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Literature Review On The Rational Pricing Model

This research deals with the behavior of stock price in relation to size and book to market equity (BE/ME).FAMA and FRENCH found that high BE/ME signals poor earnings and low BE/ME signals strong earnings. After a detailed study it was found that there is no link between BE/ME factors in earnings and returns.FAMA and FRENCH found two variables market equity (ME) and the ratio of book equity to market equity (BE/ME).The main focus of this thesis is on whether the behavior of stock prices in relation to size and book to market equity is consistent with the behavior of earnings.

Simple rational pricing model:

This model states the whether stock prices properly reflect differences in the evolution of profitability when stocks are grouped on size and BE/ME. With the help of simple rational pricing model FAMA and FRENCH found that BE/ME is related to persistent properties of earnings. It was found that high BE/ME signals low earnings on book equity high BE/ME stocks are less profitable than low BE/ME stocks. It was found that the firms having low BE/ME were the firms with high average returns on capital whereas the firms with high BE/ME were the firma with low average returns on capital.[ Fama,1995]

The study on the evolution of profitability and earning /prices ratios in relation to size and book to market equity is consistent with rational pricing. Further analysis shows that the common factors in returns signals common factors in earnings suggests that market, size and book to market factors in the earnings are the source of corresponding factors in return. The weak links in rational pricing models suggests that the book to market factors in earning drives the book to market factors in returns. The test centre on six portfolios formed on ranked values of size and BE/ME for individual stocks. The I and II section describes the portfolios and measures of profitability, III section determines the behavior of earnings for the 11 years around portfolio formation. Section IV examines the profitability in chronological times to show the performance of different size and book to market combinations. Section V examines price/earning ratios, earning growth rates and stock returns. Section VI argues that there size, market and BE/ME in shocks to earnings. Section VII examines link between returns and common factors in returns.

FAMA and FRENCH (1992) document a significant relation between firm sizes, book to market ratios and security returns for non-financial firms. Some financial economists remain unconvinced about the robustness of relation and argue that the documented anomalies are simply a result of data snooping by academics,(eg:Black (1993) and McKinley (1995).In this research the authors has tested the data snooping hypothesis by analyzing the relation between firm, size to book market ratios and security returns for sizeable sample. Later it was found out that financial and non financial firms have very similar patterns. Financial firms are those firms with standard industrial classification codes (SIC) ranging from 6000 to 6999 and remaining firms are classified as non financial firms .In order to test the data snooping hypothesis potential for data selection was also considered as described by Kothari, Shanken, and Sloan (1995).The result of this study indicates that the size and book to market ratio for financial and non financial firms have similar meaning as they relate to security returns. Further studies shows that the test allows for both variables, the negative relation between the size and average return is less significant the inclusion of market to book equity seems to absorb the role of size in selected stock returns.

The traditional capital asset pricing model (CAPM) developed by Sharpe (1964) Linter (1965) and black (1972) states that the expected returns on stocks are positively related to their risk and market betas are the only risk factors to explain the cross sectional variations of expected returns. American stock exchange (AMEX) and NASDAQ during the 1963 to 1960.FAMA and FRENCH found that the variations of cross sectional stocks returns can be captured by two firm characteristics firm size and book to market equity. Chan al (1991),Chui and Wei (1998) and Daniel et al (1997) also found that book to market equity plays a significant role in explaining the cross sectional variations in Japanese market and these studies suggested that market beta is not related to stocks.Overall studies concluded that the risk factors capture to a certain extent the return behavior observed in international stocks.Rouwenhorst (1998) showed that the return in 20 markets are qualitatively similar to those documented for many developed markets.FAMA and FRENCH (1998) and patel (1998) documented a premium for small firms and value stocks in 17 emerging market economies.Chui and Wei (1998) showed that book to market equity can explain the cross sectional variation in expected stock returns in three out of five pacific markets.

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