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Arbitrage pricing theory


The relationship between stock returns and macroeconomic variables have been a subject of interest among various academics and practitioners. There are numerous studies that have aimed to capture the relationship between stock returns and macroeconomic variables across different countries and over a range of different time horizons. The study of relationship between stock returns and macroeconomic variables interest the investors to a large extent as macroeconomic variables can influence investor's investment decision as well as they can find solutions to select optimal portfolio. It also helps investors to control their financial risk.

Chen Roll and Ross (1986) were first to use the set of macroeconomic factors as proxies for unanticipated variables in the Arbitrage Pricing Theory (APT). In simple terms, APT is theory of asset pricing in which the expected return of a financial asset can be modeled as a linear function of various macroeconomic factors. The original capital asset pricing model(CAPM) of Sharpe(1964),Lintner(1965) and Black(1972) as well as the intertemporal models of Merton(1973), Long(1974), Breeden(1979) and Cox et al(1985) focus on the relationship between expected returns on asset and measures of systematic risk. Rohini Singh(2008) reported that both CAPM and APT present different explanation of the relationship between risk and return. APT unlike CAPM computes many beta's by estimating the impact on stock returns to changes in every risk factor. Copeland and Weston(1988) have reported acute difficulties in testing the CAPM. One of the major problem of CAPM is to determine the true market portfolio.(Javed Iqbal and Aziz Haider,2005) The capacity of APT to put up various risk factors has been an advantage over CAPM.( Jay Shanken, 1982) According to Sydney J. Lambrik(2006) even after reprobation by various researchers CAPM remained as a dominant asset pricing model and only APT emerged as a substitute to challenge the CAPM.

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The present paper provides an empirical testing of multi-factor model (APT) analyzing the macroeconomic variables and portfolio returns (industrial sectors) of France. According to organization of economic co-operation and development (0CED), France is the fifth largest economy in the world in terms of GDP, behind United States, Japan, China and Germany. In 2004, France was fifth-largest exporter and the fourth-largest importer of manufactured goods in the world. However, during the last quarter of 2008, France faced a severe contraction in the economy and entered into deep recession in 2009. According to IMF survey 2008, the weakening of the outlook for the global economy and the thinning of financial situation has clouded economic scenario for France in the near term. Therefore we have limited our study from 01 March 1987 to 01 March 2007.

We follow Chen Roll and Ross's (1986) methodology to examine the relationship between macroeconomic variables and stock returns of France. However, macroeconomic variables differ from country to country and France macroeconomic variables may not have similar impact on stock returns like U.S macroeconomic variables. Moreover, the market capitalization of U.S market is more than the French market. Chen Roll and Ross(1986) considered a set of macroeconomic variables namely monthly growth in Industrial Production, changes in expected Inflation, Unanticipated inflation, Term-Structure and Risk Premium. In addition to this, they also examined oil prices and changes in real consumption. They reported that risk factors arise from unanticipated changes in the set of macroeconomic variables. The unanticipated variables examined in this paper is similar to that of Chen Roll and Ross(1982),Fama (1981),Clare and Thomas(1994), Poon and Taylor(1991) and Ferson and Harvey(1993) with minor differences. The macroeconomic variables considered in this paper are monthly growth in Industrial Production, Unanticipated Inflation rate, Term -Structure, Risk Premium and Money Supply (M1). There are studies that either relate risk premia to macroeconomic variables like exchange rate, inflation, money supply and like(E.g-Clare and Thomas,1994) or capture its time variation through ARCH (Autoregressive conditional heteroscedasticity) models by Engle(1982). As adopted by Chen Roll and Ross(1986), we also follow the two stage Fama-Macbeth(1973) procedure in order to identify relationship between unanticipated changes in economic variables and portfolio returns of France. The standard OLS regression model is used in this paper.

Recent studies have observed that domestic economic variables play an important role in determining their impact on stock returns. However, it is also noted that in a global economy, domestic variables also change because of the rules and regulations adopted or anticipated by other countries. Don Bredin and Stuart Hyde(2007) have exhibited the influence of US(global),UK and Germany(regional) macroeconomic variables on stock returns of Irish and Denmark(local). In this paper, we have extended the study of Chen Roll and Ross(1986) to an international perspective by examining the influence of global(U.S) and regional(Germany) variables on local(France) portfolio returns. U.S is one of the best performing developed countries with largest national economy in the world. Germany (regional variable) has the largest economy in Europe. We have taken NYSE and CDAX indices for our Global and Regional variable respectively. There has been an enormous amount of research about the relationship between stock returns and macroeconomic variables especially for U.S and Japan stock markets. However studies on French portfolio market returns and its relationship with the Global and Regional factors have not been much explored. Understanding of this study might help the investors in selecting favorable portfolios.

It has been noted that off late there has been extensive research on the relationship between fiscal policy and stock returns. Empirical research of Alif.Darrat (1988), Ali and Hasan(2003), William Thorbecke(2002) and like have illustrated the impact of fiscal policy on stock returns. The second interesting finding in this paper is that we also demonstrates the effect on stock returns when fiscal policy (Tax receipt and Government expenditure) are included with the set of macroeconomic variables of France (monthly growth in Industrial Production, Unanticipated Inflation rate, Term -Structure, Risk Premium and Money Supply).

This paper has therefore extended the study of Chen Roll and Ross(1986) in two ways. Firstly, The purpose of this paper is to determine the relationship between Global(U.S) Regional (Germany) and Local(France) macroeconomic variables and portfolio returns of France. Secondly, we also analyze the effect of fiscal policy on the portfolio returns of France. The result of this study is dissimilar from the results of Chen Roll and Ross(1986), Ferson and Harvey(1993), Clare and Thomas(1994) and other limited studies who have followed Chen Roll and Ross's(1986) methodology. We demonstrate mainly an insignificant relationship between macroeconomic variables and portfolio returns of France except for industrial production and regional variable (CDAX stock index-Germany) which shows a negative and significant relationship. These results state that the selected macroeconomic variables have very low impact on the stock returns of France with most of the variables exhibiting insignificancy. An insignificant relationship between macroeconomic variables and stock returns shows that the volatility of stock returns are not strongly related with macroeconomic variables. The impact of Government Taxation as well as Government Expenditure have an insignificant impact on the stock returns of France stating that fiscal policies do not display any impact on the stock returns of France.

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The rest of the paper is organized as follows: Section 2 provides a bit of Literature Review. In section 3, Data and Methodology of the study are discussed. Section 4 provides the empirical results of our study followed by a conclusion in Section 5.

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