A Multi-factor risk model for the Indian Stock Market

Ramnath Balasubramanian and Sandeep Bharatwaj

The paper attempts to find the evidence of a multi factor model for explaining stock price returns in the Indian
stock market. It makes use of the technique of statistical factor analysis. The results of the factor analysis show
that a five factor model is appropriate for explaining the returns generation process in India. The explanatory
power of this five factor model is significantly better for the five factor model, with an average R2 of 0.871, as
compared to an R2 of 0.503 for the single index model. Further, the multi factor is significantly better than the
single index model in explaining returns of small stocks.

INTRODUCTION
Multi factor models for returns generation
Multi factor models attempt to describe asset
price returns and their covariance matrix as a
function of a limited number of risk attributes.
Factor models are thus based on one of the
fundamental tenets of financial theory: no
reward without risk. The Capital Asset Pricing
Model
(CAPM)
first
presented
by
Sharpe(1964), Linter(1965) and Mossin (1996)
is a single factor model and remains one of the
most popular empirical models of the return
generation process. This model uses stock beta
as the only relevant risk measure. But
empirical studies could not confirm this
restrictive statement. Ross (1976) posited a
more general multiple factor structure for the
returns generating process, known as the
Arbitrage Pricing Theory (APT). However, he
was unable to explain the nature or specify the
number of factors. Further work carried out in
this field by Chen et al (1986) attempts to
explain some of these factors. Fama and
French (1992) find that the main prediction of
the CAPM is violated for the US stock market.
Exposures to two other factors, a size-based
factor and a book-to- market-based factor,
often called a value factor, explain a
significant part of the cross-sectional
dispersion in mean returns. Their paper was
the foundation for a number of empirical
studies in this direction.
General structure of multi factor models
In their general form, factor models posit that
the period returns of different assets are

explained by common factors in a linear

model. The asset returns are influenced by the
factors as per the sensitivity of the individual
securities to the factors. These sensitivities
thus play the role of the beta in CAPM. In
addition, the asset return is also influenced by
the specific return, which is assumed to be
independent of the other factors. A multiple
factor model for i=1...n securities of a market
can be represented in the form of an equation
Ri = i+i1F1+BikFk+ i
Where
Ri = returns to security i
i, ij =sensitivity of security i to factor j
F1.. Fk = the k factors
i = specific return to security i
There are three broad assumptions behind the
model. The first is that the specific returns are
not correlated with each other. This implies
that the correlation between the returns on
two different securities is solely determined by
their common dependence on the factors F1,
F2.Fn. The second is that the expected
specific return is zero. The third is that the
specific returns are independent of the factors.
Methodologies for estimation of multi factor
models
There are three different methodologies to
estimate factor models. The time series
analysis is the most intuitive among all the
techniques. In this analysis, a linear regression
is performed over different time periods, with
the assumption that the factor sensitivities are
constant across time. Typical factors that are
considered relevant in many studies, as for

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instance in the studies of Berry et al (1988), are

excess returns on long term bonds, exchange
rates, price changes of raw material and
inflation.
Cross sectional analysis is the second
methodology and is less intuitive than time
series analysis. In this we take factor
exposures as given. A regression is then
performed over all securities for a single time
period, rather than over one security over all
time periods. The process is then repeated
over several other time periods to obtain a
time series for factor values. Fama and French
used this technique to explain the size and
value effect in the US market. The main
drawback of this technique is that it assumes
exposures to be given.
The third common methodology for
estimating factor models is statistical factor
analysis. The statistical factor models obtain
both the factors and the sensitivities to these
factors simultaneously. The advantage of this
approach is its objectivity, as neither the
factors nor the sensitivities are defined in
advance, but rather estimated from the data.
However factor analysis requires constancy of
factors. Further, the economic interpretation of
the factors is very difficult. This technique was
employed by Ross to formulate the APT. Elton
and Gruber (1989) used this technique to find
the evidence of a multi factor risk model for
the Japanese context.
Factor models in the Indian market
In the Indian context, there has been limited
empirical research in the area of multi factor
models. Amanullah and Kamaiah (1998)
showed that the CAPM may not be relevant in
the Indian market.
Most of the research in multi factor models in
India has been done using the technique of
cross sectional regression. Connor and Sehgal
(2001) tested the Fama and French model in
India using this technique. Mohanty (2000)
tested the Indian market for efficiency in
pricing small stocks, using a similar technique.
This paper attempts to find the evidence of a
multi factor model in the Indian context. To
investigate this, we make use of the technique
of statistical factor analysis. In section two, we

describe the data sample used in the study.

