4.812456 27.90562 0.000001

153

Portfolio 3
24 20 16 12 8 4 0 -0.05 0.00 0.05 Series: Residuals Sample 2/03/2000 12/26/2002 O bservations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability 9.02E-19 -0.002410 0.075618 -0.068943 0.024381 0.343984 3.885111 7.959247 0.018693

Portfolio 4
30 25 20 15 10 5 0 -0.1 0.0 0.1 0.2 Series: Residuals Sample 2/03/2000 12/26/2002 O bservations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -1.32E-18 -0.001229 0.230936 -0.095557 0.032214 2.117807 19.37437 1811.717 0.000000

Portfolio 5
32 28 24 20 16 12 8 4 0 -0.05 0.00 0.05 0.10 0.15 Series: Residuals Sample 2/03/2000 12/26/2002 O bservations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -6.85E-19 -0.000562 0.184610 -0.064348 0.027907 1.814073 14.55761 929.3646 0.000000

154

Portfolio 6
24 20 16 12 8 4 0 -0.05 0.00 0.05 Series: Residuals Sample 2/03/2000 12/26/2002 O bservations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability 6.39E-19 -0.001802 0.089412 -0.074198 0.022758 0.352129 5.806068 53.00997 0.000000

Portfolio 7
32 28 24 20 16 12 8 4 0 -0.05 0.00 0.05 0.10 Series: Residuals Sample 2/03/2000 12/26/2002 O bservations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability 6.66E-18 0.001287 0.139257 -0.081185 0.023859 0.907173 9.771453 311.2480 0.000000

Portfolio 8
20 Series: Residuals Sample 2/03/2000 12/26/2002 O bservations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -0.10 -0.05 0.00 0.05 5.93E-19 -0.000280 0.079294 -0.108030 0.027689 -0.299125 4.767592 22.05448 0.000016

16

12

155

Portfolio 9
24 20 16 12 8 4 0 -0.05 0.00 0.05 0.10 Series: Residuals Sample 2/03/2000 12/26/2002 O bservations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -1.85E-18 0.000627 0.115926 -0.064148 0.026112 0.505025 5.124037 35.03432 0.000000

Portfolio 10
32 28 24 20 16 12 8 4 0 -0.10 Series: Residuals Sample 2/03/2000 12/26/2002 O bservations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -0.05 0.00 0.05 0.10 -5.71E-20 0.000969 0.114410 -0.090362 0.027525 0.009939 5.397909 36.41897 0.000000

156

Appendix No 4 Changes in the estimation output after including errors correction techniques for portfolios R p ,t = 0 + 2 F2,t + t Portfolio 4
Dependent Variable: P4-RF Method: Least Squares Date: 04/28/03 Time: 10:59 Sample(adjusted): 2/17/2000 12/26/2002 Included observations: 150 after adjusting endpoints Convergence achieved after 7 iterations Variable Coefficient Std. Error t-Statistic C -0.000944 0.002070 -0.455971 INDEX-RF 0.319304 0.076968 4.148546 AR(2) -0.251764 0.079526 -3.165791 R-squared 0.126001 Mean dependent var Adjusted R-squared 0.114109 S.D. dependent var S.E. of regression 0.031476 Akaike info criterion Sum squared resid 0.145638 Schwarz criterion Log likelihood 307.4541 F-statistic Durbin-Watson stat 2.090360 Prob(F-statistic)

Prob. 0.6491 0.0001 0.0019 -0.002036 0.033442 -4.059388 -3.999176 10.59617 0.000050

Portfolio 5
Dependent Variable: P5-RF Method: Least Squares Date: 04/28/03 Time: 11:03 Sample(adjusted): 2/10/2000 12/26/2002 Included observations: 151 after adjusting endpoints Convergence achieved after 5 iterations Variable Coefficient Std. Error t-Statistic C -0.000971 0.001778 -0.546332 INDEX-RF 0.271354 0.067812 4.001535 AR(1) -0.239612 0.079470 -3.015115 R-squared 0.161199 Mean dependent var Adjusted R-squared 0.149864 S.D. dependent var S.E. of regression 0.026856 Akaike info criterion Sum squared resid 0.106745 Schwarz criterion Log likelihood 333.4617 F-statistic Durbin-Watson stat 1.876127 Prob(F-statistic)

Prob. 0.5857 0.0001 0.0030 -0.001957 0.029127 -4.376976 -4.317030 14.22116 0.000002

Portfolio 8
Dependent Variable: P8-RF Method: Least Squares Date: 04/28/03 Time: 11:00 Sample: 2/03/2000 12/26/2002 Included observations: 152 Newey-West HAC Standard Errors & Covariance (lag truncation=4) Variable Coefficient Std. Error t-Statistic C -0.001938 0.002322 -0.834632 INDEX-RF 0.574836 0.087238 6.589265 R-squared 0.306541 Mean dependent var Adjusted R-squared 0.301918 S.D. dependent var S.E. of regression 0.027782 Akaike info criterion Sum squared resid 0.115772 Schwarz criterion Log likelihood 330.0025 F-statistic Durbin-Watson stat 2.203549 Prob(F-statistic)

Prob. 0.4053 0.0000 -0.003766 0.033251 -4.315822 -4.276034 66.30699 0.000000

157

Portfolio 10
Dependent Variable: P10-RF Method: Least Squares Date: 04/28/03 Time: 11:01 Sample(adjusted): 2/10/2000 12/26/2002 Included observations: 151 after adjusting endpoints Convergence achieved after 6 iterations Newey-West HAC Standard Errors & Covariance (lag truncation=4) Variable Coefficient Std. Error t-Statistic C -0.002521 0.001657 -1.521716 INDEX-RF 1.092972 0.081680 13.38112 AR(1) -0.247250 0.072311 -3.419260 R-squared 0.632883 Mean dependent var Adjusted R-squared 0.627922 S.D. dependent var S.E. of regression 0.026474 Akaike info criterion Sum squared resid 0.103732 Schwarz criterion Log likelihood 335.6236 F-statistic Durbin-Watson stat 1.998442 Prob(F-statistic)

Prob. 0.1302 0.0000 0.0008 -0.006347 0.043402 -4.405610 -4.345664 127.5707 0.000000

158

Appendix No 5 Table 1: Anti-image matrix

Anti-image
Variables WIG risk free GOLD exchange S&P AntiAntiCorrelation WIG risk free GOLD exchange S&P WIG ,895 -4,082E7,403E5,821E-,278 ,493 -4,485E7,995E6,279E-,315 risk free -4,082E,925 -,162 -,148 ,138 -4,485E,482 -,172 -,157 ,153 GOLD 7,403E-,162 ,958 -5,283E-2,517E7,995E-,172 ,533 -5,508E-2,752Eexchang rate 5,821E-,148 -5,283E,960 -,101 6,279E-,157 -5,508E,499 -,110 S&P -,278 ,138 -2,517E-,101 ,874 -,315 ,153 -2,752E-,110 ,478

AntiAntiCovariance

Source: own calculations

Table 2: Anti-image matrix

Anti-image
WIG .994 3.485E7.333E-2.949E,489 a 3,592E7,514E-3,001Erisk free 3.485E.947 -.162 -.137 3,592E,536 a -,170 -,143 GOLD 7,333E-,162 ,959 -5,645E7,514E-,170 ,543 a -5,848Eexchang rate -2,949E-,137 -5,645E,972 -3,001E-,143 -5,848E,560 a

AntiAntiCovariance

WIG risk free GOLD exchange WIG risk free GOLD exchange

AntiAntiCorrelation

Source:own calculations

159

Appendix No 6 Results of the time-series regression R p ,t = 0 + 1 F1,t + 2 F2,t + 3 F3,t + t Portfolio 1

Dependent Variable: P1 Method: Least Squares Date: 04/25/03 Time: 12:31 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable C F1 F2 F3 R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat

Coefficient -0.002405 -0.025368 0.385412 -0.123005 0.089397 0.070939 0.029029 0.124719 324.3451 2.233962

Std. Error t-Statistic 0.002380 -1.010240 0.165658 -0.153133 0.114818 3.356710 0.152579 -0.806169 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.3140 0.8785 0.0010 0.4214 -0.002633 0.030117 -4.215067 -4.135492 4.843217 0.003036

Portfolio 2
Dependent Variable: P2 Method: Least Squares Date: 04/25/03 Time: 12:32 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable C F1 F2 F3 R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat

Coefficient -0.004612 -0.267580 0.304808 -0.078523 0.065345 0.046399 0.031178 0.143870 313.4884 2.129426

Std. Error t-Statistic 0.002556 -1.803965 0.177923 -1.503911 0.123319 2.471697 0.163876 -0.479159 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.0733 0.1347 0.0146 0.6325 -0.005308 0.031928 -4.072216 -3.992640 3.449067 0.018271

Portfolio 3
Dependent Variable: P3 Method: Least Squares Date: 04/25/03 Time: 12:32 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C 0.001453 F1 0.018577 F2 0.569930 F3 -0.047475 R-squared 0.277215 Adjusted R-squared 0.262564 S.E. of regression 0.024167 Sum squared resid 0.086438 Log likelihood 352.2095 Durbin-Watson stat 1.831629

Std. Error t-Statistic 0.001982 0.733273 0.137911 0.134705 0.095587 5.962446 0.127023 -0.373755 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.4646 0.8930 0.0000 0.7091 0.001207 0.028142 -4.581704 -4.502128 18.92116 0.000000

160

Portfolio 4
Dependent Variable: P4 Method: Least Squares Date: 04/25/03 Time: 12:32 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C -0.000222 F1 0.025362 F2 0.343685 F3 -0.114360 R-squared 0.060287 Adjusted R-squared 0.041238 S.E. of regression 0.031971 Sum squared resid 0.151277 Log likelihood 309.6733 Durbin-Watson stat 2.119335

Std. Error t-Statistic 0.002621 -0.084754 0.182445 0.139012 0.126454 2.717870 0.168041 -0.680549 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.9326 0.8896 0.0074 0.4972 -0.000326 0.032651 -4.022017 -3.942441 3.164939 0.026342

Portfolio 5
Dependent Variable: P5 Method: Least Squares Date: 04/25/03 Time: 12:32 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C 0.000913 F1 -0.286785 F2 0.363908 F3 -0.184273 R-squared 0.094334 Adjusted R-squared 0.075976 S.E. of regression 0.027308 Sum squared resid 0.110367 Log likelihood 333.6357 Durbin-Watson stat 2.439310

