CAPM in China?

Question

Hello,
Im writing a paper why the CAPM doesn`t work in CHina. I need a mathematical example with the simple CAPM-equation to show it. I don`t know what I should use as the riskfree rate. So my question is whar should I use and do you know a good example or other reasons why it doesnt work?

Answer 1

First of all the extension of the original CAPM(Sharpe, Mossin,
Lintner in 1963) is termed the International CAPM or ICAPM.
To use it in china you need a beta for the stock or for a portolio of
stocks which will be difficult for some of the newly formed
Chinese publically traded corporations. Another factor is the
stock market in China is an emerging market hence it suffers from a general lack of history and liquidity though expectation is that it will grow rapidly in the future.

The model would be:R stock = risk free rate+Beta (Rmarket-RF)

Now in the literature it is common to use either the
U.S. Treasury Bill Rate or the U.S. Long Bond Rate. As
Roll's critique aptly pointed out there is no truely riskless asset
so we have used the above surrogates. Not a bad choice though since the data on them is readily available through the U.S.
Federal Reserve and the U.S. Treasury which issues these debt
obligations through the Fed has never defaulted on any obligations. Further the marke is the largest most liquid debt
market in the world which has investors from around the world and foreign governments buying and selling these assets
continuously.

So, next we address the matter of a market index surrogate
to use in the right hand terms. Since we can't really use the
Chinese swtock market Index as a true surrogate for the
world market index we must make one. Assuming there is
adequate capital market integration today to allow us to do so.
In the literature some have use a weighted average composite
consisting ofweights determined by the relative market values
of equity traded on the diverse major wold bourses(Stock Markets). For example the portion of equity traded in the NY
Stock market weighted by an index like the S& P 500 index
along with the proportion of stocks traded in London weighted
by the FTS Index. Gradually if you consider all the major
markets today such as Tokyo, Paris, London, New York,
Canada TSE, etc.,
you'll be able to compute a suitable weighted average
RORmrkt.

The major problem you need to ovwercome in any emerging market like China is thin market trading--translation too few stocks are quoted and trading activity in them takwes too long to
provide investors /money managers with enough information
derived from each successive buy-sell combination).


Assuming you did find an adequately traded stock with enough
history in the Chinese stock market, and you did compute a
world market index surrogate for the market index along
with selecting a risk free asset such as by using the U.S.
T Bill Yield, then you could use the equation to correctly
price the Chinese stock in terms of its rate of return.

Assume further that you average the returns on the world market
indexes and it turns out to be 12%.

Next regress the Chinese stock past returns (having converted from Yen capital gains and dividends) againtst the historical
world market stock index levels for the same number of observations as you have on the Chinese stock (note: the data
must be aligned so that they are matched for the same time periods as those of the Chinese stock'sprice observations.
In other words the matched pairs must be contemperaneous with one another. You should use say weekly, monthly close
data and with the problem I described earlier I would use the
later time interval for obserfvations.

The coefficient of this OLS simple regression is the Beta
on the stock. Assume it is 1.5 positive.

If we assume a yield on the U.S. T Bill of 5%, the math
then is Stock ROR% = 5% + 1.5(10%-5%) = 5%+7.5%= 12%

There's the heart of your paper...now gety busy and write it.

Try doing a dogpile or other search for academic journal, textbooks on international finance, and other sources.

Answer 2

You should use a government bond for the risk free rate. If China doesnt issue bonds backed by the government, or if there is a default risk, then the CAPM probably isnt going to work. Many companies in China are government controlled. So theoretically they woldnt have risk. So, you need a risk free rate, and you need a risky asset for the CAPM to be valid.

Answer 3

sorry i speak english very bad. china's free rate=?