We then identify the number of factors
sufficient to explain the return generation
process and attempt to explain the individual
factors. In section four, we examine the
efficacy of this multi factor model vis a vis the
single factor market model. In section five, we
describe some of the limitations of our multi
factor model. The conclusion in section six
summarizes the results.

DATA SAMPLE
For the purpose of our study, we used the
securities constituting the BSE 100 index.
Though there are over 5000 listed securities in
the various Indian stock markets, most of
them are very thinly traded. Hence, we
considered only the top 100 stocks as
identified in the BSE 100 index. The BSE 100 is
a broad-based and value-weighted stock
market index. The sample companies
constitute the major proportion of the total
market capitalization and liquidity in the
Indian equities market. Another important
reason for using the stocks constituting BSE
100 as opposed to an even broader index was
the limitation of the statistical package in
handling greater number of variables.
The share price data for a three years period
between November 1999 and October 2002
was obtained from Prowess, a highly
normalized database maintained by the Center
for Monitoring the Indian Economy (CMIE).
This database is widely used by researchers
and
practitioners to
obtain
financial
information on Indian companies and security
markets.
The price data has been adjusted for
capitalization changes such as stock splits and
bonus issues.
This share price data was then converted into
weekly logarithmic returns. We have used
weekly returns instead of daily returns to
reduce the number of outliers in the data, as
factor analysis is very sensitive to statistical
outliers.
The weekly returns were computed using the
capitalization data only, and the dividends
were ignored. However, this should not have
a significant impact on the study, as the

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average dividend yield across these companies

is very low.
Statistical analysis technique
In this study we have used Principal
Component Factor Analysis to estimate the
factors and the loadings on the factors.
Principal component factor analysis estimates
both these parameters simultaneously. The
factor solution was then rotated orthogonally
using a Varimax rotation to maximize the
variance of the squared elements in the
columns of a factor matrix.

Figure 1
R for various factor solutions
2

0.88
0.87

R2

0.8712

0.8734

0.86
0.8542

0.85
0.8452

0.84
0.8362

0.83
0.82

OBTAINING THE MULTI FACTOR

MODEL
The first stage in determining a multi-factor
return generating process was an estimation of
the number of factors that might be present.
There is a trade-off between a parsimonious
description of the return process (fewer
number of factors) and a better description of
the variance in returns (which generally
implies more number of factors).
Our objective was to determine that number of
factors which would sufficiently describe the
returns process, without adding too much to
the complexity. This was achieved by
performing a Correlation Test.
We first grouped the 100 stocks into five
portfolios constructed in descending order of
market capitalization. The returns on each of
the five portfolios as estimated by the multifactor model were regressed against the factor
returns. This was done for multi-factor models
with 2, 3, 4, 5 and 6 factors. The average R2
across the five portfolio was compared as
shown in the chart below.

0.81
2

Number of factors

We see that there is no significant addition in

the explanatory power of the model by
increasing the number of factors from 5 to 6.
This suggests that five factors are sufficient to
define the return generating process for the
Indian Stock Market.
A 5-factor principal component analysis was
performed on the three-year weekly returns of
the stocks constituting the BSE 100 index. The
factor loadings of each of the 100 stocks are as
shown in Appendix A.
Interpreting these five factors is the toughest
part of statistical factor analysis. Since these
five factors are not unique to a linear
transformation, there are infinite number of
five factor models that could serve equally
well.
Nevertheless, the examination of the factoroutput matrix does provide us an insight into
the possible explanation for some of the
factors.

