Abstract
This study attempts to investigate seven macroeconomic risk factors’ effect on fifty stock returns of Pakistani stock market for the time period of July 1998 to June 2014 respectively. The sensitivity coefficients of macro-economic risk variables are identified as market return, money supply, industrial production, and call money rate, term structure of interest rate, exchange rate and inflation. This study jointly estimates economic risk factors and also risk premium associated with these risk factors by employing extended arbitrage pricing theory (APT) model by applying non-linear seemingly unrelated regression. The innovation of each economic variable is used as risk factor and the study estimates the sensitivities of risk factors and the premium for risk using extended APT model. The results indicate that the money supply risk positively affects stock returns and the industrial production, inflationary shock, exchange rate, call rate and the term structure shocks negatively affect the stock returns respectively. Among all the macro-economic risks, the risk premium for the stock returns is significant for facing market risk, inflation risk and interest rate risk. The results of the study imply that since risk premium is the reward for taking risk while holding stock market assets, if the predictable risk increases, it reduces uncertainty of the stocks. Therefore investors, authorities and policy makers are needed to take into account the economic risk factors while considering the sensitivity of stock returns in making decisions.
Highlights
Since the last three decades, the Arbitrage Pricing Model (APT) developed by Ross (1976) tends to be one of the prominent asset pricing models in the modern portfolio theory and has gained momentum in the field of financial economics respectively
This study focuses on the risk premium earned on stock returns for facing these macro risks and the sensitivity coefficients of macro-economic risk variables identified as market return (Rm), industrial production (Q), call money rate (CR), term structure of interest rate (TS), exchange rate (EX) and inflation (INF) and money supply (MS)
The innovation of each economic variable is used as risk factor and the study estimates the sensitivities of risk factors and the premium for risk using Arbitrage Pricing Theory (APT)
Summary
Since the last three decades, the Arbitrage Pricing Model (APT) developed by Ross (1976) tends to be one of the prominent asset pricing models in the modern portfolio theory and has gained momentum in the field of financial economics respectively. The APT model explains that the returns’ on a security are best determined by a set of economic factors based on their factor sensitivities proposing that the factor risks are of acute importance in pricing of securities. Two basic approaches are used to test the Arbitrage Pricing Theory (APT) (Ross, 1976) namely statistical and theoretical approaches. Statistical approaches use factor analysis to remove the common factors and test whether the expected returns are explained by the cross-sectional fillings of asset returns on the factors. In estimating unspecified factors through factor analysis approach economic variables are used as the specified factors because measured economic factors provide additional information, thereby linking asset pricing behavior to economic conditions
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