Std. Error t-Statistic 0.002239 0.407760 0.155836 -1.840305 0.108010 3.369192 0.143532 -1.283841 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.6840 0.0677 0.0010 0.2012 0.000165 0.028408 -4.337312 -4.257737 5.138547 0.002079

Portfolio 6
Dependent Variable: P6 Method: Least Squares Date: 04/25/03 Time: 12:32 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable C F1 F2 F3 R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat

Coefficient -0.003344 -0.036810 0.344764 -0.224909 0.095900 0.077574 0.022474 0.074755 363.2456 2.230707

Std. Error t-Statistic 0.001843 -1.814769 0.128252 -0.287014 0.088892 3.878438 0.118127 -1.903958 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.0716 0.7745 0.0002 0.0589 -0.003557 0.023400 -4.726916 -4.647340 5.232910 0.001842

161

Portfolio 7
Dependent Variable: P7 Method: Least Squares Date: 04/25/03 Time: 12:32 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable C F1 F2 F3 R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat

Coefficient -0.005010 -0.313953 0.601654 -0.056357 0.327815 0.314190 0.023355 0.080729 357.4019 1.875303

Std. Error t-Statistic 0.001915 -2.616154 0.133279 -2.355602 0.092376 6.513072 0.122757 -0.459098 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.0098 0.0198 0.0000 0.6468 -0.005959 0.028202 -4.650025 -4.570449 24.05921 0.000000

Portfolio 8
Dependent Variable: P8 Method: Least Squares Date: 04/25/03 Time: 12:32 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable C F1 F2 F3 R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat

Coefficient -0.000667 -0.580418 0.556596 -0.013661 0.277328 0.262680 0.027783 0.114243 331.0129 2.229662

Std. Error t-Statistic 0.002278 -0.292996 0.158548 -3.660831 0.109890 5.065011 0.146031 -0.093549 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.7699 0.0003 0.0000 0.9256 -0.002153 0.032356 -4.302802 -4.223226 18.93188 0.000000

Portfolio 9
Dependent Variable: P9 Method: Least Squares Date: 04/25/03 Time: 12:32 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C 0.000293 F1 -0.446433 F2 0.641715 F3 -0.096088 R-squared 0.314343 Adjusted R-squared 0.300445 S.E. of regression 0.025785 Sum squared resid 0.098399 Log likelihood 342.3591 Durbin-Watson stat 2.029890

Std. Error t-Statistic 0.002114 0.138684 0.147144 -3.033983 0.101986 6.292173 0.135527 -0.708995 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.8899 0.0029 0.0000 0.4794 -0.000943 0.030829 -4.452093 -4.372517 22.61717 0.000000

162

Portfolio 10
Dependent Variable: P10 Method: Least Squares Date: 04/25/03 Time: 12:32 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C -0.002129 F1 -0.649553 F2 1.017440 F3 0.317883 R-squared 0.597561 Adjusted R-squared 0.589404 S.E. of regression 0.027910 Sum squared resid 0.115289 Log likelihood 330.3203 Durbin-Watson stat 2.509384

Std. Error t-Statistic 0.002288 -0.930508 0.159272 -4.078258 0.110392 9.216588 0.146697 2.166932 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.3536 0.0001 0.0000 0.0318 -0.004054 0.043557 -4.293689 -4.214113 73.25259 0.000000

163

Appendix No 7 Results of the test on the redundant variables F1 and F3 in the model: R p ,t = 0 + 1 F1,t + 2 F2,t + 3 F3,t + t Ho: 1 = 3 =0, both variables are redundant H1: Either or both 1 and 3 are not equal to 0 Level of significance =0.05 F test statistics Portfolio 1
Redundant Variables: F1 F3 F-statistic Log likelihood ratio 0.325047 0.666202 Probability Probability 0.723008 0.716698

Test Equation: Dependent Variable: P1 Method: Least Squares Date: 04/25/03 Time: 14:19 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C -0.002466 F2 0.325300 R-squared 0.085397 Adjusted R-squared 0.079300 S.E. of regression 0.028898 Sum squared resid 0.125266 Log likelihood 324.0120 Durbin-Watson stat 2.226116

Std. Error t-Statistic 0.002344 -1.051815 0.086923 3.742406 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.2946 0.0003 -0.002633 0.030117 -4.237000 -4.197212 14.00560 0.000259

Conclusion: There is no sufficient evidence to reject Ho, both variables are redundant. Portfolio 2
Redundant Variables: F1 F3 F-statistic Log likelihood ratio 1.155480 2.355080 Probability Probability 0.317730 0.308036

Test Equation: Dependent Variable: P2 Method: Least Squares Date: 04/25/03 Time: 14:25 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C -0.005172 F2 0.265853 R-squared 0.050751 Adjusted R-squared 0.044422 S.E. of regression 0.031211 Sum squared resid 0.146117 Log likelihood 312.3109 Durbin-Watson stat 2.137451

Std. Error t-Statistic 0.002532 -2.042522 0.093878 2.831892 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.0429 0.0053 -0.005308 0.031928 -4.083038 -4.043250 8.019615 0.005263

164

Conclusion: There is no sufficient evidence to reject Ho, both variables are redundant. Portfolio 3
Redundant Variables: F1 F3 F-statistic Log likelihood ratio 0.090361 0.185492 Probability Probability 0.913652 0.911425

Test Equation: Dependent Variable: P3 Method: Least Squares Date: 04/25/03 Time: 14:25 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C 0.001488 F2 0.546794 R-squared 0.276332 Adjusted R-squared 0.271508 S.E. of regression 0.024020 Sum squared resid 0.086543 Log likelihood 352.1168 Durbin-Watson stat 1.812175

Std. Error t-Statistic 0.001949 0.763667 0.072249 7.568186 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.4463 0.0000 0.001207 0.028142 -4.606799 -4.567012 57.27744 0.000000

Conclusion: There is no sufficient evidence to reject Ho, both variables are redundant. Portfolio 4
Redundant Variables: F1 F3 F-statistic Log likelihood ratio 0.265614 0.544609 Probability Probability 0.767099 0.761622

Test Equation: Dependent Variable: P4 Method: Least Squares Date: 04/25/03 Time: 14:26 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C -0.000178 F2 0.287911 R-squared 0.056914 Adjusted R-squared 0.050626 S.E. of regression 0.031814 Sum squared resid 0.151820 Log likelihood 309.4010 Durbin-Watson stat 2.135425

Std. Error t-Statistic 0.002581 -0.068874 0.095693 3.008692 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.9452 0.0031 -0.000326 0.032651 -4.044750 -4.004962 9.052227 0.003078

Conclusion: There is no sufficient evidence to reject Ho, both variables are redundant.

165

Portfolio 5
Redundant Variables: F1 F3 F-statistic Log likelihood ratio 2.173248 4.399675 Probability Probability 0.117426 0.110821

Test Equation: Dependent Variable: P5 Method: Least Squares Date: 04/25/03 Time: 14:26 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C 0.000306 F2 0.273280 R-squared 0.067736 Adjusted R-squared 0.061521 S.E. of regression 0.027521 Sum squared resid 0.113609 Log likelihood 331.4359 Durbin-Watson stat 2.492303

Std. Error t-Statistic 0.002233 0.136930 0.082779 3.301311 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.8913 0.0012 0.000165 0.028408 -4.334683 -4.294895 10.89865 0.001203

Conclusion: There is no sufficient evidence to reject Ho, both variables are redundant. Portfolio 6
Redundant Variables: F1 F3 F-statistic Log likelihood ratio 1.813482 3.680080 Probability Probability 0.166690 0.158811

Test Equation: Dependent Variable: P6 Method: Least Squares Date: 04/25/03 Time: 14:26 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C -0.003436 F2 0.234874 R-squared 0.073744 Adjusted R-squared 0.067569 S.E. of regression 0.022596 Sum squared resid 0.076587 Log likelihood 361.4056 Durbin-Watson stat 2.242984

Std. Error t-Statistic 0.001833 -1.874631 0.067966 3.455754 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.0628 0.0007 -0.003557 0.023400 -4.729021 -4.689233 11.94223 0.000714

Conclusion: There is no sufficient evidence to reject Ho, both variables are redundant.

166

Portfolio 7
Redundant Variables: F1 F3 F-statistic Log likelihood ratio 2.775760 5.597229 Probability Probability 0.065548 0.060894

Test Equation: Dependent Variable: P7 Method: Least Squares Date: 04/25/03 Time: 14:27 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C -0.005664 F2 0.573414 R-squared 0.302602 Adjusted R-squared 0.297952 S.E. of regression 0.023630 Sum squared resid 0.083758 Log likelihood 354.6033 Durbin-Watson stat 1.952596

Std. Error t-Statistic 0.001917 -2.954767 0.071077 8.067534 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.0036 0.0000 -0.005959 0.028202 -4.639517 -4.599729 65.08511 0.000000

Conclusion: There is no sufficient evidence to reject Ho, both variables are redundant. Portfolio 8
Redundant Variables: F1 F3 F-statistic Log likelihood ratio 6.851716 13.45986 Probability Probability 0.001426 0.001195

Test Equation: Dependent Variable: P8 Method: Least Squares Date: 04/25/03 Time: 14:27 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C -0.001871 F2 0.548586 R-squared 0.210416 Adjusted R-squared 0.205152 S.E. of regression 0.028847 Sum squared resid 0.124821 Log likelihood 324.2830 Durbin-Watson stat 2.298967

Std. Error t-Statistic 0.002340 -0.799487 0.086768 6.322451 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.4253 0.0000 -0.002153 0.032356 -4.240566 -4.200778 39.97338 0.000000

Conclusion: There is sufficient evidence to reject Ho, either or both variables are significant.

