Abstract:
Neoclassical asset pricing models try to explain cross sectional variation in stock returns. This
study critically reviews the findings of empirical investigations on neoclassical asset pricing
models in the Colombo Stock Exchange (CSE), Sri Lanka. The study uses the structural
empirical review (SER) methodology to capture a holistic view of empirical investigations
carried out in the CSE from the year 1997 to 2017.
The pioneering Capital Asset Pricing Model (CAPM) (Sharpe, 1964; Lintner, 1965: Black,
1972) (SLB) states that market betas of stocks are sufficient to explain the cross sectional
variation of stock returns. Alternatively there are multifactor models (Ross, 1976; Chen, 1986; Fama and French, 1993, 2015; Cahart, 1997) that state stock returns are driven by multiple risk
factors. Similar to other markets the findings on the SLB model are not consistent in the CSE.
The Fama and French (1993) and the Cahart (1997) models are supported in the CSE which is
consistent with other markets, but the explanatory powers of them are substantially low in the
Sri Lankan context. Contrasting the findings of a significant impact of macroeconomic factors
on stock returns in developed markets, the impact of them in the CSE are temporary.
The overall findings of the applicability of neoclassical asset pricing models in the CSE are
inconsistent and inconclusive and the study identifies two reasons that may have contributed
to such results. Firstly, it recognises that the inherent limitations of neoclassical asset pricing
models may have affected the findings in the CSE. Secondly, it supports the argument that
neoclassical models, as they are may not be applicable in emerging or frontier markets, thus
they may need to be augmented with characteristics of such markets to make them more
applicable.
