Capital Asset Pricing Model and Arbitrage Pricing Theory in the Bursa Malaysia: An empirical study

This paper compares the Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT) in the Malaysian stock market to determine which model explains the market better. In this study, we use the monthly returns of 50 randomly selected firms from the Bursa Malaysia Main Board over the period of January 1991 to December 2000. The data was used to run two separate tests on the CAPM and the APT. The CAPM is regressed to obtain betas for each period and the principal component analysis is used to determine the number of retainable factors for the APT. Four factors were retained; therefore the APT is a four-factor linear model. Consequently, both models' validity is tested using the linear regression method. Finally, the posterior odds ratio is used to compare the two models. The APT is a better explanation tool in the Malaysian stock market with an ability of 89% to describe the behaviour of the market. The CAPM is not a rejected model in this case, only that the APT has managed a more rounded explanation of the market's movement, due to its multi-index properties. As a multi-index model, the APT uses four macroeconomic variables to explain the market. In this case, the four components are assumed to be the unexpected change in the risk free rate of interest, unexpected change in the term structure of interest rates, unexpected change in industrial production, and unexpected inflation.