Chapter 1: Introduction

1.1 Urgency of research

In the era of globalization and continual fluctuations in financial markets,
understanding and accurately assessing the impact of Monetary Policy on the Stock Market
in Vietnam become increasingly vital. This topic is not merely an in-depth exploration of the
technical aspects of the market but also a pivotal step in analyzing how the monetary policy
decisions of the State Bank of Vietnam can influence the dynamics of the domestic stock
market.
The stock market in Vietnam has emerged as a crucial component of the financial
system, playing a decisive role in capital distribution and stimulating economic development.
The significance of the stock market in Vietnam extends beyond providing an effective
investment channel; it opens up numerous opportunities for companies to raise capital and
expand their operations.
In recent years, the Vietnamese stock market has witnessed remarkable growth,
marked by an increase in scale and liquidity. This development not only elevates the market
capitalization but also creates favorable conditions for foreign investors to participate,
enhancing the credibility and international standing of Vietnam's stock market. The growth of
the stock market serves as a catalyst for companies to enhance scale and management
quality, turning the market into a driving force for innovation and competitiveness.
Additionally, it helps strengthen the fundraising capacity and expand the business operations
of Vietnamese enterprises. The importance of the stock market goes beyond being a source
of capital for companies; it is a crucial tool for the disclosure and evaluation of a company's
value. Fromtheret, it fosters transparency and serves as a testament to investor confidence,
providing essential market data for investment decision-making.
Besides, monetary policy, encompassing a series of decisions and measures
implemented by the central bank to manage money supply and control interest rates,
significantly influences the economic situation of a country. The impact of monetary policy
extends beyond financial aspects to encompass the entire economic system, from
businesses to consumers. Monetary policies have a significant impact on the economic
situation, including the stock market. So understanding how this policy impacts can help
forecast the economic situation and determine potential risks in stock investment. More
specific:
Firstly, the dynamic nature of financial markets necessitates a comprehensive
understanding of the relationship between monetary policy and the stock market. In Vietnam,
as in many other economies, the stock market plays a pivotal role in capital allocation and
economic growth. Analyzing how monetary policy influences this market is imperative for
investors, financial institutions, and policymakers.
Secondly, the Vietnamese government, through its central bank, actively employs
monetary policy tools to achieve economic stability and growth. Investigating the impact of
these policy decisions on the stock market provides valuable insights into the broader
economic landscape. This knowledge is instrumental in formulating effective investment
strategies and risk management.
Thirdly, the interconnectedness of global financial markets underscores the need to
comprehend how Vietnam's stock market responds to domestic and international monetary
policy changes. As Vietnam continues to integrate into the global economy, understanding
these dynamics becomes crucial for investors and policymakers alike.
In conclusion, the research on the impact of monetary policy on the stock market in
Vietnam is highly pertinent. It not only addresses the immediate concerns of investors and
policymakers but also adds to the body of knowledge in financial economics, thereby serving
as a foundation for informed decision-making in the dynamic landscape of Vietnam's
financial markets.

1.2 Aims of the research.

1.2.1 Overall aims
- This topic is researched with the main purpose of achieving a thorough
comprehension of the intricate relationship between Monetary Policy and the
Stock Market in Vietnam, considering the unique economic dynamics of the
country.
1.2.2 Specific aims
- Examining the current state of tail risk in the Vietnamese stock market and
identifying potential sources of tail risk.
- Investigating the impact of tail risk events on the Vietnamese stock market
and the economy.
- Developing strategies for managing and mitigating tail risk in the Vietnamese
stock market.
- Providing insights and recommendations for policymakers and regulators on
how to address tail risk in the Vietnamese stock market.
1.3. Topic of research
- Systematizing factors affecting stock prices in Vietnam.
- Assessing the impact of monetary policy on stock prices in Vietnam.
1.4. Question of research
- What is the impact of interest rate changes of the State Bank of Vietnam
(SBV) on stock price fluctuations on the Vietnamese stock market?
- How does the SBV's expansion or tightening monetary policy affect liquidity in
the stock market?
- Is there a correlation between monetary policy measures and stock market
value in Vietnam?
- How does monetary policy affect the trading activities of target groups such
as individual investors, financial institutions, and investment banks on the
stock market?
