Vol (13), Issue (2), 2020

Asset Pricing Through Downside Risk-Based Arbitrage Pricing Theory: Empirical Evidence from Pakistan Stock Exchange

Syed Asim Shah, Hassan Raza & Aijaz Mustafa Hashmi

National University of Modern Languages, Islamabad

This study extends the downside risk applications in multifactor asset pricing model by incorporatingthe downside risk spillovers from economic and financial factors to stock returns. We amplify theconventional APT model by replacing the variance-based betas with semivariance based downsidebetas that better capture the risk volatilities in varying market conditions. The inclusion of downsiderisk betas based on semivariance and semideviation methods in the augmented asset pricing modelimproves both the theoretical and methodological applications relative to the limitations andrestriction of conventional APT factors model. The mean-variance hypothesis replaced by meansemivariance hypothesis and asymmetric behaviour of stock returns distribution, empirically suggestthe use of an alternative factors model. The models based on downside risk premia for asset pricingin emerging markets. The study tested the downside risk-return relationship based on the excessmonthly stock returns of listed PSX firms and observed economic, financial and global factorsrepresenting spillover triangulation from 1997 to 2017. The findings of the study indicate that theaugmented DR-APT model with pricing restrictions of unconditional linear factors method could notbe deserted over the targeted period of study. The selected observed pricing factors except exportsare significant enough for pricing the security returns in the augmented DR-APT Model. Findings ofthe panel regression, likelihood ratio tests and F-test corroborate DR-APT as a better model to pricestock returns in volatile situations compare to conventional APT model. Our findings are consistentwith the downside risk-return framework based on mean semi variance hypothesis and haveimplications for managers and decision markets that incorporate downside risk in asset valuation,cost of capital estimations, portfolio construction and investment analysis decisions.
Keywords: Downside Risk, Semi variance, Semi covariance, Downside Beta, Downside risk-basedArbitrage Pricing Theory (DR-APT).


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