Title: Testing the Arbitrage Pricing Theory in an Emerging Stock Market: The Case of Mauritius

Author: Sunil BUNDOO, University of Mauritius

Abstract
Mauritius has long been known as a small, mono-crop economy, relying on sugar revenue only. Over the years, the economy has successfully diversified into tourism, textile and, more recently financial services. With the advent of globalization and liberalization, the country has new challenges to sustain its growth; therefore the Government has put priority on economic diversification. Among the new industries to further promote economic development are: Information and Communication Technology, the Agro- Industry and the Financial Sector. A dynamic financial sector is an important segment of the financial system of any country as it plays a critical role in mobilizing savings and channeling them for productive purposes. Modern portfolio theory contemplates that there are several systematic factors representing different sources of risk underlying stock returns. Identifying those factors, therefore, is a major concern both for academic research and for policy makers and investors, who can base on those findings, design their policies and investment strategies meaningfully. Several asset-pricing models have been devised to relate expected returns to one or several factors representing various sources of risk. Extensively used asset pricing models are the Capital Asset Pricing Model, (CAPM), the Fama and French Three Factor model and the Arbitrage Pricing Theory, (APT). However, the CAPM has been criticized widely because of the difficulties in selecting a proxy for the market portfolio as a benchmark. The APT, being a multi-factor model, is potentially better than the CAPM in explaining asset returns as it provides that several factors influence asset returns by varying degrees. As risk is likely to be multidimensional, we focus on the APT framework to analyse several macroeconomic factors likely to influence market return and identify which ones are significant on the Stock Exchange of Mauritius (SEM). The sample data will be monthly observations from January 2002 to December 2006. We use SPSS to first see whether the factors considered are accepted. Then we perform a sequential model building and see which model performs best in terms of explaining changes in the market return. We also analyse the economic and statistical significance of the variables included in the model. From the results, we then construct a multi-factor model for the SEM. Finally, we perform a Cronbach test to gauge the reliability of the model. The result of this study could be of use to investors. Firstly, it will provide more understanding about the factors underlying stock returns on the SEM and secondly, help investors in their decision making process by showing them what they have to watch for in the economic conditions in the market before investing (market timing). This study may also provide a methodology to future researchers to further elaborate on the list of

macroeconomic factors that may affect the market index in emerging stock markets, particularly in Africa.

This study focuses on the arbitrage pricing theory (APT) framework to analyse several macroeconomic factors likely to influence the market return (SEMDEX return) on the Stock Exchange of Mauritius (SEM). Seven variables are considered: the consumer price index, oil price, exchange rate, tourist arrival rate, electricity consumption, Lombard rate and aggregate money supply. The sample data are monthly observations from January 2002 to December 2006. Four variables that are statistically significant at the 10% level or better in explaining variation in the equity premium on the SEM are: the level of the price index, the oil price (given that Mauritius is heavily dependent on oil imports), the exchange rate and the level of economic activity as proxied by electricity consumption. The most important variable is the exchange rate. The reliability of the model is tested and found to be adequate.

This paper attempts to fill an important gap in the empirical literature pertaining to the determinants of hedging by focusing on an upper-income developing country, Mauritius. Indeed, earlier empirical evidences on hedging were mainly based on advanced economies with little emphasis on developing countries. From the data on Mauritian firms for the year 2005-06, it transpires that managers incentives to hedge and tax convexity motive to hedge, along with financial and operational explanations underlying hedging, are basically not applicable in Mauritius. The size and age of firms are found to be positively related to hedging, endorsing the fact that high fixed costs and knowledge in establishing a derivative framework are important. This paper undertakes a review of the reasons as to why firms hedge. Basically, the empirical literature pertaining to hedging is split into three main parts. The first part of the literature underscores the strong incentives for shareholders to hedge by virtue of three main forces which comprise the convex tax structure, expected financial distress costs along with underinvestments under imperfect capital markets. The second part shows that, the managers of firms are induced to hedge not only under managerial risk aversion motive but also to send strong signals of their skills to the market. Finally, the hedging literature considers the alternative modes of hedging which may be derivativebased or non-derivativebased. The paper also points out the need of being cautious when dealing with the empirical evidences based on hedging since results are not always foolproof for diverse reasons.