Risk factors in the UK stock market

This thesis examines risk factors in the UK Stock Market. This objective is achieved by testing the validity of the Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT). The models were tested using data for the period between 1972 to 1993. Test of the CAPM was conducted by examining the relationship between stocks returns and systematic risk as measured by beta. By regressing returns against estimates of beta, the results showed that for the overall period the relationship was negative and the estimated risk premium is smaller than the observed risk premium. The results in sub-periods also failed to validate the model. However, examining the results under up and down-market conditions, showed some support to the usefulness of beta. Beta is a good predictor of average returns under down-market conditions as well as under extreme up-market conditions. Test of the APT entails the detennination on the number of factors, estimating the sensitivities or risks of stocks to these factors and finally the pricing of these risks. This study used the Principal Components Analysis (PCA) for the first two procedures. A two stage PCA was performed specifically for short sub-periods of data. The stability of the factor structure across sub-periods was also examined. For the third procedure, a cross-sectional regression between returns and the sensitivities was performed and the risk premia was estimated. The results showed that the number of factors were consistent across sub-periods. A PCA on any sample of stocks cou1l produce a first factor that is common among stocks, while other factors are more sample specific. The study found at least one significant risk premium in all the sub-periods. The first factor was the most likely to produce a significant risk premium. The sensitivities of the stocks to the factors were found to differ across sub-periods, but the risk premia remain constant. This suggests the factor structure may be stable. This thesis then identifies the economic nature of the factors. The factors were regressed against a selection of macroeconomic variables. The result showed that the first factor is related to stock market return, money supply, US and European exchange rates and dividend yield. The first factor from small size firms and low beta stocks are strongly related than usual to money supply. The second factor is related to default risk, term structure and stock market returns.