African Journal of Business Management Vol. 5(32), pp. 12598-12605,14 December, 2011 Available online at http://www.academicjournals.org/AJBM DOI: 10.5897/AJBM11.2105 ISSN 1993-8233 ©2011 Academic Journals Full Length Research Paper Validity of capital asset pricing model in Pakistan: Evidence from Karachi Stock Exchange Syed Ali Raza 1 * Syed Tehseen Jawaid 1 , Imtiaz Arif 1 and Fahim Qazi 2 1 IQRA University, Karachi-75300, Pakistan. 2 Dadabhoy Institute of Higher Education, Karachi, Pakistan. Accepted 26 October, 2011 This study investigates the validity of capital asset pricing (CAP) model in Karachi Stock Exchange (KSE). The data used in this study were collected from 387 companies of 30 different sectors on monthly, quarterly and semi-annual basis. The Paired sample t- test is applied to find the difference between actual and expected returns. Results show that capital asset pricing model (CAPM) predict more accurately the expected return on a short term investment as compare to long term investment. It is recommended that the investors should more focus on CAPM results for short term as compare to long term investments in KSE. Key words: Portfolio choice, investment decisions, capital assets pricing model, risk. INTRODUCTION Capital asset pricing model (CAPM) is one of the central model use by portfolio managers, professional and investors to predict the expected risk and expected return on investment. The main focal point of CAP model is to check whether the returns are statistically related to risks (betas). According to CAP model the investor needs to be compensated in two ways, for time value of money (risk free rate) and for taking risk. The CAP model was introduced by Jack Treynor, John Lintner, William Sharpe and Jan Mossin in the early 1960’s and was further refined later (Bodie et al., 2003). The findings and results of CAP model are very mix. The results of studies from late sixties, seventies and early eighties supported the validity of CAP Model (Black et al., 1972; Fama and MacBeth, 1973; Blume and Friend, 1973; Lau and Quay, 1974; Dowen, 1988; Jagannathan and Wang, 1993; Jagannathan and McGrattan, 1995). In these decades, it is concluded that the CAP model is able to predict the expected return on investments. But in the mid of eighties, it was found that *Corresponding author. E-mail: syed_aliraza@hotmail.com. Tel: 92-333-3448467. the single risk factor model does not accurately predict the expected return on stocks because there are so many other factors affecting the returns on investments such as firm size, market value, financial ratios, price earnings ratio, economic conditions, seasonality effect, inflation (Banz, 1981; Basu, 1983; Tinc, 1984; Groenewold and Fraser, 1997; Scheicher, 2000). Karachi Stock Exchange (KSE) is not a sustainable market and investors find fluctuations in prices of stocks, for that reason, Karachi stock exchange have very different risk-return relationship. The investors discover that the market goes up or down dramatically in a few sessions. In December 2008, in the Karachi stock exchange, 100 index was down to 3300 points from 9187 points to 5865 points in just 13 trading sessions. After two months, the 100 index of Karachi stock exchange was up to 2638 points from 5707 points to 8345 points in just 19 trading sessions. 1 The main problem of KSE for investors and portfolio managers is to quantify the risk associated with securities and expected return on bearing this risk. Therefore, the main objective of this study is to determine how accurately the capital asset pricing model predicts the 1 Information is gather from official website of KSE: www.kse.com.pk.