Validity of Beta in Explaining Expected Returns of Securities Listed in the Colombo Stock Exchange - Sri Lanka

Abstract

The share market has become a main source of raising funds for the entire economy. Therefore it’s important for a country to attract lucrative investors to invest in share market. At the same time, if an investor is in a position to predict the prices or returns into certain extent, it helps him to make rational decisions on the stock market dealings, which enables him to allocate resources efficiently. In line with the Capital Asset Pricing Model (CAPM), the empirical results of studies indicate that beta is a significant variable in predicting average stock returns of a stock market. This study investigates the validity of beta explaining the expected returns of securities listed in the Colombo Stock Exchange (CSE). In addition to that, this research further explore any other factors which is responsible for influencing the predictability power of forecasting share returns of companies. Companies were selected on the basis of size and liquidity of companies. Data analysis was performed by selecting 90 companies out of total 287 listed companies in the CSE covering five year period from 2008 to 2012 with a view to provide empirical evidence on CAPM, which states that expected returns on securities are a positive linear function of market beta. Conceptual model has been developed to predict expected return using Beta, Earning to Price Ratio and Company Size by applying statistical techniques such as correlation coefficient, coefficient determination and regression analysis. This study finds that beta is a significant variable in explaining average stock returns of companies. But Earning to Price Ratio and Size of the company has weak negative and weak positive relationships respectively with average security returns.