The Asset Pricing and Bid-Ask Spread: An Empirical Evidence Based on the KLSE Market

Asset pricing theories, particularly the Capital Asset Pricing Model (CAPM) asserts that the expected returns on any particular capital asset consists of only two components, namely the returns on a risk-free security and a premium for the risk. This study reexamines the CAPM by incorporating two important variables, namely the bid-ask spread as a measure of the transaction costs and firm size to test on the validity of both variables in the equilibrium asset returns model. Using the Generalized Linear Regression method as described in Kmenta (1986), this study finds a positive significant relationship between the stock returns and bid-ask spreads as a measure of the transaction costs for all the three regression models, namely all-companies, average-size companies and ten size-sorted portfolios models. The findings confirm the theoretical conjecture that bid-ask spreads are priced in the asset returns, and stocks with higher bid-ask spreads carry a liquidity premium in their prices. The results suggest that by decreasing the transaction costs will generate a greater order flow, which in turn increase the frequency of the market. Nevertheless, the negative relation between the firm size and stock returns can only be found in two out of the three regression models, that is, the all-companies and average size companies models. The results corroborate previous studies where small firm anomaly exist in the asset pricing model in the KLSE market. However, the size effect is found to be insignificant in explaining the portfolios returns in the ten size-sorted portfolios model. Thus, this study evidenced the ability of the spread variable in explaining the variation in the stock returns as compare to the firm size variable in the KLSE market.

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