Share trading is an important part of the economy of a country from both the industry’s point of view as well as the investor’s point of view. Whenever a company wants to raise funds for expansion, instead of taking loans it can issue shares while an investor can get part ownership of the company through buying shares. The stock market investments are considered as high return investment, investors have the ability to quickly and easily sell securities.
Forecasting Return and Risk
Yet, the share market investments are incorporated with high risk, due to uncertainty in the market. Generally, investors expect higher returns at a lower risk; as such, they are very much concerned about the information on the possible risk of the investment. Therefore, forecasting risk and return of assets were of immense interest over the past decades. Statistical techniques play a vital role in stock market forecasting. Statistical techniques comprise, Fundamental analysis and Technical analysis. Fundamental analysis involves analyzing the economic factors or characteristics of a company, namely; company value, company earnings and book-to-market equity. On the other hand, Technical analysis is the price movements and trading volume in the market. Modern Portfolio theory was a milestone of Fundamental analysis. The ultimate output of the modern portfolio theory is the Capital Asset Pricing Model (CAPM). The CAPM assumes a linear relationship between individual company returns (Ri) and the market risk (). It is considered that, if β =0, the share price is not at all related with the market, therefore no risk; if β=+1, an average level of risk; if β>1, security returns fluctuate more than the market returns, at high risk; if β<1, asset inversely follows the market, at less risk. The model CAPM has been widely used in stock market forecasting all over the world, but applicability of the CAPM has been debated. Many studies have shown that the CAPM is not applicable to their markets, hence they attempted to find suitable forecasting techniques and were successful.
In statistical terms, the Beta () coefficient is defined as the ratio; (Co-variance between Individual Company Returns and Total Market Returns) to (Variance of Total Market Returns). The variance is the volatility measurement of total market returns. The co-variance measures a certain kind of dependence between two or more variables. The sign of the co-variance shows the tendency in a linear relationship between two variables. In other words, sign of the co-variance indicates, whether the variables are directly (positively) or inversely (negatively) related. As such, the co-variance between individual company returns and the total market returns see whether the individual company returns move with the total market returns in a line. In practice, the Beta () coefficient is estimated by the “Simple Linear Regression” technique; taking the individual company returns (Ri) as the dependent variable and the total market returns (Rm) as the independent variable. In short, the linear relationship between individual company returns and the total market returns is a must in Beta estimation.
Share Trading in Sri Lanka
The Colombo Share Brokers’ Association commenced share trading in Sri Lanka in the 19th century. Later, in 1985, “Colombo Securities Exchange Ltd. was formed and was renamed as ‘Colombo Stock Exchange’ (CSE) in 1990. The principal activity of the CSE is the operation of a Stock Exchange. At present, 299 companies are listed in the Colombo Stock Exchange (CSE), representing 20 business sectors. All Share Price Index (ASPI) and S&P SL 20 index are the main indices of CSE. The ASPI measures the movement of share prices of all listed companies, while the S&P SL 20 captures the top twenty companies.
The Capital Asset Pricing Model (CAPM) is being used for forecasting in Sri Lankan Share market. The CSE publishes Beta () values of all the listed companies on a quarterly basis, against the ASPI and the S&P SL 20 index. However, studies conducted by academicians and researchers have given enough evidence that the individual company returns and the total market returns of the Sri Lankan share market are not linearly related. As such, the Beta () coefficient does not reveal the truth; yet, the Sri Lankan share market relies on CAPM and makes pitfalls to investors.
In the recent past, some studies have introduced suitable techniques for forecasting risk and return of the individual companies of the Sri Lankan share market. It is high time for the authorities to further test such techniques and implement them for the stabilization of a healthy stock market.
The writer is a Senior Lecturer / Statistician; Institute of Mathematics & Management