167

Portfolio 9
Redundant Variables: F1 F3 F-statistic Log likelihood ratio 4.619808 9.204904 Probability Probability 0.011318 0.010027

Test Equation: Dependent Variable: P9 Method: Least Squares Date: 04/25/03 Time: 14:27 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C -0.000639 F2 0.593772 R-squared 0.271538 Adjusted R-squared 0.266682 S.E. of regression 0.026400 Sum squared resid 0.104542 Log likelihood 337.7566 Durbin-Watson stat 2.031500

Std. Error t-Statistic 0.002142 -0.298163 0.079408 7.477518 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.7660 0.0000 -0.000943 0.030829 -4.417850 -4.378062 55.91328 0.000000

Conclusion: There is sufficient evidence to reject Ho, either or both variables are significant. Portfolio 10
Redundant Variables: F1 F3 F-statistic Log likelihood ratio 12.57348 23.85313 Probability Probability 0.000009 0.000007

Test Equation: Dependent Variable: P10 Method: Least Squares Date: 04/25/03 Time: 14:24 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C -0.003453 F2 1.171136 R-squared 0.529182 Adjusted R-squared 0.526043 S.E. of regression 0.029986 Sum squared resid 0.134878 Log likelihood 318.3938 Durbin-Watson stat 2.391936

Std. Error t-Statistic 0.002433 -1.419261 0.090196 12.98439 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.1579 0.0000 -0.004054 0.043557 -4.163076 -4.123288 168.5945 0.000000

Conclusion: There is sufficient evidence to reject Ho, either or both variables are significant.

168

Appendix No 8 Results of the residual tests on the model R p ,t = 0 + 1 F1,t + 2 F2,t + 3 F3,t + t 4. Autocorrelation Ho: errors are independent H1: errors are autocorrelated Level of significance =0.05 LaGrange Multiplier with four lags test statistics Portfolio 1
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 1.230697 5.024507 Probability Probability 0.300481 0.284792

Portfolio 2
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 2.857992 11.17955 Probability Probability 0.025718 0.024619

Portfolio 3
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 1.213874 4.958067 Probability Probability 0.307529 0.291627

Portfolio 4
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 3.158425 12.25996 Probability Probability 0.015971 0.015519

Portfolio 5
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 2.908010 11.36058 Probability Probability 0.023762 0.022797

Portfolio 6
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 0.703692 2.914182 Probability Probability 0.590647 0.572288

169

Portfolio 7
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 0.529102 2.201630 Probability Probability 0.714520 0.698731

Portfolio 8
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 1.789412 7.197535 Probability Probability 0.134124 0.125810

Portfolio 9
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 0.399189 1.666979 Probability Probability 0.808982 0.796707

Portfolio 10
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 3.350398 12.94169 Probability Probability 0.011764 0.011564

5. Heteroskedasticity Ho: the variance of t is constant H1: the variance of t is not constant Level of significance =0.05 2 test statistics Portfolio 1
White Heteroskedasticity Test: F-statistic Obs*R-squared 1.318419 7.863411 Probability Probability 0.252544 0.248282

Portfolio 2
White Heteroskedasticity Test: F-statistic Obs*R-squared 0.531442 3.270661 Probability Probability 0.783704 0.774189

170

Portfolio 3
White Heteroskedasticity Test: F-statistic Obs*R-squared 2.381517 13.63523 Probability Probability 0.031787 0.033987

Portfolio 4
White Heteroskedasticity Test: F-statistic Obs*R-squared 0.420098 2.597127 Probability Probability 0.864734 0.857443

Portfolio 5
White Heteroskedasticity Test: F-statistic Obs*R-squared 0.192120 1.198838 Probability Probability 0.978629 0.976942

Portfolio 6
White Heteroskedasticity Test: F-statistic Obs*R-squared 0.959063 5.801926 Probability Probability 0.455233 0.445740

Portfolio 7
White Heteroskedasticity Test: F-statistic Obs*R-squared 0.599668 3.680383 Probability Probability 0.730247 0.719836

Portfolio 8
White Heteroskedasticity Test: F-statistic Obs*R-squared 2.511336 14.30853 Probability Probability 0.024239 0.026373

Portfolio 9
White Heteroskedasticity Test: F-statistic Obs*R-squared 0.731242 4.464184 Probability Probability 0.625184 0.614122

Portfolio 10
White Heteroskedasticity Test: F-statistic Obs*R-squared 1.076716 6.483314 Probability Probability 0.379176 0.371278

171

6. Distribution of the residuals graphically and statistically Ho: t have normal distribution H1: t have not normal distribution Level of significance =0.05 2 test statistics

Portfolio 1
16 14 12 10 8 6 4 2 0 -0.05 0.00 0.05 Series: Residuals Sample 2/03/2000 12/26/2002 O bservations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability 1.75E-18 -0.002448 0.091168 -0.067661 0.028739 0.645623 3.882293 15.48980 0.000433

Portfolio 2
28 24 20 16 12 8 4 0 -0.05 0.00 0.05 0.10 Series: Residuals Sample 2/03/2000 12/26/2002 O bservations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability 2.92E-18 -0.001358 0.134339 -0.084265 0.030867 0.543737 5.062900 34.44166 0.000000

172

Portfolio 3
20 Series: R esiduals Sample 2/03/2000 12/26/2002 O bservations 152 M ean M edian M aximum M inimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -0.05 0.00 0.05 1.95E-18 -0.002441 0.073214 -0.066815 0.023926 0.450151 3.958209 10.94848 0.004193

16

12

Portfolio 4
28 24 20 16 12 8 4 0 -0.10 Series: Residuals Sample 2/03/2000 12/26/2002 Observations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -0.05 0.00 0.05 0.10 0.15 0.20 1.51E-18 0.000489 0.229060 -0.095902 0.031652 2.152003 20.14395 1978.783 0.000000

Portfolio 5
35 30 25 20 15 10 5 0 -0.05 0.00 0.05 0.10 0.15 Series: Residuals Sample 2/03/2000 12/26/2002 O bservations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -9.59E-19 -0.000110 0.186205 -0.065530 0.027035 2.031336 16.91937 1331.609 0.000000

173

Portfolio 6
20 Series: Residuals Sample 2/03/2000 12/26/2002 O bservations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -0.05 0.00 0.05 1.60E-19 3.85E-05 0.088406 -0.085643 0.022250 0.351991 5.973343 59.13030 0.000000

16

12

Portfolio 7
32 28 24 20 16 12 8 4 0 -0.05 0.00 0.05 0.10 0.15 Series: Residuals Sample 2/03/2000 12/26/2002 O bservations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability 7.85E-19 -0.000272 0.142107 -0.077373 0.023122 1.162156 11.51972 493.9244 0.000000

Portfolio 8
32 28 24 20 16 12 8 4 0 -0.10 -0.05 0.00 0.05 Series: Residuals Sample 2/03/2000 12/26/2002 Observations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -5.71E-20 0.001506 0.080765 -0.118237 0.027506 -0.201049 5.180095 31.12514 0.000000

174

Portfolio 9
20 Series: R esiduals Sample 2/03/2000 12/26/2002 O bservations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -0.05 0.00 0.05 0.10 -1.34E-18 -0.001641 0.115874 -0.066109 0.025527 0.629736 5.381907 45.97843 0.000000

16

12

Portfolio 10
35 30 25 20 15 10 5 0 -0.10 Series: R esiduals Sample 2/03/2000 12/26/2002 O bservations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -0.05 0.00 0.05 0.10 -1.39E-18 0.000806 0.107117 -0.090970 0.027632 -0.085925 5.025290 26.16510 0.000002

175

Appendix No 9 Changes in the estimation output after including errors correction techniques for portfolios R p ,t = 0 + 1 F1,t + 2 F2,t + 3 F3,t + t Portfolio 2
Dependent Variable: P2 Method: Least Squares Date: 04/27/03 Time: 11:58 Sample(adjusted): 2/17/2000 12/26/2002 Included observations: 150 after adjusting endpoints Convergence achieved after 7 iterations Variable Coefficient Std. Error t-Statistic Prob. C -0.004227 0.001947 -2.170725 0.0316 F1 -0.441216 0.189685 -2.326050 0.0214 F2 0.443532 0.116142 3.818865 0.0002 F3 -0.240978 0.169701 -1.420015 0.1577 AR(2) -0.292197 0.082286 -3.551009 0.0005 R-squared 0.130171 Mean dependent var -0.005365 Adjusted R-squared 0.106176 S.D. dependent var 0.032105 S.E. of regression 0.030353 Akaike info criterion -4.119087 Sum squared resid 0.133588 Schwarz criterion -4.018733 Log likelihood 313.9315 F-statistic 5.424870 Durbin-Watson stat 2.134371 Prob(F-statistic) 0.000424

Portfolio 3
Dependent Variable: P3 Method: Least Squares Date: 04/27/03 Time: 12:07 Sample: 2/03/2000 12/26/2002 Included observations: 152 Newey-West HAC Standard Errors & Covariance (lag truncation=4) Variable Coefficient Std. Error t-Statistic C 0.001453 0.002277 0.638240 F1 0.018577 0.163333 0.113738 F2 0.569930 0.111925 5.092062 F3 -0.047475 0.133874 -0.354626 R-squared 0.277215 Mean dependent var Adjusted R-squared 0.262564 S.D. dependent var S.E. of regression 0.024167 Akaike info criterion Sum squared resid 0.086438 Schwarz criterion Log likelihood 352.2095 F-statistic Durbin-Watson stat 1.831629 Prob(F-statistic)

Prob. 0.5243 0.9096 0.0000 0.7234 0.001207 0.028142 -4.581704 -4.502128 18.92116 0.000000

Portfolio 4
Dependent Variable: P4 Method: Least Squares Date: 04/27/03 Time: 12:06 Sample(adjusted): 2/17/2000 12/26/2002 Included observations: 150 after adjusting endpoints Convergence achieved after 8 iterations Variable Coefficient Std. Error t-Statistic Prob. C -0.000234 0.002075 -0.112664 0.9105 F1 -0.004101 0.194645 -0.021067 0.9832 F2 0.370791 0.119380 3.105966 0.0023 F3 -0.076247 0.174904 -0.435935 0.6635 AR(2) -0.245680 0.080786 -3.041131 0.0028 R-squared 0.113468 Mean dependent var -0.000597 Adjusted R-squared 0.089012 S.D. dependent var 0.032713 S.E. of regression 0.031223 Akaike info criterion -4.062527 Sum squared resid 0.141361 Schwarz criterion -3.962173 Log likelihood 309.6896 F-statistic 4.639671 Durbin-Watson stat 2.138995 Prob(F-statistic) 0.001489

176

Portfolio 5
Dependent Variable: P5 Method: Least Squares Date: 04/27/03 Time: 11:56 Sample(adjusted): 2/10/2000 12/26/2002 Included observations: 151 after adjusting endpoints Convergence achieved after 5 iterations Variable Coefficient Std. Error t-Statistic C 0.000284 0.001715 0.165429 F1 -0.183777 0.148259 -1.239563 F2 0.309504 0.099968 3.096037 F3 -0.144080 0.136542 -1.055208 AR(1) -0.255977 0.080109 -3.195379 R-squared 0.147579 Mean dependent var Adjusted R-squared 0.124225 S.D. dependent var S.E. of regression 0.026008 Akaike info criterion Sum squared resid 0.098759 Schwarz criterion Log likelihood 339.3333 F-statistic Durbin-Watson stat 1.958521 Prob(F-statistic) Inverted AR Roots -.26

