Why an Asset Pricing Model Fails to Explain the Cross Section of Stock Returns in the Korean Market'

Abstract

This paper investigates the reason that none of asset pricing models show substantial performance in the Korean market. Based upon previous literature, the main reasons for the failure are categorized into three: transaction costs, investors' irrationality, and missing risk factors. We analyze the difference between the expected return from an asset pricing model and the realized return with respect to three possible reasons for the failure of asset pricing models. By regressing the difference between the expected return and the realized return on proxies of transaction costs, investors' irrationality, and missing risk factors, we find that transaction costs and investors' irrationality are tenaciously disrupting the performance of asset pricing models. We also show that the inferior performance of an asset pricing model from transaction costs and investors' irrationality cannot be improved by just adding more factors in an asset pricing model.

Keywords: Asset pricing Model, Transaction cost, Investors irrationality, Missing risk factor

JEL Classification: G12