- What is the impact of measures to control money supply and interest rates on
the investment and development abilities of businesses listed on the
Vietnamese stock exchange?
- How do events related to monetary policy, such as policy announcements or
changes in interest rates, affect investors' investment sentiment in the stock
market?
1.5. Scope of research
1.5.1 Object of research.
1.5.2 Range of research.
- Content range:
- Time range:
- Spatial range:
1.6. Contribution of research.
1.7. Research methods.
1.8. Structure of research.
Chapter 2: Literature Review
2.1. Overview.
2.1.1 Overview of macro factors.
2.1.1.1 The concept of currency
Currency is a means of payment, widely recognized and accepted as an
intermediary in the exchange of goods.
For example, let's consider an economy that produces two types of products:
bread and noodles. It is observed that producing a bowl of noodles requires twice the
cost and time of producing a loaf of bread. Instead of engaging in complex and time-
consuming bartering, currency comes into play to facilitate faster and more accurate
exchanges. For instance, it could be agreed that 1 bowl of noodles equals 2 units of
currency, and 1 loaf of bread equals 1 unit of currency. The following types are
considered currency and are arranged in decreasing order of liquidity:
● Cash: paper money, coins issued by the central bank.
● Bank deposits: non-term deposits that are easily withdrawable or
transferable.
● Savings deposits with a fixed term in banks are also considered
currency.
● Certain types of goods, in some cases chosen as intermediaries for
exchange but less widely accepted, are not considered currency.
2.1.1.2 The concept of money supply:
According to Investopedia, the money supply is defined as the aggregate
amount of currency and other readily available assets within an economy at a
specific point in time. It includes all physical cash circulating in the economy as well
as all bank deposits that can be readily converted into cash.
Central banks or treasuries, sometimes in collaboration, are responsible for
issuing paper currency and coins. To maintain economic stability, banking regulators
adjust the money supply by implementing policy changes and making regulatory
decisions that either increase or decrease the availability of money in the economy.
Types of money supply:
● M0: M0 includes all cash and coins in circulation within a country or
territory it governs. M0 does not encompass the money deposited in
banking systems. The M0 money supply can easily fluctuate by
depositing money or withdrawing cash from banks. Therefore, it is
rarely used to calculate the money supply.
● M1: M1 refers to a narrow measure of the money supply that includes
the most liquid forms of money. It typically consists of currency held by
the public (such as coins and paper money) and checking account
deposits. M1 is considered a key indicator of the money supply's
immediate purchasing power because it includes assets that can be
quickly converted into goods and services. Central banks often
monitor M1 closely as part of their efforts to manage monetary policy
and stabilize the economy.
● M2: M2 is a measure of the money supply that includes all elements of
M1 (cash and checking deposits) as well as "near money"
components like savings deposits, money market mutual funds, and
other time deposits. It represents a broader definition of money that
includes not only cash and highly liquid assets but also assets that
 can be easily converted into cash. M2 is often used by economists
and policymakers to analyze and understand the overall liquidity and
stability of an economy.
2.1.2 Overview of monetary policy.
2.1.2.1 Concept of interest rate
An interest rate is the percentage of principal that a lender charges as
compensation for lending money, or that a borrower pays for the use of borrowed
money. It is typically expressed as an annual percentage of the loan or investment
amount. Interest rates play a crucial role in economics and finance, influencing
borrowing and lending decisions, investment returns, inflation, and overall economic
activity. Central banks often adjust interest rates as a monetary policy tool to achieve
macroeconomic objectives such as controlling inflation, stimulating economic growth,
or stabilizing financial markets.
The State Bank announces refinancing rates, base interest rates, and other
types of interest rates to manage monetary policy and combat usury lending. From
the base interest rate, banks determine the interest rates for deposits made by both
institutions and individuals. These rates vary depending on the deposit term and
amount. There are various types of interest rates, including non-term interest rates,
term interest rates, and savings interest rates. Additionally, commercial banks also
set interest rates for loans to individuals or organizations in need of capital. This
interest is the amount that individuals or organizations borrowing from banks must
repay regularly.
Discount interest rate is the interest rate that banks offer to customers by
discounting promissory notes or other valuable documents before the maturity date,
calculated as a percentage of the face value deducted immediately when the bank
lends money to customers.
