We present an empirical investigation of the Arbitrage Pricing Theory (henceforth APT) in the Korean equity market using Korean macroeconomic factors. Factors examined include (1) industrial production index, (2) inflation, (3) foreign exchange, (4) oil prices, (5) house-price index, (6) risk premium, (7) trade balance, (8) money supply(M2), and (9) guaranteed bonds rate. These are chosen in view of a simple financial theory of asset pricing.
By replacing the unknown random factors of factor analysis with observed macroeconomic variables, APT is recast as a multivariate nonlinear regression model with across-equation restrictions. An explicit theoretical justification for the inclusion of an arbitrary, well-diversified market index in given. Using monthly returns on 30 portfolios consisted of 270 stocks, 27 portfolios formed according to stock price indices by industry, and 30 portfolios formed by firm size, iterated nonlinear seemingly unrelated regression techniques(ITNLSUR) are employed to obtain joint estimates of asset sensitivities and their associated APT risk "prices."
Our paper allows us to examine the international robustness of the theory and hence to compare the results with those for the U.S and Japan. Priced and non-priced factors in the Korean economy are also discussed. We further test the validity of the CAPM beta. The result shows that the CAPM beta does not capture any extra risk that may have been missed by the macroeconomic factors.
In conclusion, There exists 4 or 5 common factors in the Korean equity market.
