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
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.
A Doctoral Thesis. Submitted in partial fulfillment of the requirements for the award of Doctor of Philosophy of Loughborough University.