Rediscount rate is the interest rate that central banks provide capital to
commercial banks or rediscount promissory notes or documents that have not yet
matured. Because this is a capital supply activity for commercial banks, the
rediscount rate is usually lower than the discount rate. If the central bank wants to
tighten the money supply, this interest rate will be higher.
Refinancing rate is the interest rate that central banks lend to commercial
banks based on the credit loans of commercial banks. Interbank interest rate is the
interest rate that banks use when borrowing from each other in the interbank market.
Interest rates can affect the stock market in a number of ways as follows:
● Impact on Stock Market Investment: When the central bank
announces a reduction in the basic interest rate, commercial banks
will correspondingly lower deposit interest rates and lending rates.
Therefore, depositing money in banks seems to yield little profit for
individuals and investors. In such cases, they may want to withdraw
their bank deposits to transfer to other investment channels offering
higher returns, such as the stock market. Conversely, when interest
rates rise, the attractiveness of the stock market may decrease
compared to other markets.
● Impact on Present Value of Stocks: Low interest rates can increase
the present value of stocks because the value of future cash flows is
discounted by a lower interest rate. Conversely, high interest rates can
decrease the present value of stocks.
 ● Impact on Borrowing Costs: Interest rates also affect the borrowing
costs of companies. For companies using borrowed capital for
financial operations, increases in interest rates by banks and the
government may cause stock prices to fluctuate unfavorably. An
increase in interest rates will lead to higher interest expenses for
companies, resulting in increased debt. Therefore, when borrowing
costs are passed on to shareholders, the profit available to pay
dividends to shareholders decreases. When investors see a decrease
in dividend profits, they may have the psychological tendency to
withdraw their investments from that company. When too many
investors lose trust in the company, it leads to the consequence of
losing investors and failing to attract other investors. As a result, the
stock price of the company will either remain unchanged or even
decrease.
2.1.2.2 Concept of exchange rate.
According to D. Steinberg (2013), exchange rate is defined as the amount of
domestic currency that is required to purchase one unit of foreign currency. It refers
to the value of one currency in terms of another currency, it represents the rate at
which one currency can be exchanged for another. Exchange rates are typically
expressed as the amount of one currency required to purchase one unit of another
currency.
For example, if the exchange rate between the Dong (VND) and the US dollar
(USD) is 0,000041, it means that 1 VND can be exchanged for 0,000041 Euros.
Exchange rates fluctuate constantly due to various factors such as supply and
demand dynamics, economic conditions, geopolitical events, and central bank
policies. Governments and central banks sometimes intervene in the foreign
exchange market to stabilize their currencies or achieve certain economic objectives.
It plays a crucial role in international trade and investment, as they affect the cost of
imports and exports, influence tourism and cross-border investment flows, and
impact the profitability of multinational corporations.
The research by authors Đinh Thị Thanh Long & Nguyễn Thị Thu Trang
(2008) has indicated that the predominant trend of fluctuation between exchange
rates and stock markets is inverse.
When the value of a country's currency depreciates, it means that when
exchanging one unit of this currency, you will receive fewer units of another country's
currency. Therefore, investors are less inclined to convert currencies for trading. If
those stocks are not attractive and promising to deliver high profits, investors will not
risk investing in them, thus increasing their investment risks.
Conversely, when the value of a country's currency appreciates, it implies that
one unit of this currency can be exchanged for more units of another country's
currency, resulting in increased profit from currency conversion. This extra amount of
money may provide investors with funds for investment opportunities, attracting more
investors to the market.
2.1.2.3 Concept of required reserve.
Required reserves refer to the amount of funds that banks are required to
hold in reserve, either in cash or in deposits with the central bank, to ensure they can
meet their depositors' withdrawal demands and maintain liquidity. This reserve
requirement is set by the central bank as part of its monetary policy tools to regulate
the banking system and control the money supply in the economy. Banks must hold
these reserves as a percentage of their total deposits.
The required reserve is a tool used by central banks like the Federal Reserve
to regulate the banking system and influence economic activity. By setting reserve
requirements, central banks ensure that banks maintain enough liquidity to meet
withdrawal demands from depositors and prevent bank runs.
