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ijcrb.webs.com INTERDISCIPLINARY JOURNAL OF CONTEMPORARY RESEARCH IN BUSINESS Value, Size and Market Risk Premium in Karachi Stock Exchange (Pakistan) during Bull, Neutral and Bear Market Trends Abstract Nadia Asghar Lecturer FUIEMS, Foundation University, Islamabad Maria Tahir Management Trainee Pakistan Telecommunication Limited Anam Ejaz Ahmad Sheikh Research Asistant , Bahria University Islamabad Dr. Muhammad Iqbal Saif HOD, Foundation University Islamabad The past is a good source of guidance on how securities markets might perform in the future. Investors face critical choices about which method to use when extrapolating from the past. Fama-French Three Factor Model attempts to explain the stock returns by using more than one risk factor (market risk factor). The current study evaluates the performance of Fama and French Three Factor model in Karachi Stock Exchange (KSE), by considering KSE-100 index companies as the sample representative of the overall Karachi stock exchange market. Twenty stocks were selected from Karachi Stock Exchange. Sample contains monthly stock returns of four years. The annualized six month Pakistan‘s T Bill rate was used as risk free rate to determine the excess returns. These excess returns were then divided in to bull, neutral and bear time periods and were regressed on market, size and value factors. T- Test and F- Test statistics were employed in order to test the validity of Fama and French three factor model. The results have supported the validity of three factor model during bullish time period in the sample, as the intercept is insignificant and market, size and value premium factors are significant. Keywords: Bull, Bear, Neutral, Return, Fama and French model 1. Introduction Financial economics as a discipline revolves around a rational investor aiming for maximum returns by assuming minimum possible risk. However, according to the efficient market hypothesis, it is not possible to consistently outperform the market as all the information is already reflected in prices. Therefore, the only way to get higher returns is to take higher levels of risk. This phenomenon has been extensively discussed in the financial theory as well as practice. Fama-French Three Factor Model has been the COPY RIGHT © 2011 Institute of Interdisciplinary Business Research 248 JANUARY 2011 VOL 2, NO 9 Listed in ULRICH’S
ijcrb.webs.com INTERDISCIPLINARY JOURNAL OF CONTEMPORARY RESEARCH IN BUSINESS most successful among multifactor models in explaining the factors that affect the return of an asset. Financial analysts and stock market analyst used to categorize the underlying trend in stock prices into bull and bear markets. Durations of bull and bear markets are key components of the risk and return characteristics of stock returns so it is clearly important to understand their determinants. This study will analyze the beta return, firm size and book to market return relationships in aggregate market to determine which of these explanatory variables is a better measure of overall market risk and to determine in which types of markets the premium on each variable is realized. 1.1 Problem Statement Does Fama French three factor model perform equally well in determining returns during bull, neutral and bear market conditions in KSE-100 in Pakistan? 1.2 Significance of study The purpose of this research is to study the power of FF three factors model to explain the returns of KSE traded stocks in both bearish and bullish market conditions. Previous studies on FF on KSE were done in bullish conditions but the aim of this study would be to find out whether market condition (bullish or bearish) have an impact on the performance of KSE or not. The outcome of research will provide an insight about the validity of FF three factors model to explain the risk return relationship in an emerging market in different market conditions. 1.3 Rational of Study The specific objective of the study is to answer the following questions: The discrepancies in CAPM model have led researchers to find alternative models like Fama French model, Arbitrage Pricing Theory etc. Fama French model was previously observed to be valid in emerging markets so this study would test whether FF model can explain risk return relationship in emerging market of KSE. Previous studies on FF model in KSE were done in bullish conditions only so this study would go a step ahead and investigate whether markets conditions (bullish, neutral and bearish) have an effect on its performance or not. This study would find out whether there is a relation between market conditions and performance of FF model. 2. Literature Review Markowitz 1952 The first modern portfolio theory was developed by Lintner, Mossin 1965, 1966 Markowitz. Continued the work of Markowitz and presented the initial Capital Asset Pricing Model: CAPM, which shows how to relate the average return of stock and market risk factors. COPY RIGHT © 2011 Institute of Interdisciplinary Business Research 249 JANUARY 2011 VOL 2, NO 9 Mirza, N. (2008) studied validity of Fama French model and found that B/M Effect is essentially associated with bullish market characteristics Connor and Sehgal (2001) Empirically examined the Fama-French three factor model of stock returns for India. these results were tested under bullish market conditions. Naranjo, Nimalendran and (1998) (1999) The approach presented by Fama French has gained considerable popularity as a framework for investigating a
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