The Dichotomous Asset Pricing Model
The Dichotomous Asset Pricing Model Evidence from the UK market
1. Introduction Ever since its introduction by Sharpe-Lintner-Black, the Capital Asset Pricing Model (CAPM) has been subject to criticism, appraisal and continuous efforts for improvement, such as the Reward Beta approach (Bornholt, 2007), conditional CAPM or the consumption CAPM. The Dichotomous Asset Pricing Model (DAPM), introduced by Professor Liang Zou at the Universiteit van Amsterdam, brings a fresh approach to asset pricing and contributes significantly to enhancing the over-disputed CAPM. The model manages to combine mean-variance (MV) and the gain-loss (GL) approaches to portfolio selection and asset pricing by proving that a benchmark portfolio is MV and GL efficient if and only if a dichotomous asset pricing model holds. More precisely, the DAPM holds if for all assets i the following predictions are satisfied, in relation to a benchmark portfolio m: The model was so far tested and compared to the CAPM and best-beta CAPM (BCAPM) on the Fama-French 100 portfolios sorted on size and value, with significant insights. The aim of this paper is to repeat the analysis and test the predictive power of the DAPM for a European market, more precisely to answer the following question: Does DAPM hold for the UK stock market? UK market was chosen because of its size and trading volumes, but also because it bears most resemblances to the US one. This way, we are more prone to obtaining comparable results for the two markets. In particular, in order to answer the above question, the following hypotheses are tested:
, for each individual stock i and
, for the cross section regression, where the benchmark portfolio is the market portfolio m. 2. Background and predictions The analysis performed by professor Zou on the Fama-French 100 portfolios sorted on size and value proves the superior predictive power of the DAPM, both over the BCAPM and the CAPM. The results can be summarized as follows:
,,i2,H1:
1. Introduction Ever since its introduction by Sharpe-Lintner-Black, the Capital Asset Pricing Model (CAPM) has been subject to criticism, appraisal and continuous efforts for improvement, such as the Reward Beta approach (Bornholt, 2007), conditional CAPM or the consumption CAPM. The Dichotomous Asset Pricing Model (DAPM), introduced by Professor Liang Zou at the Universiteit van Amsterdam, brings a fresh approach to asset pricing and contributes significantly to enhancing the over-disputed CAPM. The model manages to combine mean-variance (MV) and the gain-loss (GL) approaches to portfolio selection and asset pricing by proving that a benchmark portfolio is MV and GL efficient if and only if a dichotomous asset pricing model holds. More precisely, the DAPM holds if for all assets i the following predictions are satisfied, in relation to a benchmark portfolio m: The model was so far tested and compared to the CAPM and best-beta CAPM (BCAPM) on the Fama-French 100 portfolios sorted on size and value, with significant insights. The aim of this paper is to repeat the analysis and test the predictive power of the DAPM for a European market, more precisely to answer the following question: Does DAPM hold for the UK stock market? UK market was chosen because of its size and trading volumes, but also because it bears most resemblances to the US one. This way, we are more prone to obtaining comparable results for the two markets. In particular, in order to answer the above question, the following hypotheses are tested:
, for each individual stock i and
, for the cross section regression, where the benchmark portfolio is the market portfolio m. 2. Background and predictions The analysis performed by professor Zou on the Fama-French 100 portfolios sorted on size and value proves the superior predictive power of the DAPM, both over the BCAPM and the CAPM. The results can be summarized as follows:
,,i2,H1:
References: Pettengill, G. Sundararn, S. Mathur, I. (1995). The conditional relation between beta and returns. Journal of Financial and Quanritative Analysis 30, pp. 101-116 Zou, L. (2005). Dichotomous Asset Pricing Model. Annals of Economics and Finance 6, pp. 185-207 Zou, L. (2006). The best-beta CAPM. Applied Financial Economic Letters 2, pp. 131-137