Prob. 0.8688 0.2171 0.0024 0.2931 0.0017 -0.000346 0.027792 -4.428255 -4.328345 6.319203 0.000102

Portfolio 8
Dependent Variable: P8 Method: Least Squares Date: 04/27/03 Time: 12:07 Sample: 2/03/2000 12/26/2002 Included observations: 152 Newey-West HAC Standard Errors & Covariance (lag truncation=4) Variable Coefficient Std. Error t-Statistic C -0.000667 0.002201 -0.303270 F1 -0.580418 0.188491 -3.079286 F2 0.556596 0.138224 4.026762 F3 -0.013661 0.200942 -0.067985 R-squared 0.277328 Mean dependent var Adjusted R-squared 0.262680 S.D. dependent var S.E. of regression 0.027783 Akaike info criterion Sum squared resid 0.114243 Schwarz criterion Log likelihood 331.0129 F-statistic Durbin-Watson stat 2.229662 Prob(F-statistic)

Prob. 0.7621 0.0025 0.0001 0.9459 -0.002153 0.032356 -4.302802 -4.223226 18.93188 0.000000

Portfolio 10
Dependent Variable: P10 Method: Least Squares Date: 04/27/03 Time: 11:57 Sample(adjusted): 2/10/2000 12/26/2002 Included observations: 151 after adjusting endpoints Convergence achieved after 7 iterations Variable Coefficient Std. Error t-Statistic Prob. C -0.002491 0.001714 -1.453504 0.1482 F1 -0.624755 0.148029 -4.220500 0.0000 F2 0.996932 0.101094 9.861402 0.0000 F3 0.405940 0.138028 2.940997 0.0038 AR(1) -0.282885 0.079962 -3.537753 0.0005 R-squared 0.627337 Mean dependent var -0.004737 Adjusted R-squared 0.617127 S.D. dependent var 0.042878 S.E. of regression 0.026532 Akaike info criterion -4.388414 Sum squared resid 0.102773 Schwarz criterion -4.288504 Log likelihood 336.3253 F-statistic 61.44379 Durbin-Watson stat 1.971545 Prob(F-statistic) 0.000000 Inverted AR Roots -.28

177

Appendix No 10 Results of the time-series regression R p ,t = 0 + 1 F1,t + 2 F2,t + t Portfolio 1

Dependent Variable: P1 Method: Least Squares Date: 04/27/03 Time: 14:43 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C -0.002461 F1 -0.002219 F2 0.325305 R-squared 0.085398 Adjusted R-squared 0.073122 S.E. of regression 0.028995 Sum squared resid 0.125266 Log likelihood 324.0121 Durbin-Watson stat 2.225976

Std. Error t-Statistic 0.002376 -1.035735 0.162959 -0.013617 0.087215 3.729936 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.3020 0.9892 0.0003 -0.002633 0.030117 -4.223844 -4.164162 6.956216 0.001294

Portfolio 2
Dependent Variable: P2 Method: Least Squares Date: 04/27/03 Time: 14:42 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C -0.004648 F1 -0.252803 F2 0.266438 R-squared 0.063895 Adjusted R-squared 0.051330 S.E. of regression 0.031098 Sum squared resid 0.144093 Log likelihood 313.3706 Durbin-Watson stat 2.124975

Std. Error t-Statistic 0.002549 -1.823641 0.174776 -1.446439 0.093539 2.848401 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.0702 0.1502 0.0050 -0.005308 0.031928 -4.083824 -4.024142 5.085096 0.007306

Portfolio 3
Dependent Variable: P3 Method: Least Squares Date: 04/27/03 Time: 14:43 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C 0.001431 F1 0.027512 F2 0.546731 R-squared 0.276533 Adjusted R-squared 0.266822 S.E. of regression 0.024097 Sum squared resid 0.086519 Log likelihood 352.1378 Durbin-Watson stat 1.818690

Std. Error t-Statistic 0.001975 0.724638 0.135430 0.203143 0.072482 7.543014 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.4698 0.8393 0.0000 0.001207 0.028142 -4.593919 -4.534237 28.47631 0.000000

178

Portfolio 4
Dependent Variable: P4 Method: Least Squares Date: 04/27/03 Time: 14:44 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C -0.000275 F1 0.046884 F2 0.287802 R-squared 0.057346 Adjusted R-squared 0.044693 S.E. of regression 0.031913 Sum squared resid 0.151750 Log likelihood 309.4358 Durbin-Watson stat 2.134060

Std. Error t-Statistic 0.002616 -0.105102 0.179360 0.261396 0.095992 2.998177 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.9164 0.7941 0.0032 -0.000326 0.032651 -4.032050 -3.972369 4.532165 0.012282

Portfolio 5
Dependent Variable: P5 Method: Least Squares Date: 04/27/03 Time: 14:44 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C 0.000828 F1 -0.252106 F2 0.273863 R-squared 0.084248 Adjusted R-squared 0.071956 S.E. of regression 0.027367 Sum squared resid 0.111597 Log likelihood 332.7940 Durbin-Watson stat 2.461815

Std. Error t-Statistic 0.002243 0.369177 0.153810 -1.639073 0.082319 3.326863 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.7125 0.1033 0.0011 0.000165 0.028408 -4.339395 -4.279713 6.853878 0.001421

Portfolio 6
Dependent Variable: P6 Method: Least Squares Date: 04/27/03 Time: 14:44 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C -0.003448 F1 0.005516 F2 0.234861 R-squared 0.073755 Adjusted R-squared 0.061323 S.E. of regression 0.022672 Sum squared resid 0.076586 Log likelihood 361.4065 Durbin-Watson stat 2.240875

Std. Error t-Statistic 0.001858 -1.855581 0.127419 0.043291 0.068194 3.444018 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.0655 0.9655 0.0007 -0.003557 0.023400 -4.715876 -4.656194 5.932321 0.003319

179

Portfolio 7
Dependent Variable: P7 Method: Least Squares Date: 04/27/03 Time: 14:44 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C -0.005036 F1 -0.303347 F2 0.574115 R-squared 0.326858 Adjusted R-squared 0.317823 S.E. of regression 0.023293 Sum squared resid 0.080844 Log likelihood 357.2937 Durbin-Watson stat 1.889881

Std. Error t-Statistic 0.001909 -2.637866 0.130914 -2.317151 0.070064 8.194112 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.0092 0.0219 0.0000 -0.005959 0.028202 -4.661760 -4.602078 36.17505 0.000000

Portfolio 8
Dependent Variable: P8 Method: Least Squares Date: 04/27/03 Time: 14:45 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C -0.000674 F1 -0.577847 F2 0.549921 R-squared 0.277286 Adjusted R-squared 0.267585 S.E. of regression 0.027691 Sum squared resid 0.114249 Log likelihood 331.0084 Durbin-Watson stat 2.230032

Std. Error t-Statistic 0.002269 -0.296879 0.155628 -3.713004 0.083291 6.602379 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.7670 0.0003 0.0000 -0.002153 0.032356 -4.315901 -4.256219 28.58361 0.000000

Portfolio 9
Dependent Variable: P9 Method: Least Squares Date: 04/27/03 Time: 14:45 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C 0.000249 F1 -0.428349 F2 0.594761 R-squared 0.312015 Adjusted R-squared 0.302780 S.E. of regression 0.025742 Sum squared resid 0.098734 Log likelihood 342.1014 Durbin-Watson stat 2.039310

Std. Error t-Statistic 0.002110 0.117980 0.144675 -2.960777 0.077429 7.681358 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.9062 0.0036 0.0000 -0.000943 0.030829 -4.461860 -4.402179 33.78718 0.000000

180

Portfolio 10
Dependent Variable: P10 Method: Least Squares Date: 04/27/03 Time: 14:45 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C -0.001983 F1 -0.709376 F2 1.172775 R-squared 0.584793 Adjusted R-squared 0.579220 S.E. of regression 0.028254 Sum squared resid 0.118946 Log likelihood 327.9465 Durbin-Watson stat 2.431763

Std. Error t-Statistic 0.002316 -0.856292 0.158795 -4.467258 0.084986 13.79960 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.3932 0.0000 0.0000 -0.004054 0.043557 -4.275612 -4.215931 104.9286 0.000000

181

Appendix No 11 Results of the time-series regression R p ,t = 0 + 2 F2,t + t

Portfolio 1
Dependent Variable: P1 Method: Least Squares Date: 04/27/03 Time: 12:30 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C -0.002466 F2 0.325300 R-squared 0.085397 Adjusted R-squared 0.079300 S.E. of regression 0.028898 Sum squared resid 0.125266 Log likelihood 324.0120 Durbin-Watson stat 2.226116

Std. Error t-Statistic 0.002344 -1.051815 0.086923 3.742406 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.2946 0.0003 -0.002633 0.030117 -4.237000 -4.197212 14.00560 0.000259

Portfolio 2
Dependent Variable: P2 Method: Least Squares Date: 04/27/03 Time: 12:31 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C -0.005172 F2 0.265853 R-squared 0.050751 Adjusted R-squared 0.044422 S.E. of regression 0.031211 Sum squared resid 0.146117 Log likelihood 312.3109 Durbin-Watson stat 2.137451

Std. Error t-Statistic 0.002532 -2.042522 0.093878 2.831892 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.0429 0.0053 -0.005308 0.031928 -4.083038 -4.043250 8.019615 0.005263

Portfolio 3
Dependent Variable: P3 Method: Least Squares Date: 04/27/03 Time: 12:31 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C 0.001488 F2 0.546794 R-squared 0.276332 Adjusted R-squared 0.271508 S.E. of regression 0.024020 Sum squared resid 0.086543 Log likelihood 352.1168 Durbin-Watson stat 1.812175

Std. Error t-Statistic 0.001949 0.763667 0.072249 7.568186 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.4463 0.0000 0.001207 0.028142 -4.606799 -4.567012 57.27744 0.000000

182

Portfolio 4
Dependent Variable: P4 Method: Least Squares Date: 04/27/03 Time: 12:31 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C -0.000178 F2 0.287911 R-squared 0.056914 Adjusted R-squared 0.050626 S.E. of regression 0.031814 Sum squared resid 0.151820 Log likelihood 309.4010 Durbin-Watson stat 2.135425

