Abstract
This study examines the role of quality minus junk factor in explaining cross-sectional differences in stock returns for the equity market of Pakistan. A new factor quality minus junk has been added to the existing Fama & French three factor model (1993) as a fourth factor to check whether it is priced as a risk factor. The study also compares the explanatory power of the newly proposed model with the existing single-factor Capital Asset Pricing Model (CAPM) and Fama & French three factor model (1993). A high quality data set of 70 non-financial firms listed on the PSX is employed as a sample for the period 2008- 2016. Results show that quality minus junk factor is priced in the equity market of Pakistan and this newly proposed four factor model has significantly higher explanatory power than the existing three factor model.
Highlights
Recent studies in the field of asset pricing document that the financial quality of stocks is a strong predictor of their expected returns (Asness et al 2018; Zaremba 2015)
Market premium is priced in the equity market of Pakistan but this factor alone is not enough to explain the behavior of stock returns
Results indicate that inclusion of size and value premium in Capital Asset Pricing Model (CAPM) better explains the average returns as depicted through increased explanatory power of the three factor model presented by Fama and French (1992)
Summary
Recent studies in the field of asset pricing document that the financial quality of stocks is a strong predictor of their expected returns (Asness et al 2018; Zaremba 2015). These quality characteristics may vary from country to country and these country-specific factors can be utilized in multifactor asset pricing models to evaluate the performance of different investment strategies This specific study evaluates the quality characteristics identified and tested by Asness et al (2018), for the very first time in 2014, on Pakistan financial market which is considered to be a rapidly emerging market of Asia. Because stock return and its price are linked to each other QMJ (quality minus junk) portfolio that invests long quality stocks and shorts junk stocks yields high risk adjusted returns i.e. higher the price of quality of stock, lower will be its return
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