Abstract
This study aims to test the explanatory power of Fama and French three factor model (1993) in explaining cross-sectional average return for Pakistan’s equity market for the time frame of 10 years from 2004-2014. The sample includes firms that traded on KSE-100 index from 2004-2014. Six portfolios were formed by the intersection of two size portfolios and three value portfolios. Excess monthly returns of the six portfolios i.e. the dependent variable were individually regressed against market premium, size premium and value premium (MRP, SMB and HML) i.e. the independent variables to test the validity of Fama and French three factor model. Along the line of original Fama & French, this study aims to provide valuable insights into components of excess returns and lay ground work towards further studies in this domain. An important insight it is bound to show is whether BE/ME & size factors hold as proxies for time-varying systematic risk as is proclaimed by past researches.
Highlights
1.1 IntroductionThe Capital Asset Pricing Model (CAPM), developed by Sharpe (1964) and Lintner (1965), has been long used by academics and practitioners to explain the relationship between risk and expected returns of an asset
The aim of our study is to check if Fama and French three-factor model holds true for Pakistani equity market
According to Fama and French (1992, 1993), the three-factor model does a better job than the CAPM at explaining cross-sectional variation in average stock returns
Summary
The Capital Asset Pricing Model (CAPM), developed by Sharpe (1964) and Lintner (1965), has been long used by academics and practitioners to explain the relationship between risk and expected returns of an asset. This model takes into account only one risk factor which is the excess market portfolio return (Market premium). The CAPM model explains that covariance of portfolio return with the market portfolio return has an important role in explaining variations on the excess portfolio return. Fama and French, three factor model states that the expected excess returns on a portfolio [
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