Additionally, adjusting reserve requirements can be used as a tool in
monetary policy. Lowering reserve requirements encourages banks to lend more,
stimulating economic activity, while increasing reserve requirements tightens the
availability of credit, slowing down economic growth.
The required reserve ratio can be used by investors as an indicator of the
economic situation. When the required reserve ratio is low, banks have more free
capital available for lending and supporting business activities. This often leads to
economic growth and increased optimism in the stock market, as businesses may
experience better growth prospects and higher profits.
Conversely, if the government or central bank increases the required reserve
ratio, banks will have to retain a larger portion of their capital, limiting their ability to
lend and support business operations. This can dampen economic growth and cause
negative fluctuations in the stock market, as businesses may struggle to grow and
achieve expected profits.
2.1.2.4 Concept of open market operation (OMO)
Open market operations (OMO) refer to the buying and selling of government
securities in the open market by a central bank. The primary objective of OMO is to
regulate the money supply in the economy and influence short-term interest rates.
Here's how OMO typically works:
● Expansionary OMO: If a central bank wants to increase the money
supply and stimulate economic activity, it purchases government
securities from commercial banks and other financial institutions. This
injects cash into the banking system, leading to lower interest rates
and increased lending and spending by businesses and consumers.
● Contractionary OMO: Conversely, if a central bank aims to reduce the
money supply to control inflation or cool down an overheating
economy, it sells government securities to banks and other financial
institutions. This drains liquidity from the banking system, leading to
higher interest rates and decreased lending and spending.
OMO is one of the key monetary policy tools used by central banks worldwide
due to its effectiveness in influencing short-term interest rates and overall economic
activity.
Open Market Operations (OMO) can have several effects on the stock
market:
● Interest Rates: OMOs can influence short-term interest rates, such as
the federal funds rate. When central banks buy securities through
OMOs, they increase the money supply, leading to lower interest
rates. Lower interest rates can make stocks more attractive compared
to other investments, potentially boosting stock prices.
● Market Sentiment: OMOs signal the central bank's stance on
monetary policy. Large-scale purchases of securities can signal
 accommodative monetary policy, which may be interpreted positively
by investors, leading to increased confidence and higher stock prices.
● Liquidity: OMOs inject liquidity into the financial system. This
increased liquidity can lead to lower borrowing costs for businesses,
which may stimulate investment and economic growth. Higher
economic growth can be favorable for corporate earnings and,
consequently, stock prices.
● Risk Appetite: OMOs can influence investors' risk appetite. Lower
interest rates resulting from OMOs may encourage investors to seek
higher returns in riskier assets like stocks, leading to increased
demand and higher stock prices.
● Market Expectations: OMOs can affect market expectations regarding
future monetary policy actions. For example, if the central bank
conducts OMOs to tighten monetary policy, it may signal expectations
of higher interest rates in the future, which could dampen stock prices.
2.1.3 Overview of stock market.
2.1.3.1 Concept of stock.
According to Investopedia (2023),A stock, also referred to as equity, is a
financial instrument representing ownership in a company. Each unit of stock, called
a "share," signifies a portion of the corporation's assets and earnings corresponding
to the amount of stock owned.
Stocks are primarily traded on stock exchanges and form a key component of
many investors' investment portfolios. Trading in stocks is subject to government
regulations aimed at safeguarding investors against fraudulent activities.
Companies issue stock to raise capital for various purposes, such as
expanding operations, investing in research and development, or paying off debt. In
return for purchasing stock, investors become shareholders and acquire certain
rights, including the right to vote on corporate matters, the right to receive dividends if
the company distributes them, and the right to participate in the company's growth
and success.
Stocks are typically bought and sold on stock exchanges, where buyers and
sellers come together to trade shares. Stock prices can fluctuate based on a variety
of factors, including the company's financial performance, economic conditions,
industry trends, and investor sentiment. Investors often buy stocks with the
expectation that their value will appreciate over time, allowing them to earn a profit by
selling the shares at a higher price in the future.
2.1.3.2 Concept of stock market.
a. Definition.
The stock market, also known as the equity market, is a centralized
marketplace where buyers and sellers trade shares of publicly listed companies. It is
one of the most important components of a market economy as it provides
companies with access to capital and investors with ownership in businesses,
allowing them to share in the company's profits and losses.
