The Risk and Return Relations: New Evidence from Pakistani Stock Market

Abstract

In this study, we try to answer several empirical questions related to testing of asset pricing models in Pakistan. First, we test the assumptions of capital asset pricing model (CAPM) using cross-sectional regression methodology of Fama and MacBeth (FMB) (1973). Second, we test the conditional relationship between beta and expected returns using FMB cross-sectional regressions. Third, we test and compare the explanatory power of CAPM and Fama and French (1993) three factor models using time-series regressions. For all of the above empirical tests, we use sufficiently large data set of weekly data from January 2006 to December 2018 of non-financial firms listed at the Pakistan Stock Exchange. Results of the cross-sectional regressions suggest that beta cannot explain expected returns. However, there is weak evidence that a conditional relation exits between beta and expected returns. Results of the time-series regression suggest that both CAPM and three factor model do well in explaining expected returns. However, GRS-based test of regression intercepts and regressions R2 indicate that Fama and French model better captures variations in observed stock returns than the CAPM.