Std. Error t-Statistic 0.002581 -0.068874 0.095693 3.008692 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.9452 0.0031 -0.000326 0.032651 -4.044750 -4.004962 9.052227 0.003078

Portfolio 5
Dependent Variable: P5 Method: Least Squares Date: 04/27/03 Time: 12:32 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C 0.000306 F2 0.273280 R-squared 0.067736 Adjusted R-squared 0.061521 S.E. of regression 0.027521 Sum squared resid 0.113609 Log likelihood 331.4359 Durbin-Watson stat 2.492303

Std. Error t-Statistic 0.002233 0.136930 0.082779 3.301311 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.8913 0.0012 0.000165 0.028408 -4.334683 -4.294895 10.89865 0.001203

Portfolio 6
Dependent Variable: P6 Method: Least Squares Date: 04/27/03 Time: 12:32 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C -0.003436 F2 0.234874 R-squared 0.073744 Adjusted R-squared 0.067569 S.E. of regression 0.022596 Sum squared resid 0.076587 Log likelihood 361.4056 Durbin-Watson stat 2.242984

Std. Error t-Statistic 0.001833 -1.874631 0.067966 3.455754 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.0628 0.0007 -0.003557 0.023400 -4.729021 -4.689233 11.94223 0.000714

183

Portfolio 7
Dependent Variable: P7 Method: Least Squares Date: 04/27/03 Time: 12:32 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C -0.005664 F2 0.573414 R-squared 0.302602 Adjusted R-squared 0.297952 S.E. of regression 0.023630 Sum squared resid 0.083758 Log likelihood 354.6033 Durbin-Watson stat 1.952596

Std. Error t-Statistic 0.001917 -2.954767 0.071077 8.067534 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.0036 0.0000 -0.005959 0.028202 -4.639517 -4.599729 65.08511 0.000000

Portfolio 8
Dependent Variable: P8 Method: Least Squares Date: 04/27/03 Time: 12:32 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C -0.001871 F2 0.548586 R-squared 0.210416 Adjusted R-squared 0.205152 S.E. of regression 0.028847 Sum squared resid 0.124821 Log likelihood 324.2830 Durbin-Watson stat 2.298967

Std. Error t-Statistic 0.002340 -0.799487 0.086768 6.322451 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.4253 0.0000 -0.002153 0.032356 -4.240566 -4.200778 39.97338 0.000000

Portfolio 9
Dependent Variable: P9 Method: Least Squares Date: 04/27/03 Time: 12:33 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C -0.000639 F2 0.593772 R-squared 0.271538 Adjusted R-squared 0.266682 S.E. of regression 0.026400 Sum squared resid 0.104542 Log likelihood 337.7566 Durbin-Watson stat 2.031500

Std. Error t-Statistic 0.002142 -0.298163 0.079408 7.477518 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.7660 0.0000 -0.000943 0.030829 -4.417850 -4.378062 55.91328 0.000000

Portfolio 10
Dependent Variable: P10 Method: Least Squares Date: 04/27/03 Time: 12:33 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C -0.003453 F2 1.171136 R-squared 0.529182 Adjusted R-squared 0.526043 S.E. of regression 0.029986 Sum squared resid 0.134878 Log likelihood 318.3938 Durbin-Watson stat 2.391936

Std. Error t-Statistic 0.002433 -1.419261 0.090196 12.98439 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.1579 0.0000 -0.004054 0.043557 -4.163076 -4.123288 168.5945 0.000000

184

Appendix No 12 Results of the residual tests on the model R p ,t = 0 + 1 F1,t + 2 F2,t + t 7. Autocorrelation Ho: errors are independent H1: errors are autocorrelated Level of significance =0.05 LaGrange Multiplier with four lags test statistics Portfolio 1
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 1.221666 4.955562 Probability Probability 0.304213 0.291888

Portfolio 2
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 2.583442 10.11198 Probability Probability 0.039588 0.038583

Portfolio 3
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 1.216437 4.935041 Probability Probability 0.306412 0.294028

Portfolio 4
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 3.204688 12.34613 Probability Probability 0.014819 0.014955

Portfolio 5
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 3.136997 12.10612 Probability Probability 0.016505 0.016579

Portfolio 6
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 0.948356 3.875175 Probability Probability 0.437979 0.423163

Portfolio 7
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 0.550034 2.271877 Probability Probability 0.699286 0.685894

185

Portfolio 8
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 1.827581 7.295431 Probability Probability 0.126635 0.121076

Portfolio 9
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 0.325481 1.352629 Probability Probability 0.860524 0.852385

Portfolio 10
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 2.464720 9.676872 Probability Probability 0.047666 0.046237

8. Heteroskedasticity Ho: the variance of t is constant H1: the variance of t is not constant Level of significance =0.05 2 test statistics Portfolio 1
White Heteroskedasticity Test: F-statistic Obs*R-squared 1.564152 6.205307 Probability Probability 0.186912 0.184331

Portfolio 2
White Heteroskedasticity Test: F-statistic Obs*R-squared 0.401352 1.642082 Probability Probability 0.807440 0.801210

Portfolio 3
White Heteroskedasticity Test: F-statistic Obs*R-squared 3.266385 12.40718 Probability Probability 0.013397 0.014567

186

Portfolio 4
White Heteroskedasticity Test: F-statistic Obs*R-squared 0.535495 2.183026 Probability Probability 0.709858 0.702138

Portfolio 5
White Heteroskedasticity Test: F-statistic Obs*R-squared 0.229889 0.944923 Probability Probability 0.921252 0.918029

Portfolio 6
White Heteroskedasticity Test: F-statistic Obs*R-squared 1.138313 4.566673 Probability Probability 0.340834 0.334715

Portfolio 7
White Heteroskedasticity Test: F-statistic Obs*R-squared 0.759964 3.079570 Probability Probability 0.552948 0.544599

Portfolio 8
White Heteroskedasticity Test: F-statistic Obs*R-squared 3.392238 12.84483 Probability Probability 0.010957 0.012059

Portfolio 9
White Heteroskedasticity Test: F-statistic Obs*R-squared 0.329949 1.352542 Probability Probability 0.857494 0.852400

Portfolio 10
White Heteroskedasticity Test: F-statistic Obs*R-squared 0.794805 3.217765 Probability Probability 0.530340 0.522066

187

9. Distribution of the residuals graphically and statistically Ho: t have normal distribution H1: t have not normal distribution Level of significance =0.05 2 test statistics

Portfolio 1
16 Series: Residuals Sample 2/03/2000 12/26/2002 Observations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -0.05 0.00 0.05 9.42E-19 -0.003479 0.092160 -0.066990 0.028802 0.679189 3.881913 16.61210 0.000247

12

Portfolio 2

28 24 20 16 12 8 4 0 -0.05 0.00 0.05 0.10 Series: Residuals Sample 2/03/2000 12/26/2002 Observations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability 1.42E-18 -0.001756 0.134557 -0.084296 0.030891 0.553401 5.055777 34.52446 0.000000

188

Portfolio 3
16 Series: Residuals Sample 2/03/2000 12/26/2002 O bservations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -0.05 0.00 0.05 -6.85E-19 -0.002047 0.072850 -0.066660 0.023937 0.434671 3.947705 10.47470 0.005314

12

Portfolio 4
35 30 25 20 15 10 5 0 -0.10 Series: Residuals Sample 2/03/2000 12/26/2002 Observations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -0.05 0.00 0.05 0.10 0.15 0.20 1.20E-18 0.000921 0.229186 -0.096381 0.031701 2.156819 20.06758 1962.761 0.000000

Portfolio 5
35 30 25 20 15 10 5 0 -0.05 0.00 0.05 0.10 0.15 Series: Residuals Sample 2/03/2000 12/26/2002 Observations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -1.83E-19 0.000244 0.187494 -0.064967 0.027185 2.047667 16.99754 1347.119 0.000000

189

Portfolio 6
25 Series: Residuals Sample 2/03/2000 12/26/2002 O bservations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -0.05 0.00 0.05 1.96E-18 -0.000370 0.090224 -0.084416 0.022521 0.321071 6.028512 60.70014 0.000000

20

15

10

Portfolio 7
32 28 24 20 16 12 8 4 0 -0.05 0.00 0.05 0.10 0.15 Series: R esiduals Sample 2/03/2000 12/26/2002 O bservations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability 1.01E-18 -0.000426 0.141857 -0.077827 0.023139 1.149837 11.43901 484.5342 0.000000

Portfolio 8
30 25 20 15 10 5 0 -0.10 -0.05 0.00 0.05 Series: Residuals Sample 2/03/2000 12/26/2002 Observations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability 2.29E-18 0.001273 0.080020 -0.118162 0.027507 -0.208482 5.158508 30.60910 0.000000

190

Portfolio 9
20 Series: R esiduals Sample 2/03/2000 12/26/2002 O bservations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -0.05 0.00 0.05 0.10 1.03E-19 -0.000690 0.116650 -0.064966 0.025571 0.646268 5.425238 47.83205 0.000000

16

12

Portfolio 10
35 30 25 20 15 10 5 0 -0.10 Series: Residuals Sample 2/03/2000 12/26/2002 O bservations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -0.05 0.00 0.05 0.10 -7.65E-19 -0.000572 0.119703 -0.090422 0.028066 0.083934 5.681180 45.70708 0.000000

191

Appendix No 13 Results of the residual tests on the model R p ,t = 0 + 2 F2,t + t 10. Autocorrelation Ho: errors are independent H1: errors are autocorrelated Level of significance =0.05 LaGrange Multiplier with four lags test statistics Portfolio 1
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 1.227993 4.947387 Probability Probability 0.301535 0.292739

Portfolio 2
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 2.130591 8.383248 Probability Probability 0.079915 0.078506

Portfolio 3
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 1.206500 4.863565 Probability Probability 0.310594 0.301585

Portfolio 4
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 3.296958 12.59236 Probability Probability 0.012776 0.013449

Portfolio 5
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 3.567267 13.53286 Probability Probability 0.008294 0.008945

Portfolio 6
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 0.951795 3.862908 Probability Probability 0.436029 0.424877

192

Portfolio 7
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 1.131437 4.570075 Probability Probability 0.344048 0.334319

Portfolio 8
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 3.117081 11.95940 Probability Probability 0.017016 0.017656

Portfolio 9
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 0.177065 0.733805 Probability Probability 0.949920 0.947096