In the stock market, investors can buy and sell stocks through exchanges or
over-the-counter markets. Stock prices are determined by supply and demand
dynamics, as well as various factors such as company performance, economic
conditions, and investor sentiment.
 The stock market plays a crucial role in allocating capital efficiently, facilitating
economic growth, and providing liquidity to investors. It serves as a barometer of the
overall health of the economy and is closely monitored by policymakers, economists,
and investors worldwide.
b. Structure of stock market.
● On the stock market, there are two main types of markets based on the
nature of trading:
❖ Primary Market: This is where newly issued securities are bought and
sold for the first time. In the primary market, capital from investors is
transferred to the issuing company through the purchase of newly
issued securities. It is the initial venue for the sale of securities to the
public.
❖ Secondary Market: This is where previously issued securities are
traded among investors. The secondary market ensures liquidity for
securities already issued. It serves as a platform for the exchange and
trading of securities that have already been issued. Investors buy and
sell securities in the secondary market for various purposes such as
asset preservation, earning fixed annual income, or capitalizing on
price differentials.
Relationship between the Primary and Secondary Markets:
❖ The primary market serves as the foundation for the development of
the secondary market by providing the securities traded in the latter.
Without a primary market, the existence of a secondary market would
be challenging. The secondary market cannot emerge without a
robust primary market offering a variety of securities attractive to
investors.
❖ Conversely, the secondary market acts as a catalyst and condition for
the development of the primary market. Once securities are issued in
the primary market, if there is no secondary market for circulation,
trading, and exchange to create liquidity for the securities, it would be
difficult to persuade investors to invest in them.
❖ Trading securities in the secondary market facilitates the liquidity of
investment capital. Investors can easily convert from securities to
cash, switch from one type of security to another, or move from one
investment sector to another.
❖ With the high liquidity of securities and the dynamic nature of the
secondary market, investors are attracted to invest in securities. This
is essential for issuers to sell securities in the primary market and
mobilize significant capital as needed.
● Based on the operational methods, the stock market can be categorized into:
❖ Centralized Stock Market: Trading is conducted at a centralized
physical location. The typical form of a centralized stock market is a
stock exchange. At the stock exchange, trading is centralized at one
location, and orders are matched to form transaction prices.
❖ Decentralized Stock Market: Also known as over-the-counter (OTC)
market. In the OTC market, trading takes place through a network of
dispersed securities firms across the country, connected
electronically. Prices in this market are formed through negotiation.
 ● Based on the commodities traded, the stock market is divided into:
❖ Equity Market: Trading and exchange of various types of shares,
including common shares and preferred shares.
❖ Bond Market: Trading and exchange of various types of bonds already
issued, including corporate bonds, municipal bonds, and government
bonds.
❖ Derivatives Market: Issuance and trading of various financial
instruments such as stock options, warrants, and futures contracts.
2.1.3.3 Concept of stock market index.
a. Definition.
The stock market index is a statistical measure reflecting the overall
performance of the stock market. It is synthesized from a portfolio of stocks using a
specific calculation method. Typically, the portfolio includes stocks with common
characteristics, such as being listed on the same exchange, belonging to the same
industry, or having similar market capitalization.
The stock market index is not only of interest to economists for its close
relationship with the economy and society of a country, but also to investors and
market practitioners. They use it to describe the market, compare returns, or estimate
investment yields before making investment decisions.
In Vietnam, the stock market currently has several popular stock market
indices, including the VN-Index on the Ho Chi Minh City Stock Exchange (HOSE)
and the HNX-Index on the Hanoi Stock Exchange (HNX). Additionally, there are
indices like the Upcom-index, VN30, and HNX30. Among these, the VN-Index is
often used for research purposes more frequently than other indices.
b. The VN-Index
The VN-Index is a stock market index that reflects the price movement trend
of all stocks listed and traded on the Ho Chi Minh City Stock Exchange (HOSE).
The VN-Index is calculated using the Passcher method formula:
❑

VN-Index = ∑
❑
P1 i Q 1 i
❑
Where:
❑
● ∑
❑
P1 i Q1 i: represents the total market capitalization of listed

companies at the current time.