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Table 1
Stocks with loadings > 0.5 on respective factors
Factor 1
Pharma Factor

Factor 2
Technology
Factor

Factor 3
Old
Economy
Factor

Factor 4
FMCG factor

Factor 5
Unknown

Dabur

Satyam

BPCL

Asian Paints

Corporation Bank

Abbott

Global
Telesystems

HPCL

HLL

Aventis

Pfizer

SSI

Escorts

Wockhardt

Titan

Silverline

Neyveli
Lignite
SCI

Britannia

Ranbaxy

Novartis

Pentamedia
Graphics
Infosys

IPCL

GSK Consumer
Healthcare
Nestle

MTNL

Digital
Globalsoft
Wipro

Tata Power

Visualsoft

Tata
Chemicals
Gujarat
Ambuja
Grasim

HFCL
Hughes
Software
HCL
Infosystems
Zee

IOC

Bank Of India

Dr. Reddy's

Colgate-Palmolive

TISCO
India Cements

HCL

L&T

NIIT

ACC

As shown in Table 1 above, it is only pharma

stocks that have a high loading (loading
greater than 0.5) on factor 1. Thus, Factor 1
appears to be highly correlated to variables
that affect the stock price of pharmaceutical
companies in India.
Similarly, it is only the technology stocks that
have a high loading on Factor 2. This is a
pointer to the possibility that there is a
technology factor underlying the Indian
stock market. This factor could be highly

correlated to technology related variables such

as returns on the Nasdaq Index.
Almost all the stocks which have a high
loading on Factor 3 are the typical old
economy stocks belonging to heavy industries
such as cement (ACC, India Cement, Gujarat
Ambuja), petrochemicals (IPCL, IOC, HPCL),
heavy engineering (L & T), shipping (SCI),
power (Tata Power) etc. This suggests that
there is an old economy factor underlying the
returns generation process in the Indian stock
markets.

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Most of the stocks that have a high loading

(0.5 and above) on Factor 4 are stocks of
consumer
non-durables
(HLL,
Nestle,
Britannia). This factor can thus be postulated
to be an FMCG factor. This factor must be
highly correlated to variables that impact the
performance of FMCG companies such as
Consumer Price Index, growth in per-capita
income, performance of monsoon etc.
While the loadings on Factor 5 seems to high
for pharmaceutical companies (Ranbaxy,
Aventis, Wockhardt and Dr.Reddy Labs), the
presence of stocks such as MTNL and
Corporation Bank in this list complicates the
possible explanation for this factor. Also, it is
not clear as to how this factor is different from
Factor 1.

MODEL EXPLANATORY POWER

In this section, we examine how much of the
total returns are explained by the five factors
and compare this to the amount explained by
the more conventional single index model.
To examine this, we divided the 100 stocks
into five equally weighted portfolios of 20
stocks each. These portfolios were constructed
on the basis of descending order of size, based
on the average monthly market capitalization
of the stocks over the three year period. Elton
and Gruber (1989) suggest that such grouping
of the stocks would increase the amount
explained by any model. Also, it creates a
manageable set of data which not only allows
us to examine average explanatory power, but
also explanatory power across set of stocks.
Table 2 shows the sensitivities and the R2
when the returns on each of the five portfolios
are regressed on the factor returns over the
three year period from November 1999 to
October 2002.

P1
P2
P3
P4

Table 2
Sensitivities and explanatory power of
five factor model
F1
F2
F3
F4
F5
R2
.017* .324 .211 .118 .275 .906
.169
.225 .325 .166 .135 .758
.201
.378 .206 .189 .145 .930
.317
.182 .269 .171 .206 .925

P5 .29
.206 .316 .172 .189 .837
Average:
0.871
* denotes insignificance at 5% level
The average adjusted R2 across the five
portfolios is 0.871. Moreover, the sensitivities
are highly significant. Of the 25 different
sensitivity estimates, all but two are significant
at the 5% level.
As a standard of comparison, we use the BSE
100 index. This index is a value weighted
index, made of the same 100 securities that we
are analyzing. Thus, the relationship between
our five portfolios and the index is likely to be
higher than if we had chosen another market
index. Table 3 presented below shows the
results.

