Corporate Finance

78
Corporate Finance

The same is true of many other countries. Emerging market returns are not only higher than returns from
developed markets but also far more volatile due to economic shocks, military coups and many such factors.
In addition, the mean and variance of returns change over time. One recent study of emerging market returns
suggests that there is no relation between expected returns and beta measured with respect to the world
market portfolio.^7 Further, according to CAPM, expected return is a function of beta. The beta is measured
by analyzing the way the equity returns covary with a benchmark return. In many countries beta cannot be
estimated because the equity market does not exist! One solution to this problem is to establish a relation-
ship between expected returns and, say, country credit ratings.

ARBITRAGE PRICING THEORY

CAPM is based on the concept of diversification. By holding sufficient number of stocks an investor can
diversify company specific risk. Even if the investor were to hold all stocks in the market, s/he will still be
exposed to market risk. The Arbitrage Pricing Theory, APT, a competitor to CAPM, suggests that a small
number of systematic factors affect the long term returns of securities and the beta alone does not explain
differences in security returns. Consider two portfolios: one comprising stocks of financial services companies
and the other, of food products companies. Would you expect both the portfolios to react in the same manner
to rising interest rates and inflation? Obviously not. Financial services companies are more sensitive to
increase in interest rates. The betas of the portfolios may be the same but investors may not expect the

Exhibit 3.16 Monthly returns—Mexico

20

0

40

60

80

100

120

20

0

40

60

80

100

120

–80 –70 –60 –50 –40 –30 –20 –10 0 10 20 30 40 50 60

11/87 12/8210/87

mean: 1.14%

std: 13.5%

frequency normal

Mexico

Monthly return: January 1976–August 1999

Return (%)

Frequency

(^7) Harvey, Campbell R (1995). ‘Predictable Risk and Returns in Emerging Markets’, Review of Financial Studies, Vol. 8. He
found that the regression of average returns on average betas produces an R^2 of zero.