❑
● ∑
❑
P 0i Q0 i: represents the total market capitalization of listed

companies at the base time.

2.2 Theoretical Foundation.
2.2.1 Modern Portfolio Theory.
Modern Portfolio Theory (MPT), introduced by Harry Markowitz, transformed
investment strategy by emphasizing the importance of portfolios over individual assets.
Markowitz, honored with the Nobel Prize in Economics in 1990, proposed evaluating the
risk-return relationship within a portfolio context. He introduced diversification as a key
concept, highlighting the interplay of returns among assets and pioneering the use of a
covariance/variance matrix to model these relationships. It is a framework for making
investment decisions based on the principles of diversification and risk management. It
revolutionized the field of finance by introducing the concept of viewing investments as part
of a broader portfolio rather than as individual assets.Markowitz developed a mathematical
framework to quantify the inherent risk in portfolios, suggesting the existence of "efficient
portfolios" that maximize returns for a given level of risk tolerance.
Markowitz's framework identified various efficient portfolios tailored to different risk
tolerance levels. By plotting the maximum return against each portfolio's risk level, he
delineated the "efficient frontier," illustrating the risk-return tradeoff. Markowitz advocated for
diversified portfolios to mitigate nonsystematic risk, leaving investors with only systematic
risk exposure. This enabled investors to select portfolios on the efficient frontier aligned with
their risk preferences, optimizing returns while managing risk. These efficient portfolios form
the basis for equity market transactions, guiding investors' decisions and contributing to
market equilibrium.
Key concepts of Modern Portfolio Theory include:
● Diversification: MPT advocates for spreading investments across a range of
assets with different risk levels and returns. By diversifying, investors can
reduce the overall risk of their portfolio without sacrificing potential returns.
This is based on the premise that individual assets may be subject to specific
risks, but these risks can be mitigated when combined with other assets
whose returns are not perfectly correlated.
● Efficient Frontier: The efficient frontier is a graphical representation of the
optimal portfolios that offer the highest expected return for a given level of
risk, or the lowest risk for a given level of return. Portfolios that lie on the
efficient frontier are considered to be the most efficient because they offer the
best risk-return tradeoff.
● Risk and Return: According to MPT, investors are rational and risk-averse,
meaning they seek to maximize returns while minimizing risk. MPT quantifies
risk as the volatility of returns, typically measured using standard deviation. It
asserts that investors should be compensated for taking on higher levels of
risk with the expectation of higher returns.
● Correlation: MPT recognizes that the correlation between asset returns
affects the overall risk of a portfolio. Assets with low or negative correlations
offer greater diversification benefits because they tend to move independently
of each other. By combining assets with low correlations, investors can further
reduce portfolio risk.
● Portfolio Optimization: MPT uses mathematical models to determine the
optimal allocation of assets within a portfolio to achieve the desired level of
risk and return. This involves analyzing historical returns, volatilities, and ❑❑
correlations of assets to construct efficient portfolios.
2.2.2 Capital Asset Pricing Model.
The Capital Asset Pricing Model (CAPM) is a fundamental framework in finance used
to determine the expected return on an investment based on its risk and the overall market's
return. It was developed by William Sharpe, John Lintner, and Jan Mossin in the 1960s.
According to CAPM, the expected rate of return for an asset is directly related to the
risk associated with that asset. Investors evaluate the discounted future expected payoffs
from an asset and decide whether to buy or sell it. Market equilibrium is achieved when the
asset's market price equals the discounted value of its expected future payoffs. When all
asset prices reach equilibrium, there is equilibrium in the market for assets as a whole.
Sharpe (as cited in Chiarella et al., 2013) proposed that there is a linear relationship
between the expected rate of return of an asset and its associated risk, under certain
assumptions. This risk is measured by the asset's beta coefficient, which reflects its
sensitivity to market movements. One of the key innovations of CAPM is the introduction of
the risk-free asset, which allows investors to allocate their wealth between risk-free assets
and risky portfolios based on their risk tolerance.
Tobin's (as cited in Balvers & Huang, 2009) contribution to modern portfolio theory
introduced the role of cash or risk-free assets in optimal portfolio selection. Sharpe further
expanded this idea by allowing investors to both lend and borrow at the risk-free rate,
enabling them to optimize their portfolios based on their risk preferences.