Table 3
Sensitivities and explanatory power for
the single index model
Beta
R2
Avg. return
P1
P2
P3
P4
P5
Average

0.693
0.510
0.734
0.493
0.448

0.746
0.595
0.395
0.391
0.388
0.503

0.24%
0.41%
0.06%
0.25%
0.38%

The explanatory power of the single index

model is much less than that of the multi
factor model. The average adjusted R2 of
0.503 is much less than the average R2 of 0.871
of the multi factor model. Hence, the multi
factor model explains considerably more of
the time series of stock price returns in the
Indian market.

Returns of Small Stocks

In the US market, empirical studies have
shown that beta coefficients increase as size
decreases (Elton and Gruber, 1988). This
suggests that smaller firms are perceived be
riskier than the bigger firms. We tried to
examine if this was true in the Indian context.
Based on our analysis, we could not find any
real evidence in this direction. As per table 3,
except for portfolio 3, which has the highest

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market beta of 0.734, the betas have actually

declined from the largest to the smallest
portfolio .
An examination of our results (table 3)
indicates that beta may not be a sufficient
metric for capturing risk. Portfolio 3, which
has the highest beta (0.734) among the five
portfolios, gives the lowest average weekly
return (0.06%) over the three years. Similarly,
though portfolio 2 has a lower beta (0.51) as
compared to portfolio 1 (0.69), it gives higher
average weekly returns of 0.41% as compared
to 0.24% for portfolio 1.
The third important observation was that the
R2 across the 5 portfolios declines significantly
in case of the single factor model (by nearly
50%). On the other hand the multi factor
model is able to explain a significant
proportion of the variance even in case of the
smaller stock portfolios.
This only supports the postulate by Fischer
(1988) that CAPM may be inadequate in
explaining returns of certain small stocks.

LIMITATIONS OF THE MODEL

The model presented above suffers from some
inherent limitations of factor analysis. The
major assumption that the factor analysis
makes is that the covariance matrix remains
constant over time. Also, in factor analysis, the
factors are orthogonal- i.e. they are
independent of each other. In reality however,

it may not be possible to obtain factors which

are completely independent of each other.
Typically, the statistical factor models do not
provide a good fit to data out of sample in
those
periods
when
the
company
characteristics are subject to change. Only if
the companies remain unchanged over time,
will a statistical factor model, estimated on
basis of long data series, provide a better fit.
This implies that a pure statistical factor model
may lead to over fitting of the parameters to
the data.
In spite of these limitations, the objectivity of
statistical factor analysis enables us to gain
crucial insights on the returns generation
process in the Indian stock market.

CONCLUSION
In this paper we have estimated a five-factor
return generating process for the Indian stock
market. We have found that five factors are
sufficient to describe the return generating
process. It is not possible to provide a
conclusive explanation for these five factors.
However the examination of the factor loading
matrix suggests that the four of the five factors
underlying the stock market could be termed
as Pharma Factor, Technology Factor, Old
economy Factor and FMCG Factor.
We have also showed that this multi-factor
model has better descriptive power than the
commonly used single factor market model.
The performance of this five-factor model is
particularly impressive for smaller stocks.

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REFERENCES

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Appendix A: Factor Loadings

Factors
Stock
Abbott India Ltd.
Asea Brown Boveri Ltd.
Ashok Leyland Ltd.
Asian Paints (India) Ltd.
Associated Cement Cos. Ltd.
Aventis Pharma Ltd.
B S E S Ltd.
Bajaj Auto Ltd.
Bank Of Baroda
Bank Of India
Bharat Electronics Ltd.
Bharat Forge Ltd.
Bharat Heavy Electricals Ltd.
Bharat Petroleum Corpn. Ltd.
Britannia Industries Ltd.
Castrol India Ltd.
Cipla Ltd.
Colgate-Palmolive (India) Ltd.
Corporation Bank
Cummins India Ltd.
Dabur India Ltd.
Digital Globalsoft Ltd.
Dr. Reddy'S Laboratories Ltd.
E I H Ltd.
Escorts Ltd.
Essel Propack Ltd.
G T L Ltd.
Gas Authority Of India Ltd.
GSK Consumer Healthcare
GSK Pharma
Grasim Industries Ltd.
Great Eastern Shipping Co. Ltd.
Gujarat Ambuja Cements Ltd.
Gujarat Narmada Valley
Fertilizers
H C L Infosystems Ltd.
H C L Technologies Ltd.
H D F C Bank Ltd.
Hero Honda Motors Ltd.
HFCL
Hind Lever Chemicals Ltd.
Hindalco Industries Ltd.
Hindustan Lever Ltd.
Hindustan Petroleum Corpn. Ltd.
HDFC
Hughes Software Systems Ltd.
I C I C I Bank Ltd.
I T C Ltd.
India Cements Ltd.

