TESTNG OF CAPM FORPAKISTAN’S LONG-TERM CORPORATE BOND PRICING

Abstract

Government bond markets serve as a stepping-stone on the path to developing a corporate bond market. A government bond market, if functioning satisfactorily, can significantly increase investors' confidence in the overall bond market, and in the whole capital market. One of the intra-market relationships between two sub-markets of the bond market is dependency of corporate bond market (from now on referred to as CBM) on government bond market (from now on referred to as GBM) for benchmark interest rates i.e. risk free interest rate. The study closely scrutinizes the bond markets of Pakistan to determine the interest rate structure of long term government bonds, if any, and long term corporate bonds. The research question is whether CAPM can be used to determine the prices of long-term corporate bonds? In form of an equation, CAPM is as below Rj = Rf + β(Rm-Rf) Where Rj = Required return on security j Rf = Risk free rate β = Beta for security j Rm = return on market portfolio The corporate bond market consists of Term Finance Certificate (TFC). Paramount leasing is selected, as Subject Company for which required rate of return is determined using CAPM and Yield To Maturity (YTM). Regression analysis was used to determine the relation ship between (Rm- Rf) and Ri using ex-post values. So Return on Paramount stock is a dependent variable (Y), Excess of market return over risk free rate or Market risk premium (Rm-Rf) is the independent variable (X), coefficient b that explains the relation between dependent and independent variable is β and the vertical intercept is risk free rate. Market portfolio was taken as a portfolio comprising of shares of all the listed companies such as KSE 100 that is highly diversified. The return for a specific period is calculated by calculating percentage change in the returns on market portfolio from a base year. The YTC is 6.76% while the required return via CAPM is 27.71%. Themajor reason for this discrepancy is that the rate of return on stock market is higher because the total return component of stocks consist of dividend + capital gains on the sale of stock in the secondary market. In comparison, TFCs however do not have the availability of a strong and developed secondary market like stocks. Their total return comprises of coupon payments + principle redeemed. If our aim is to enhance the breadth and depth of our TFC market then development of secondary market for TFCs is highly crucial. The limitations in applying CAPM in Pakistan include absence of Beta values, absence of bond index, Lack of sufficient similar companies to determine proxy betas, difficulty in estimating the value of independent variable, excess return on market portfolio (Rm-Rf), Floating Rate TFCs Vs. Fixed rate TFCs