ASSET PRICING WITH MARKET FRICTIONS : APPLICATION TO THE SINGAPORE MARKET

Abstract

The Capital Asset Pricing Model (CAPM) is a fundamental paradigm in modern financial theory. Many studies have been carried out to ascertain the validity of the CAPM. While some studies have presented evidence in support of the CAPM, others have uncovered empirical inadequacies such as the size effect and the controversy over the CAPM remains unresolved today.

This academic exercise considers the CAPM in the context of securities traded on the Stock Exchange of Singapore (SES) for the period October 1997 through September 1998. The validity of the CAPM is first examined on the assumption that the trading process is frictionless. Specifically, we investigate the relationship between stock returns, beta and firm size using gross returns unadjusted for market frictions. Neither beta nor firm size appears to possess significant explanatory power.

Since developing markets such as the SES exhibit greater trading frictions, which distort the returns generating process, we also consider the asset pricing relation in the presence of market frictions. Completely different regression results are obtained. Results indicate that the corrected risk measure is an important explanatory variable. We also find stock returns net of transaction costs to be significantly related to firm size - large equity stocks are observed to post higher risk-adjusted net returns, on average, than small equity stocks.

These findings hold interesting implications for the securities pricing relationship. The significance of the reverse firm size effect suggests that the return on a security is not independent of its nonsystematic risk. It appears that this reverse firm size effect is masked when measured returns are not adjusted for transaction costs since small equity stocks are generally more costly to transact. Finally, our results show that substantial bias is introduced into the empirical testing process as a result of the nonsynchronous trading problem.