Profitability Ratios and Downside Risk in Asset Pricing

Abstract:

The aim of the study is to verify the pricing of assets in the Polish capital market using CAPM extended version. In the research, in addition to market risk in the form of a beta coefficient, the variables adopted for the model were the fundamental ratios used to analyse  profitability, ROA and ROE. Market risk was considered in a variance and downside framework. For calculating the downside risk the Harlow and Rao formula was used. The subject of the research were stocks of the companies with various capitalization and across different industries, belonging to the large, medium and small indexes and equally-weighted portfolios based on these stocks. Two-factor models for quarterly returns were estimated in a two stage procedure in which cross-sectional regression was applied. The regressions give an evidence of existing positive risk premium for market risk both in conventional and downside approach For all samples of companies downside beta is a little better risk measure than the conventional one. The findings of our study indicate also that the ROA and ROE ratios proved to be valid factors in the risk-return relationship. Profitability ratios considerably outperform market beta coefficients as factors explaining average returns on the Warsaw Stock Exchange. Mean returns in the capital market are much more responsive to the financial performance of a company, especially ROE, than to the market index. The highest explanatory power have models for portfolios, large and medium stocks and with downside beta and ROE ratio. The results show that the combination of financial analysis’ factors with downside risk measure contributes to a better understanding of capital asset pricing.