At the heart of the CAPM is the concept of systematic risk, also known as beta ( 𝛽 ).
Systematic risk refers to the risk that cannot be diversified away by holding a diversified
portfolio. According to CAPM, the expected return on an investment (E(R ¿¿ i))¿ is
determined by the risk-free rate R f plus a risk premium proportional to the asset's systematic
❑
risk (beta) multiplied by the market risk premium ( E(R ¿¿ M )¿ - R f ¿❑ ¿ :
E(R ¿¿ i)=R f + β i ¿¿
Where:
● ( E(R ¿¿ i) ¿ is the expected return on the investment.
● R f is the risk-free rate of return, typically represented by the yield on
government bonds
● β i is the beta coefficient of the investment, representing its systematic risk
relative to the market.
● E(R ¿¿ m)¿ is the expected return on the market portfolio.
● E(R ¿¿ m)−R f ¿ is the market risk premium, which measures the excess
return expected from investing in the market rather than the risk-free asset.
The CAPM assumes that investors are rational and risk-averse, seeking to maximize
their returns while minimizing risk. It also assumes that markets are efficient, meaning that
asset prices reflect all available information.
Despite its simplicity and widespread use, the CAPM has faced criticism for its
reliance on simplifying assumptions and its inability to fully explain market behavior in all
situations. However, it remains a valuable tool for estimating the required return on an
investment based on its risk characteristics.
2.2.3 Single-Factor Model of CAPM.
The Single-Factor Model of the Capital Asset Pricing Model (CAPM) is a simplified
version that focuses on one key factor: systematic risk. In this model, the expected return of
a security or portfolio is determined by its sensitivity to systematic risk, often represented by
the market return.
The single-factor CAPM model is based on the following equation:
E(R ¿¿ i)=E (R¿¿ f )+ β j ׿ ¿ ¿ ¿

Where:
● E(R ¿¿ i) ¿ is the expected return of the security or portfolio.
● E(R ¿¿ f )¿ is the risk-free rate, representing the return on a risk-free
investment.
● E(R ¿¿ m)¿ is the expected return of the market portfolio.
● β is the beta coefficient of the security or portfolio or the systematic risk of
security j, measuring its sensitivity to market movements.
 In this model, the risk premium, or the excess return above the risk-free rate, is
determined by multiplying the market risk premium ( E(R ¿¿ m)−E (R¿¿ f )¿ ¿ by the beta
coefficient
( β i). The beta coefficient reflects how much the security or portfolio's return is expected to
move in response to changes in the market return.
According to equation, which represents the standard CAPM model:
● Expected return from a security is linearly related to its systematic risk. Higher
systematic risk means higher expected rate of return.
● If the risk-free rate and market returns remain constant, a security's expected
returns are solely determined by its systematic risk.
● The risk-free rate is the y-intercept of the linear relationship between a
security's expected returns and systematic risk.
● According to Spyrou and Kassimatis (2009), the risk-free rate has a beta of
zero while the market portfolio has a beta of one.
The CAPM model can be summarized as follows: (a) the degree of risk for each
investment is the probability that actual returns will differ from expected returns; (b) the total
risk of investing in an asset can be divided into systematic and unsystematic risks; and (c)
investors are only concerned with the expected rate of return, assuming a bell-shaped
symmetric distribution of returns. However, according to the CAPM's assumptions, holding
an asset within a well-diversified portfolio can effectively eliminate unsystematic risk caused
by firm-specific factors (Spyrou & Kassimatis, 2009). Systematic risk, on the other hand, is
related to the entire economy and is determined by factors beyond the firms' control and
cannot be eliminated through diversification. However, the systematic risks of different
assets vary depending on the type of business that firms operate in. The distinction is due to
the covariance of their returns with the return on the entire asset market. The key takeaway
from this analysis is that if investors have well-diversified portfolios, only systematic risk will
affect their required returns. To estimate a security's expected returns, consider its
systematic risk, risk-free rate, and market returns for risky assets (Patterson, cited in Spyrou
& Kassimatis, 2009).
