Capital Market Reform and Asset Pricing: The Case Of India

Abstract

The reforms of the Indian capital market provide a unique opportunity to test if reforms affect asset pricing. The reform that is the focus of this study is the establishment of the National Stock Exchange (NSE) in late 1994. The NSE, among other reforms, introduced nationwide screen-based trading with a dish-to-satellite data transmission system that provides instant trading access to brokers anywhere in India. The establishment of the National Stock Exchange (NSE) provides a unique natural experiment in that the NSE resulted in a dramatic reduction in market frictions and a tremendous improvement in market efficiency. The model that is employed here to test the asset pricing behavior is the Fama- French (1993) three-factor model. We fit the Fama-French model, which is the Capital Asset Pricing Model (CAPM) supplemented by two additional factors, namely the size and the value factor, in the pre-NSE period and the post-NSE period. We test if there is any change in the explanatory power of the Fama-French (1993) model and the sensitivities of the asset returns to the three factors, namely market return, size and value across the two periods.