Financial sector value and the CAPM: evidence from Tokyo stock exchange firms

Abstract

With sample data from manufacturing and non-manufacturing firms listed in the first section of Tokyo Stock Exchange we investigate the market portfolio proxy missing problem in which the value-weighted market index is used as a proxy variable for the true market portfolio in the tests of the CAPM. In the current paper we pay particular attention to the role played by financial sector of the economy and hypothesize that the financial sector adds extra value and/or risk to the real sector of the economy. Hence, we augment the value-weighted index, which is composed of manufacturing and non-manufacturing firms only, with an index of firms from the financial sector of the economy. We also argue that this procedure can simultaneously take into account the cross-holding phenomena of Japanese firms between financial and non-financial sector of the economy. We find that the performance of cross-sectional regressions improves with the use of this additional financial index. We interpret that the additional risk factor may be related to the leverage risk of the manufacturing and non-manufacturing firms, especially during the time surrounding Japanese "bubble" period. We investigate whether the conventional factors like the size and the book-to-price ratios, which are known to explain Japanese stock returns well, are related to this financial factor variable. Our answer is yes and we find that the financial factor is related to the size factor but not so much so to the book-to-price ratio factor. Finally we reconfirm the previous findings on Japanese data that the CAPM does not hold when one use value weighted index as a sole proxy variable for the true market portfolio.