An ARCH/GARCH arbitrage pricing theory approach to modelling the return generating process of South African stock returns.

Abstract

This study investigates the return generating process underlying the South African stock market. The investigation of the return generating process is framed within the Arbitrage Pricing Theory (APT) framework with the APT reinterpreted so as to provide a conceptual framework within which the return generating process can be investigated. In modelling the return generating process, the properties of South African stock returns are taken into consideration and an appropriate econometric framework in the form of Autoregressive Conditional Heteroscedastic (ARCH) and Generalized Autoregressive Conditional Heteroscedastic (GARCH) models is applied. Results indicate that the return generating process of South African stock returns is described by innovations in multiple risk factors representative of several risk categories. The multifactor model of the return generating process explains a substantial amount of variation in South African stock returns and the ARCH/GARCH methodology is an appropriate econometric framework for the estimation of models of the return generating process. The APT framework is successfully applied to model and investigate the return generating process of South African stock returns.