However, the systematic risks of various assets differ depending on the type of
business in which a company operates. The distinction stems from the covariance of their
returns with the return on the entire asset market. The main takeaway from this analysis is
that if investors have well-diversified portfolios, only systematic risk will affect their expected
returns. To calculate a security's expected returns, consider its systematic risk, risk-free rate,
and market returns for risky assets (Patterson, cited in Spyrou & Kassimatis, 2009).
2.2.4 Multifactor Models and CAPM
Sharpe and Linter's asset pricing theory has long been accepted by academics and
practitioners as the model for pricing financial assets.
However, since the 1970s, researchers have recognized that this simple model does
not fit well with the complexity of today's equity markets. "Moreover, CAPM lost its credibility
because of empirical contradictions, specifically because of asset pricing anomalies that
were evidenced by researchers who applied the model in various stock markets across the
world" (Hojat, 2014, pp. 22-23).
According to Sehgal and Balakrishnan's (2013) research, firm-specific factors play a
significant role in the impact of macro variables on equity market asset prices. Sehgal and
Balakrishnan cited studies on (a) the size of the company by Banz, (b) the value effect by
Chan et al., (c) the price-to earnings ratio by Basu, (d) the ratio of leverage to average return
on stocks by Bhandari, and (e) the book equity-to-market equity ratio by Stattman.
Additionally, Fama-French expanded upon the CAPM framework by introducing an
asset pricing model (FFM) that incorporated two new variables: (a) size, assessed through
market capitalization; and (b) value, gauged by the book equity to market equity ratio. This
augmentation resulted in the formulation of the three-factor model (FF3). Through extensive
empirical testing, this model was purported to outperform traditional theoretical asset pricing
models (Chiarella et al., 2013). Consequently, Fama-French asserted that their multifactor
model serves as a viable alternative to the CAPM, offering greater explanatory power for
most of the anomalies associated with the CAPM. In alignment with the Fama-French
approach, I integrated company affiliation as a company-specific risk factor into my model
(Chiarella et al., 2013).
Furthermore, Fama-French proposed the inclusion of another factor known as the
distress factor in asset pricing models. They elaborated that the presence of a distress factor
in companies could be discerned through indicators such as the price-to-book equity (P/B)
ratio, price-to-earning (P/E) ratio, and price-to-sales growth (PSG). Consequently,
companies experiencing distress would need to offer higher returns to attract investors to
invest in their stocks (Chiarella et al., 2013).
Chiarella et al. (2013) delved into the heterogeneity and evolutionary behavior
observed among investors in the equity market. They integrated the adaptive behavior of
agents with diverse beliefs and formulated a new rendition of the CAPM, termed the
evolutionary capital asset pricing model (ECAPM). Their findings revealed a phenomenon of
spillover, where the market price of one asset influences others when rational agents switch
to more lucrative trading strategies. Additionally, Chiarella et al. (2013) noted a positive
correlation between price volatility and trading volume, indicating that high trading volumes
contribute to the spillover effect. They concluded that such shifts in trading strategies could
induce instability in the equity market, elucidating phenomena such as long-term deviations
of market prices from intrinsic values and market crashes triggered by asset bubbles.
Abdymomunova and Morleyb (2011) improved the CAPM for book-to-market (B/M)
across stocks by incorporating time variation, known as the conditional CAPM.
Abdymomunova and Morleyb found that when the unconditional CAPM was rejected, using
the CCAPM resulted in better outcomes. Furthermore, they found that the conditional CAPM
was more effective in explaining capital market behavior than the unconditional CAPM.
Levy (2012) linked the CAPM to Kahneman and Tversky's prospect theory (PT),
which was awarded the Nobel Prize in Economics in 2002. Prospect theory proposes
replacing the CAPM's assumption of anticipated utility (EU) maximization and risk aversion
with a new paradigm that is more applicable to the actual economy. Levy (2012) proposed
an alternative paradigm in which investors make investment decisions based on wealth and
loss aversion, maximizing the expectation of an S-shaped value function with a risk-seeking
component.
2.3. Research Gap

Chapter 3: Methodology
3.1 Research process
3.2. Research models and data.
3.2.1 Research models
3.2.2 Research data
3.3. Recommendations.

Chapter 4: Results
4.1. Statistical description of data
4.2. Results from the model

Chapter 5: Discussion and Conclusion

References