1
0.547
0.428
0.448
0.094
0.07
0.26
-0.062
0.259
0.407
0.4
0.324
0.448
0.288
0.069
0.148
0.019
0.158
0.21
0.198
0.447
0.562
0.162
0.33
0.363
0.121
-0.007
0.157
0.001
0.135
0.366
-0.029
0.375
0.043

2
0.128
0.199
0.189
0.037
0.289
0.376
0.394
0.025
0.127
0.043
0.243
0.304
0.188
-0.003
0.076
0.005
0.257
-0.067
-0.009
0.178
-0.011
0.736
0.313
0.146
0.311
0.495
0.799
0.088
0.063
0.063
0.139
0.08
0.34

3
0.171
0.27
0.213
0.199
0.452
-0.082
0.204
0.275
0.375
0.54
0.387
0.246
0.421
0.703
-0.138
0.114
0.211
0.368
0.209
0.379
0.12
0.117
-0.002
-0.018
0.226
0.264
0.054
0.397
0.058
0.119
0.506
0.228
0.523

4
-0.026
0.283
0.341
0.562
0.154
0.038
0.092
0.298
0.176
0.186
-0.061
0.097
0.345
0.016
0.512
0.396
-0.075
0.447
0.284
0.089
0.181
0.149
-0.143
0.167
0.528
0.37
0.224
0.231
0.511
0.146
0.141
-0.018
-0.008

5
0.065
0.031
0.231
0.055
0.476
0.546
0.442
0.324
0.175
0.183
0.315
0.35
0.187
0.11
-0.045
0.322
0.284
-0.075
0.56
0.111
0.207
0.23
0.47
0.01
0.267
0.152
0.032
0.03
0.097
0.287
0.436
0.044
0.415

0.262
0.299
0.068
0.129
0.309
0.243
0.156
0.231
-0.046
-0.017
0.06
0.05
0.222
-0.268
0.038

0.337
0.638
0.618
0.292
-0.105
0.726
0.086
0.356
0.146
0.175
0.035
0.649
0.286
0.196
0.178

0.37
0.163
0.068
0.057
0.074
0.094
0.237
0.058
0.174
0.653
-0.033
0.126
0.184
0.247
0.466

-0.093
-0.023
0.154
-0.096
0.252
0.236
0.444
0.133
0.533
-0.025
0.066
-0.08
-0.059
0.283
0.239

0.237
0.211
0.174
0.449
0.375
0.032
-0.086
0.314
0.08
0.089
0.387
0.108
0.432
0.252
0.216

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Stock
Indian Hotels Co. Ltd.
Indian Oil Corpn. Ltd.
IPCL
Indo Gulf Corpn. Ltd.
IDBI
Infosys Technologies Ltd.
Ingersoll-Rand (India) Ltd.
Larsen & Toubro Ltd.
Madras Cements Ltd.
MTNL
Mahindra & Mahindra Ltd.
Mirc Electronics Ltd.
Monsanto India Ltd.
N I I T Ltd.
National Aluminium Co. Ltd.
Nestle India Ltd.
Neyveli Lignite Corpn. Ltd.
Nicholas Piramal India Ltd.
Nirma Ltd.
Novartis India Ltd.
Pentamedia Graphics Ltd.
Pfizer Ltd.
P&G
Punjab Tractors Ltd.
Ranbaxy Laboratories Ltd.
Raymond Ltd.
Reliance Capital Ltd.
Reliance Industries Ltd.
S S I Ltd.
Satyam Computer Services Ltd.
Shipping Corpn. Of India Ltd.
Siemens Ltd.
Silverline Technologies Ltd.
State Bank Of India
Steel Authority Of India Ltd.
Sun Pharmaceutical Inds. Ltd.
T V S Motor Co. Ltd.
Tata Chemicals Ltd.
TELCO
Tata Iron & Steel Co. Ltd.
Tata Power Co. Ltd.
Tata Tea Ltd.
Titan Industries Ltd.
Videocon International Ltd.
Videsh Sanchar Nigam Ltd.
Visualsoft Technologies Ltd.
Wipro Ltd.
Wockhardt Ltd.
Zee Telefilms Ltd.