Portfolio 10
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 1.944017 7.686257 Probability Probability 0.106215 0.103771

11. Heteroskedasticity Ho: the variance of t is constant H1: the variance of t is not constant Level of significance =0.05 2 test statistics Portfolio 1
White Heteroskedasticity Test: F-statistic Obs*R-squared 2.184002 4.329043 Probability Probability 0.116181 0.114805

Portfolio 2
White Heteroskedasticity Test: F-statistic Obs*R-squared 0.101959 0.207738 Probability Probability 0.903130 0.901343

193

Portfolio 3
White Heteroskedasticity Test: F-statistic Obs*R-squared 5.250751 10.00761 Probability Probability 0.006258 0.006712

Portfolio 4
White Heteroskedasticity Test: F-statistic Obs*R-squared 0.704061 1.423026 Probability Probability 0.496210 0.490901

Portfolio 5
White Heteroskedasticity Test: F-statistic Obs*R-squared 0.483996 0.981108 Probability Probability 0.617281 0.612287

Portfolio 6
White Heteroskedasticity Test: F-statistic Obs*R-squared 2.205713 4.370839 Probability Probability 0.113757 0.112431

Portfolio 7
White Heteroskedasticity Test: F-statistic Obs*R-squared 1.263923 2.535723 Probability Probability 0.285555 0.281433

Portfolio 8
White Heteroskedasticity Test: F-statistic Obs*R-squared 3.975636 7.700437 Probability Probability 0.020792 0.021275

Portfolio 9
White Heteroskedasticity Test: F-statistic Obs*R-squared 0.505932 1.025274 Probability Probability 0.603976 0.598914

Portfolio 10
White Heteroskedasticity Test: F-statistic Obs*R-squared 1.613802 3.222778 Probability Probability 0.202590 0.199610

194

12. Distribution of the residuals graphically and statistically Ho: t have normal distribution H1: t have not normal distribution Level of significance =0.05 2 test statistics

Portfolio 1
16 Series: Residuals Sample 2/03/2000 12/26/2002 Observations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -0.05 0.00 0.05 1.12E-18 -0.003514 0.092148 -0.066939 0.028802 0.679665 3.882553 16.63563 0.000244

12

Portfolio 2
28 24 20 16 12 8 4 0 -0.05 0.00 0.05 0.10 Series: Residuals Sample 2/03/2000 12/26/2002 Observations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability 1.83E-18 -0.001119 0.137575 -0.083235 0.031107 0.584540 5.155906 38.09296 0.000000

195

Portfolio 3
20 Series: Residuals Sample 2/03/2000 12/26/2002 Observations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -0.05 0.00 0.05 2.18E-18 -0.002054 0.073120 -0.066883 0.023940 0.440341 3.980442 11.00015 0.004086

16

12

Portfolio 4
32 28 24 20 16 12 8 4 0 -0.10 Series: Residuals Sample 2/03/2000 12/26/2002 Observations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -0.05 0.00 0.05 0.10 0.15 0.20 9.36E-19 0.001140 0.229598 -0.095765 0.031708 2.170166 20.17607 1987.753 0.000000

Portfolio 5
35 30 25 20 15 10 5 0 -0.05 0.00 0.05 0.10 0.15 Series: Residuals Sample 2/03/2000 12/26/2002 O bservations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -3.65E-19 9.36E-05 0.186807 -0.065502 0.027429 1.976847 16.28152 1216.193 0.000000

196

Portfolio 6
24 20 16 12 8 4 0 -0.05 0.00 0.05 Series: Residuals Sample 2/03/2000 12/26/2002 O bservations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability 1.10E-18 -0.000362 0.090256 -0.084542 0.022521 0.321672 6.037644 61.06076 0.000000

Portfolio 7
35 30 25 20 15 10 5 0 -0.05 0.00 0.05 0.10 0.15 Series: Residuals Sample 2/03/2000 12/26/2002 Observations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability 1.23E-18 -0.000430 0.144663 -0.076491 0.023552 1.142220 11.34212 473.7944 0.000000

Portfolio 8
30 25 20 15 10 5 0 -0.10 -0.05 0.00 0.05 0.10 Series: Residuals Sample 2/03/2000 12/26/2002 O bservations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability 4.99E-19 0.000322 0.097024 -0.104901 0.028751 -0.144773 5.041746 26.93290 0.000001

197

Portfolio 9
20 Series: Residuals Sample 2/03/2000 12/26/2002 O bservations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -0.05 0.00 0.05 0.10 -6.16E-19 -4.55E-05 0.114180 -0.063706 0.026312 0.546633 5.047371 34.11740 0.000000

16

12

Portfolio 10
20 Series: Residuals Sample 2/03/2000 12/26/2002 O bservations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -0.05 0.00 0.05 0.10 -7.08E-19 0.002026 0.098345 -0.099663 0.029887 -0.099234 4.513454 14.75624 0.000625

16

12

0 -0.10

198

Appendix No 14 Changes in the estimation output after including errors correction techniques for portfolios R p ,t = 0 + 1 F1,t + 2 F2,t + 3 F3,t + t Portfolio 2
Dependent Variable: P2 Method: Least Squares Date: 04/27/03 Time: 15:03 Sample(adjusted): 2/17/2000 12/26/2002 Included observations: 150 after adjusting endpoints Convergence achieved after 6 iterations Variable Coefficient Std. Error t-Statistic Prob. C -0.004344 0.002002 -2.169308 0.0317 F1 -0.349877 0.182413 -1.918043 0.0571 F2 0.327616 0.086949 3.767915 0.0002 AR(2) -0.258986 0.082456 -3.140891 0.0020 R-squared 0.118860 Mean dependent var -0.005365 Adjusted R-squared 0.100754 S.D. dependent var 0.032105 S.E. of regression 0.030445 Akaike info criterion -4.119500 Sum squared resid 0.135325 Schwarz criterion -4.039216 Log likelihood 312.9625 F-statistic 6.564804 Durbin-Watson stat 2.110067 Prob(F-statistic) 0.000341

Portfolio 3
Dependent Variable: P3 Method: Least Squares Date: 04/27/03 Time: 15:03 Sample: 2/03/2000 12/26/2002 Included observations: 152 Newey-West HAC Standard Errors & Covariance (lag truncation=4) Variable Coefficient Std. Error t-Statistic C 0.001431 0.002297 0.623114 F1 0.027512 0.153856 0.178815 F2 0.546731 0.104342 5.239776 R-squared 0.276533 Mean dependent var Adjusted R-squared 0.266822 S.D. dependent var S.E. of regression 0.024097 Akaike info criterion Sum squared resid 0.086519 Schwarz criterion Log likelihood 352.1378 F-statistic Durbin-Watson stat 1.818690 Prob(F-statistic)

Prob. 0.5342 0.8583 0.0000 0.001207 0.028142 -4.593919 -4.534237 28.47631 0.000000

Portfolio 4
Dependent Variable: P4 Method: Least Squares Date: 04/27/03 Time: 15:03 Sample(adjusted): 2/17/2000 12/26/2002 Included observations: 150 after adjusting endpoints Convergence achieved after 8 iterations Variable Coefficient Std. Error t-Statistic Prob. C -0.000258 0.002067 -0.124845 0.9008 F1 0.020165 0.185548 0.108677 0.9136 F2 0.336209 0.089027 3.776471 0.0002 AR(2) -0.246599 0.080203 -3.074680 0.0025 R-squared 0.112300 Mean dependent var -0.000597 Adjusted R-squared 0.094059 S.D. dependent var 0.032713 S.E. of regression 0.031137 Akaike info criterion -4.074544 Sum squared resid 0.141548 Schwarz criterion -3.994260 Log likelihood 309.5908 F-statistic 6.156647 Durbin-Watson stat 2.153262 Prob(F-statistic) 0.000571

199

Portfolio 5
Dependent Variable: P5 Method: Least Squares Date: 04/27/03 Time: 15:03 Sample(adjusted): 2/10/2000 12/26/2002 Included observations: 151 after adjusting endpoints Convergence achieved after 5 iterations Variable Coefficient Std. Error t-Statistic C 0.000226 0.001705 0.132386 F1 -0.158216 0.145652 -1.086259 F2 0.239777 0.074553 3.216188 AR(1) -0.263201 0.079107 -3.327172 R-squared 0.141051 Mean dependent var Adjusted R-squared 0.123521 S.D. dependent var S.E. of regression 0.026019 Akaike info criterion Sum squared resid 0.099515 Schwarz criterion Log likelihood 338.7573 F-statistic Durbin-Watson stat 1.938473 Prob(F-statistic) Inverted AR Roots -.26

Prob. 0.8949 0.2791 0.0016 0.0011 -0.000346 0.027792 -4.433871 -4.353943 8.046443 0.000053

Portfolio 8
Dependent Variable: P8 Method: Least Squares Date: 04/27/03 Time: 15:03 Sample: 2/03/2000 12/26/2002 Included observations: 152 Newey-West HAC Standard Errors & Covariance (lag truncation=4) Variable Coefficient Std. Error t-Statistic C -0.000674 0.002215 -0.304214 F1 -0.577847 0.192162 -3.007083 F2 0.549921 0.101660 5.409397 R-squared 0.277286 Mean dependent var Adjusted R-squared 0.267585 S.D. dependent var S.E. of regression 0.027691 Akaike info criterion Sum squared resid 0.114249 Schwarz criterion Log likelihood 331.0084 F-statistic Durbin-Watson stat 2.230032 Prob(F-statistic)

Prob. 0.7614 0.0031 0.0000 -0.002153 0.032356 -4.315901 -4.256219 28.58361 0.000000

Portfolio 10
Dependent Variable: P10 Method: Least Squares Date: 04/27/03 Time: 15:04 Sample(adjusted): 2/10/2000 12/26/2002 Included observations: 151 after adjusting endpoints Convergence achieved after 6 iterations Variable Coefficient Std. Error t-Statistic Prob. C -0.002354 0.001822 -1.291448 0.1986 F1 -0.690301 0.151183 -4.566003 0.0000 F2 1.186652 0.080295 14.77870 0.0000 AR(1) -0.234029 0.080869 -2.893934 0.0044 R-squared 0.606223 Mean dependent var -0.004737 Adjusted R-squared 0.598186 S.D. dependent var 0.042878 S.E. of regression 0.027180 Akaike info criterion -4.346547 Sum squared resid 0.108596 Schwarz criterion -4.266619 Log likelihood 332.1643 F-statistic 75.43582 Durbin-Watson stat 2.008499 Prob(F-statistic) 0.000000 Inverted AR Roots -.23

