Liquidity, time‐varying betas and anomalies: Is the high trading activity enhancing the validity of the CAPM in the UK equity market?

Abstract

In the last decades, a large number of multifactor assetpricing models have emerged with the aim of correcting the estimated equity risk premiums for some well-documented market anomalies. In any case, recent research on asset pricing shows how the higher liquidity resulting from the globalization of financial markets has significantly reduced returns tied to many strategies based on market anomalies. In this framework, questions arise about the possible renovated validity of classic assetpricing models. On this basis, in this paper we study to what extent the capital assetpricing model (CAPM) has recovered its past explanatory power. Specifically, we propose a time-varying beta CAPM in order to control for the variable nature of beta risk to changes in the market liquidity, using the variation of the Amihud illiquidity measure to account for the degree of trading activity. We test both the time-varying and constant beta models on different sets of anomaly portfolios for the UK equity market, and we compare their performance to that of the Fama-French threeand five-factor models. Additionally, we test the constant beta model on a set of actively managed portfolios, formed according to the variation in market illiquidity in the previous year. Our results show that the pricing errors of the CAPM have significantly decreased with respect to those of previous literature. Furthermore, the time-varying beta model performs similarly to the Fama-French models in most cases. These results are consistent with increased trading activity that reduces arbitrage opportunities and, therefore, enhances market efficiency.

Using the Capital Asset Pricing Model and the Fama–French Three-Factor and Five-Factor Models to Manage Stock and Bond Portfolios: Evidence from Timor-Leste

“…Moreover, the beta model, which varies over time, has a similar performance to the Fama-French model in most cases. This result is consistent with increased trading activity reducing arbitrage opportunities and thus increasing market efficiency (Rojo-Suárez et al 2022). CAPM betas positively predict portfolio and individual stock returns when market returns are expected to be high, which is about 50% of the time.…”

Short-run and Long-run Effects of ESG Policies on Value Creation and the Cost of Equity of Firms

“…Furthermore, following the common practice of testing the Ohlson (1995) model using panel data analysis under fixed or variable effects, Φ 1 and Φ 2 are often assumed to be constant over time. However, this practice is inconsistent with the main results and conclusions of the literature on the predictability of stock returns, which shows that different economic and non-economic variables exhibit significant predictive power in forecasting expected returns (Campbell, 1987;Fama and French, 1988;Baker and Wurgler, 2000;Lettau and Ludvigson, 2001;Lamont and Stein, 2004;Cochrane, 2011;Novy-Marx, 2014;Rojo-Suárez et al, 2022). On this basis, Campbell and Shiller (1988) develop their widely-recognized loglinear present value model, which overcomes the constraint of a constant discount rate in Eq.…”

Trends in the explanatory power of factor-based asset pricing models in determining the cost of capital

“…In contrast to the above studies, there is also evidence that the size effect is disappearing in the US market (Horowitz et al 2000;Amihud 2002), while in Europe it may even become negative (Baetge et al 2010). More recently, studies for the UK equity market, such as Rojo et al (2020), show that the pricing errors delivered by the CAPM have significantly decreased with respect to those in the previous literature, highlighting that time-varying beta models can perform similarly to the Fama-French models.…”