Modelling Interdependent Returns and Risk in the Environmental Industry

This paper stresses the importance of assessing the risk-return trade-off faced by environmentalindustries in financial markets. One of the most widely-used theoretical models in finance is the conditionalCAPM, which describes the conditional risk-return tradeoff in financial markets, whereby both the conditionalmean return and conditional beta risk are allowed to vary over time. This paper models the time-varyingconditional mean and variances of returns, and the correlations between the individual asset return and the marketreturn in the conditional CAPM in a multivariate GARCH framework. Specifically, the Vector ARMAAsymmetricMultivariate GARCH model of Chan, Hoti and McAleer (2003), which incorporates the CCCMGARCHof Bollerslev (1990) and the Vector ARMA-GARCH of Ling and McAleer (2002), is applied to theconditional CAPM, with the conditional CAPM specification replacing the ARMA specification in theconditional mean equation. The main motivation for using the Conditional CAPM-AMGARCH-in-mean modelspecification is not only because it has the ability to capture the stylized facts of financial asset returns such aspersistence of volatility, volatility clusters and excess kurtosis, but it also considers the interdependencies ofvolatilities between the individual asset return and the market return, and the asymmetric effects of theunconditional shocks on the conditional variances of the individual asset return and the market returnrespectively. Further, the structural and statistical properties of this model have been established in Chan et al.(2003). Our dataset consists of monthly excess returns on the Australian Mining industry sectors including GoldMining, Other Mining and Mining Finance from the period January 1980 to December 2002. The paper suggeststhat the conditional CAPM is inadequate in explaining the financial risk-return tradeoff for the environmentalindustry sectors; however, there appears to be some interdependent ARCH/GARCH effects between the OtherMining and Mining Finance excess returns and the market excess return, and no asymmetric ARCH/GARCHeffects.