200

Appendix No 15 Changes in the estimation output after including errors correction techniques for portfolios R p ,t = 0 + 2 F2,t + t Portfolio 3
Dependent Variable: P3 Method: Least Squares Date: 04/27/03 Time: 15:08 Sample: 2/03/2000 12/26/2002 Included observations: 152 Newey-West HAC Standard Errors & Covariance (lag truncation=4) Variable Coefficient Std. Error t-Statistic C 0.001488 0.002298 0.647573 F2 0.546794 0.104410 5.236996 R-squared 0.276332 Mean dependent var Adjusted R-squared 0.271508 S.D. dependent var S.E. of regression 0.024020 Akaike info criterion Sum squared resid 0.086543 Schwarz criterion Log likelihood 352.1168 F-statistic Durbin-Watson stat 1.812175 Prob(F-statistic)

Prob. 0.5183 0.0000 0.001207 0.028142 -4.606799 -4.567012 57.27744 0.000000

Portfolio 4
Dependent Variable: P4 Method: Least Squares Date: 04/27/03 Time: 15:08 Sample(adjusted): 2/17/2000 12/26/2002 Included observations: 150 after adjusting endpoints Convergence achieved after 6 iterations Variable Coefficient Std. Error t-Statistic C -0.000223 0.002032 -0.109607 F2 0.336301 0.088683 3.792188 AR(2) -0.247827 0.079788 -3.106071 R-squared 0.112229 Mean dependent var Adjusted R-squared 0.100151 S.D. dependent var S.E. of regression 0.031032 Akaike info criterion Sum squared resid 0.141559 Schwarz criterion Log likelihood 309.5848 F-statistic Durbin-Watson stat 2.154799 Prob(F-statistic)

Prob. 0.9129 0.0002 0.0023 -0.000597 0.032713 -4.087798 -4.027585 9.291634 0.000159

Portfolio 5
Dependent Variable: P5 Method: Least Squares Date: 04/27/03 Time: 15:09 Sample(adjusted): 2/10/2000 12/26/2002 Included observations: 151 after adjusting endpoints Convergence achieved after 5 iterations Variable Coefficient Std. Error t-Statistic C -0.000111 0.001665 -0.066925 F2 0.235964 0.074278 3.176758 AR(1) -0.273346 0.077689 -3.518460 R-squared 0.134096 Mean dependent var Adjusted R-squared 0.122394 S.D. dependent var S.E. of regression 0.026035 Akaike info criterion Sum squared resid 0.100321 Schwarz criterion Log likelihood 338.1484 F-statistic Durbin-Watson stat 1.912337 Prob(F-statistic) Inverted AR Roots -.27

Prob. 0.9467 0.0018 0.0006 -0.000346 0.027792 -4.439052 -4.379106 11.45977 0.000024

201

Portfolio 8
Dependent Variable: P8 Method: Least Squares Date: 04/27/03 Time: 15:09 Sample: 2/03/2000 12/26/2002 Included observations: 152 Newey-West HAC Standard Errors & Covariance (lag truncation=4) Variable Coefficient Std. Error t-Statistic C -0.001871 0.002264 -0.826437 F2 0.548586 0.110929 4.945370 R-squared 0.210416 Mean dependent var Adjusted R-squared 0.205152 S.D. dependent var S.E. of regression 0.028847 Akaike info criterion Sum squared resid 0.124821 Schwarz criterion Log likelihood 324.2830 F-statistic Durbin-Watson stat 2.298967 Prob(F-statistic)

Prob. 0.4099 0.0000 -0.002153 0.032356 -4.240566 -4.200778 39.97338 0.000000

Portfolio 10
Dependent Variable: P10 Method: Least Squares Date: 04/27/03 Time: 15:10 Sample(adjusted): 2/10/2000 12/26/2002 Included observations: 151 after adjusting endpoints Convergence achieved after 6 iterations Variable Coefficient Std. Error t-Statistic C -0.003838 0.001941 -1.977290 F2 1.171754 0.085242 13.74625 AR(1) -0.214009 0.080226 -2.667587 R-squared 0.550570 Mean dependent var Adjusted R-squared 0.544496 S.D. dependent var S.E. of regression 0.028939 Akaike info criterion Sum squared resid 0.123944 Schwarz criterion Log likelihood 322.1836 F-statistic Durbin-Watson stat 1.920530 Prob(F-statistic) Inverted AR Roots -.21

Prob. 0.0499 0.0000 0.0085 -0.004737 0.042878 -4.227597 -4.167651 90.65287 0.000000

202

Appendix No 16 Results of the Chow Breakpoint Test for the time-series models on 4 July 2002 Ho: Model is stable over the period H1: Model is different after 4 July 2002 Level of significance =0.05 F - test statistics
Portfolio 1 Chow Breakpoint Test: 7/04/2002 F-statistic Log likelihood ratio Portfolio 2 Chow Breakpoint Test: 7/04/2002 F-statistic Log likelihood ratio 1.219886 2.485294 Probability Probability 0.298215 0.288619 0.613151 1.254267 Probability Probability 0.543011 0.534121

Portfolio 3 Chow Breakpoint Test: 7/04/2002 F-statistic Log likelihood ratio 1.113439 2.270039 Probability Probability 0.331163 0.321416

Portfolio 4 Chow Breakpoint Test: 7/04/2002 F-statistic Log likelihood ratio 0.680438 1.391280 Probability Probability 0.507972 0.498755

Portfolio 5 Chow Breakpoint Test: 7/04/2002 F-statistic Log likelihood ratio 0.303882 0.622921 Probability Probability 0.738408 0.732377

Portfolio 6 Chow Breakpoint Test: 7/04/2002 F-statistic Log likelihood ratio 0.514891 1.053961 Probability Probability 0.598632 0.590385

Portfolio 7 Chow Breakpoint Test: 7/04/2002 F-statistic Log likelihood ratio 9.117991 17.66182 Probability Probability 0.000184 0.000146

Portfolio 8

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Chow Breakpoint Test: 7/04/2002 F-statistic Log likelihood ratio 0.996792 2.033807 Probability Probability 0.371525 0.361713

Portfolio 9 Chow Breakpoint Test: 7/04/2002 F-statistic Log likelihood ratio 1.437201 2.923797 Probability Probability 0.240888 0.231796

Portfolio 10 Chow Breakpoint Test: 7/04/2002 F-statistic Log likelihood ratio 3.914811 7.835757 Probability Probability 0.022043 0.019883

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Appendix No 17 Results of the time-series regression R p ,t = 0 + 1 F1,t + 2 F2,t + 3 F3,t + t , portfolios formed alphabetically. Portfolio 1
Dependent Variable: P1 Method: Least Squares Date: 04/29/03 Time: 08:29 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable C F1 F2 F3 R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat

Coefficient -0.003346 -0.020109 -0.027823 0.178185 0.018631 -0.001262 0.024062 0.085688 352.8714 1.996753

Std. Error t-Statistic 0.001973 -1.695996 0.137311 -0.146445 0.095171 -0.292343 0.126471 1.408901 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.0920 0.8838 0.7704 0.1610 -0.003405 0.024047 -4.590414 -4.510838 0.936560 0.424702

Portfolio 2
Dependent Variable: P2 Method: Least Squares Date: 04/29/03 Time: 08:29 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C -0.002377 F1 0.078409 F2 0.015397 F3 0.175062 R-squared 0.014133 Adjusted R-squared -0.005851 S.E. of regression 0.032949 Sum squared resid 0.160675 Log likelihood 305.0924 Durbin-Watson stat 2.106504

Std. Error t-Statistic 0.002702 -0.879871 0.188027 0.417009 0.130323 0.118145 0.173182 1.010851 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.3804 0.6773 0.9061 0.3137 -0.002254 0.032853 -3.961742 -3.882166 0.707204 0.549159

Portfolio 3
Dependent Variable: P3 Method: Least Squares Date: 04/29/03 Time: 08:29 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C -0.000834 F1 0.014168 F2 0.098606 F3 0.060672 R-squared 0.020600 Adjusted R-squared 0.000747 S.E. of regression 0.025040 Sum squared resid 0.092795 Log likelihood 346.8157 Durbin-Watson stat 2.091272

Std. Error t-Statistic 0.002053 -0.406276 0.142892 0.099149 0.099039 0.995626 0.131611 0.460993 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.6851 0.9212 0.3211 0.6455 -0.000866 0.025049 -4.510733 -4.431157 1.037627 0.377813

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Portfolio 4
Dependent Variable: P4 Method: Least Squares Date: 04/29/03 Time: 08:29 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable C F1 F2 F3 R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat

Coefficient -0.001317 0.078000 -0.089273 0.204282 0.007242 -0.012882 0.038167 0.215591 282.7487 2.125686

Std. Error t-Statistic 0.003129 -0.420834 0.217802 0.358124 0.150960 -0.591367 0.200606 1.018323 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.6745 0.7208 0.5552 0.3102 -0.001146 0.037923 -3.667746 -3.588170 0.359860 0.782077

Portfolio 5
Dependent Variable: P5 Method: Least Squares Date: 04/29/03 Time: 08:29 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C -0.002272 F1 0.123644 F2 0.075355 F3 0.162521 R-squared 0.042044 Adjusted R-squared 0.022626 S.E. of regression 0.024457 Sum squared resid 0.088524 Log likelihood 350.3967 Durbin-Watson stat 1.913312

Std. Error t-Statistic 0.002005 -1.133215 0.139565 0.885920 0.096733 0.778993 0.128547 1.264301 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.2590 0.3771 0.4372 0.2081 -0.002084 0.024738 -4.557851 -4.478275 2.165195 0.094583

Portfolio 6
Dependent Variable: P6 Method: Least Squares Date: 04/29/03 Time: 08:30 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C -1.90E-05 F1 -0.102236 F2 0.080018 F3 0.200052 R-squared 0.050713 Adjusted R-squared 0.031470 S.E. of regression 0.026491 Sum squared resid 0.103863 Log likelihood 338.2520 Durbin-Watson stat 1.728309

Std. Error t-Statistic 0.002172 -0.008743 0.151174 -0.676278 0.104780 0.763681 0.139239 1.436754 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.9930 0.4999 0.4463 0.1529 -0.000308 0.026918 -4.398052 -4.318476 2.635483 0.051973