1
0.349
0.03
0.267
0.427
0.288
0.007
0.402
0.046
0.24
-0.184
0.193
-0.113
0.341
0.159
0.346
0.116
0.187
0.417
0.176
0.483
0.175
0.532
0.142
0.431
0.308
0.154
0.263
0.094
0.179
0.04
0.295
0.25
0.191
0.235
0.287
-0.008
0.421
0.29
0.246
0.297
0.193
0.096
0.509
0.303
-0.273
0.132
0.113
0.342
0.135

2
0.224
0.173
0.086
0.135
0.132
0.75
0.132
0.353
0.052
0.273
0.428
0.417
0.268
0.575
0.088
-0.095
-0.045
0.212
0.432
0.119
0.755
0.159
0.018
0.193
0.24
0.265
0.497
0.37
0.787
0.808
0.016
0.155
0.78
0.184
0.127
0.102
0.112
0.133
0.098
0.145
0.239
0.245
0.213
0.378
0.447
0.727
0.735
0.4
0.627

3
0.296
0.56
0.569
0.448
0.23
0.007
0.351
0.459
0.399
0.23
0.247
0.221
0.267
0.18
0.421
0.003
0.63
0.116
0.208
0.029
0.077
0.036
0.349
0.284
-0.043
0.271
0.298
0.229
0.013
0.088
0.594
0.314
0.171
0.384
0.397
0.198
0.264
0.536
0.396
0.479
0.552
0.322
0.378
0.393
0.29
0.097
0.121
0.079
0.017

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4
0.321
0.233
0.008
0.345
0.254
0.044
0.318
0.141
0.213
0.402
0.358
-0.047
0.155
0.133
0.081
0.459
0.124
0.204
-0.045
0.17
0.006
-0.072
0.352
0.304
0.228
0.187
0.276
0.341
0.237
0.177
0.09
0
0.045
0.223
0.12
-0.011
0.251
0.166
0.414
0.31
0.247
0.181
0.174
0.09
0.222
0.119
-0.179
-0.085
0.037

5
0.033
0.054
0.163
0.273
0.179
0.297
0.01
0.457
0.062
0.484
0.341
0.011
0.241
0.101
-0.038
0.187
0.045
0.332
-0.056
0.139
0.106
0.091
-0.093
0.108
0.485
0.234
0.316
0.389
0.083
0.132
0.162
0.374
0.172
0.419
0.221
-0.102
0.283
0.189
0.28
0.335
0.031
0.39
0.054
0.004
0.426
0.062
0.177
0.532
0.136

About the Author(s)

Ramnath Balasubramanian is a second year Post Graduate Diploma in Management (PGDM)
student at IIM Ahmedabad. He completed his graduation in Commerce from Mumbai University
in 2001. He is also a Diploma in Business Finance Holder from ICFAI, Hyderabad. His areas of
interest are potfolio theory and valuation. He is an avid quizzer, and has featured on BBC World
Mastermind India Quiz. He has also won a number of Business School Case contests.
Sandeep Bharatwaj is a 2nd Year Student at IIM Ahmedabad. He finished his graduation from
IT-BHU in 2001, majoring in Computer Science and Engineering. He loves playing tennis, and is
keenly interested in Capital markets and Derivatives. He co-authored a paper on municipal bond
markets published in the 'India Infrastructure Report 2003' by Oxford University Press.

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