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Portfolio 7
Dependent Variable: P7 Method: Least Squares Date: 04/29/03 Time: 08:30 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable C F1 F2 F3 R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat

Coefficient -0.001423 -0.268465 -0.067171 0.150678 0.021745 0.001916 0.033147 0.162616 304.1800 1.860688

Std. Error t-Statistic 0.002718 -0.523432 0.189159 -1.419255 0.131107 -0.512335 0.174225 0.864848 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.6015 0.1579 0.6092 0.3885 -0.001971 0.033179 -3.949737 -3.870162 1.096620 0.352576

Portfolio 8
Dependent Variable: P8 Method: Least Squares Date: 04/29/03 Time: 08:30 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable C F1 F2 F3 R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat

Coefficient -0.004039 -0.105581 -0.065707 0.156367 0.010183 -0.009881 0.031114 0.143280 313.8006 2.118429

Std. Error t-Statistic 0.002551 -1.583385 0.177558 -0.594630 0.123066 -0.533919 0.163540 0.956144 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.1155 0.5530 0.5942 0.3406 -0.004252 0.030962 -4.076323 -3.996747 0.507532 0.677681

Portfolio 9
Dependent Variable: P9 Method: Least Squares Date: 04/29/03 Time: 08:30 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable Coefficient C -0.003266 F1 -0.061129 F2 0.046841 F3 0.308565 R-squared 0.044406 Adjusted R-squared 0.025035 S.E. of regression 0.034532 Sum squared resid 0.176481 Log likelihood 297.9616 Durbin-Watson stat 2.278450

Std. Error t-Statistic 0.002831 -1.153410 0.197058 -0.310206 0.136582 0.342947 0.181501 1.700077 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.2506 0.7568 0.7321 0.0912 -0.003472 0.034972 -3.867916 -3.788341 2.292474 0.080486

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Portfolio 10
Dependent Variable: P10 Method: Least Squares Date: 04/29/03 Time: 08:30 Sample: 2/03/2000 12/26/2002 Included observations: 152 Variable C F1 F2 F3 R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat

Coefficient -0.001690 0.135191 -0.028143 0.217079 0.013298 -0.006702 0.036535 0.197556 289.3882 1.915904

Std. Error t-Statistic 0.002996 -0.564264 0.208493 0.648420 0.144507 -0.194752 0.192032 1.130428 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Prob. 0.5734 0.5177 0.8459 0.2601 -0.001435 0.036414 -3.755107 -3.675532 0.664892 0.574897

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Appendix No 18 Results of the residual tests on the model R p ,t = 0 + 1 F1,t + 2 F2,t + 3 F3,t + t , portfolios formed alphabetically. 13. Autocorrelation Ho: errors are independent H1: errors are autocorrelated Level of significance =0.05 LaGrange Multiplier with four lags test statistics Portfolio 1
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 0.173384 0.728559 Probability Probability 0.951740 0.947761

Portfolio 2
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 0.648359 2.689087 Probability Probability 0.628929 0.611126

Portfolio 3
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 0.867569 3.576870 Probability Probability 0.485091 0.466287

Portfolio 4
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 1.148788 4.700443 Probability Probability 0.336125 0.319437

Portfolio 5
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 0.335134 1.401959 Probability Probability 0.853942 0.843854

Portfolio 6
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 1.917462 7.686542 Probability Probability 0.110653 0.103759

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Portfolio 7
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 0.676909 2.805313 Probability Probability 0.609034 0.590916

Portfolio 8
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 0.401874 1.678067 Probability Probability 0.807058 0.794698

Portfolio 9
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 1.635980 6.607214 Probability Probability 0.168372 0.158159

Portfolio 10
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 0.699477 2.897058 Probability Probability 0.593522 0.575198

14. Heteroskedasticity Ho: the variance of t is constant H1: the variance of t is not constant Level of significance =0.05 2 test statistics Portfolio 1
White Heteroskedasticity Test: F-statistic Obs*R-squared 0.924375 5.599810 Probability Probability 0.479367 0.469476

Portfolio 2
White Heteroskedasticity Test: F-statistic Obs*R-squared 0.425314 2.628811 Probability Probability 0.861195 0.853782

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Portfolio 3
White Heteroskedasticity Test: F-statistic Obs*R-squared 2.268080 13.04148 Probability Probability 0.040198 0.042382

Portfolio 4
White Heteroskedasticity Test: F-statistic Obs*R-squared 0.193005 1.204315 Probability Probability 0.978376 0.976671

Portfolio 5
White Heteroskedasticity Test: F-statistic Obs*R-squared 0.568716 3.494785 Probability Probability 0.754715 0.744663

Portfolio 6
White Heteroskedasticity Test: F-statistic Obs*R-squared 2.228277 12.83193 Probability Probability 0.043627 0.045784

Portfolio 7
White Heteroskedasticity Test: F-statistic Obs*R-squared 0.958776 5.800251 Probability Probability 0.455430 0.445934

Portfolio 8
White Heteroskedasticity Test: F-statistic Obs*R-squared 0.679879 4.159196 Probability Probability 0.666114 0.655143

Portfolio 9
White Heteroskedasticity Test: F-statistic Obs*R-squared 0.908729 5.508460 Probability Probability 0.490491 0.480435

Portfolio 10
White Heteroskedasticity Test: F-statistic Obs*R-squared 0.187734 1.171679 Probability Probability 0.979862 0.978260

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15. Distribution of the residuals graphically and statistically Ho: t have normal distribution H1: t have not normal distribution Level of significance =0.05 2 test statistics

Portfolio 1
20 Series: Residuals Sample 2/03/2000 12/26/2002 O bservations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -0.05 0.00 0.05 1.55E-18 -0.002405 0.074629 -0.068142 0.023822 0.311155 3.895838 7.535376 0.023105

16

12

Portfolio 2
32 28 24 20 16 12 8 4 0 -0.10 -0.05 0.00 0.05 Series: Residuals Sample 2/03/2000 12/26/2002 O bservations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability 5.14E-18 -0.001773 0.077189 -0.132766 0.032620 -0.429508 4.386454 16.84770 0.000220

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Portfolio 3
24 20 16 12 8 4 0 -0.05 0.00 0.05 Series: Residuals Sample 2/03/2000 12/26/2002 O bservations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -1.05E-18 0.001603 0.074577 -0.072962 0.024790 -0.243588 3.688469 4.505089 0.105131

Portfolio 4
30 25 20 15 10 5 0 0.0 0.1 0.2 Series: Residuals Sample 2/03/2000 12/26/2002 O bservations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability 2.25E-18 -0.000683 0.283947 -0.075088 0.037786 2.931883 22.76911 2692.943 0.000000

Portfolio 5
20 Series: Residuals Sample 2/03/2000 12/26/2002 O bservations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -0.050 -0.025 0.000 0.025 0.050 0.075 -5.71E-19 0.001466 0.074129 -0.062871 0.024213 0.051144 3.139100 0.188808 0.909915

16

12

213

Portfolio 6
16 Series: Residuals Sample 2/03/2000 12/26/2002 O bservations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -0.05 0.00 0.05 1.83E-19 -0.000987 0.092501 -0.074278 0.026227 0.078651 4.040973 7.019671 0.029902

12

Portfolio 7
30 25 20 15 10 5 0 -0.05 0.00 0.05 0.10 Series: Residuals Sample 2/03/2000 12/26/2002 O bservations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -1.48E-18 -0.004427 0.127720 -0.071181 0.032817 0.931137 4.666932 39.56261 0.000000

Portfolio 8
16 14 12 10 8 6 4 2 0 -0.05 0.00 0.05 Series: Residuals Sample 2/03/2000 12/26/2002 O bservations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability 1.95E-18 -0.000274 0.092972 -0.086084 0.030804 0.174309 3.909603 6.009781 0.049544

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Portfolio 9
16 14 12 10 8 6 4 2 0 -0.05 0.00 0.05 0.10 Series: Residuals Sample 2/03/2000 12/26/2002 O bservations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -1.92E-18 -0.001396 0.101669 -0.080126 0.034187 0.307682 3.365505 3.244354 0.197468

Portfolio 10
24 20 16 12 8 4 0 -0.05 0.00 0.05 0.10 0.15 0.20 Series: Residuals Sample 2/03/2000 12/26/2002 O bservations 152 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -1.51E-18 -0.001168 0.211403 -0.073034 0.036171 1.376739 9.669236 329.7155 0.000000

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Appendix No 19 Changes in the estimation output after including errors correction techniques for portfolios R p ,t = 0 + 1 F1,t + 2 F2,t + 3 F3,t + t , portfolios formed alphabetically. Portfolio 3
Dependent Variable: P3 Method: Least Squares Date: 04/29/03 Time: 08:47 Sample: 2/03/2000 12/26/2002 Included observations: 152 Newey-West HAC Standard Errors & Covariance (lag truncation=4) Variable Coefficient Std. Error t-Statistic C -0.000834 0.002118 -0.393796 F1 0.014168 0.129529 0.109379 F2 0.098606 0.110099 0.895610 F3 0.060672 0.119734 0.506720 R-squared 0.020600 Mean dependent var Adjusted R-squared 0.000747 S.D. dependent var S.E. of regression 0.025040 Akaike info criterion Sum squared resid 0.092795 Schwarz criterion Log likelihood 346.8157 F-statistic Durbin-Watson stat 2.091272 Prob(F-statistic)

Prob. 0.6943 0.9131 0.3719 0.6131 -0.000866 0.025049 -4.510733 -4.431157 1.037627 0.377813

Portfolio 6
Dependent Variable: P6 Method: Least Squares Date: 04/29/03 Time: 08:48 Sample: 2/03/2000 12/26/2002 Included observations: 152 Newey-West HAC Standard Errors & Covariance (lag truncation=4) Variable Coefficient Std. Error t-Statistic C -1.90E-05 0.002331 -0.008147 F1 -0.102236 0.178843 -0.571652 F2 0.080018 0.109564 0.730329 F3 0.200052 0.125117 1.598916 R-squared 0.050713 Mean dependent var Adjusted R-squared 0.031470 S.D. dependent var S.E. of regression 0.026491 Akaike info criterion Sum squared resid 0.103863 Schwarz criterion Log likelihood 338.2520 F-statistic Durbin-Watson stat 1.728309 Prob(F-statistic)

Prob. 0.9935 0.5684 0.4663 0.1120 -0.000308 0.026918 -4.398052 -4.318476 2.635483 0.051973

216