International Journal of Contemporary Business Studies

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International Journal of Contemporary Business StudiesVol: 3, No: 4. May, 2012 ISSN 2156-7506Available online at http://www.akpinsight.webs.comIn this paper we have introduced a 4 th factor in existing Fama and French (1993) three-factor model tomake it a four-factor model. This 4 th factor is leverage or LMU [emphasis added] (LeveragedminusUnleveraged portfolio of stocks). Hence in this four-factor model we assume:(1) “High Cap stocks outperform low Cap stocks”(2) “Value stocks outperform growth stocks”(3) High Leveraged stocks outperform Low leveraged stocks known as Leverage Premium [emphasisadded].This Leverage premium is measured by an additional 4 th factor in three-factor equation called LMU[emphasis added]. This LMU is return on portfolio with leveraged stocks minus return on portfolio withunleveraged stocks (or low leveraged stocks).This factor determines whether the leverage has any impacton stock returns of a company or not. The equation comes out to be in the following form finally.RESEARCH OBJECTIVESE(Ri)-Rf= β 1 [(Rm)-Rf] + β 2 (SMB) + β 3 (HML) +β 4 (LMU) + alphaWe have attempted to study whether the capital structure of a firm has any impact on the risk premiumgiven by its stocks. The objectives of the research can be outlined as follows:• To determine the impact of leverage on stock returns• To identify whether there is any kind of size premium given by KSE• To identify whether there is any kind of value premium given by KSE• To determine that what impact market premium has on stock returns• To determine the validity of Fama and French three factor model in Pakistan’s marketSIGNIFICANCE OF RESEARCHThis study provides important implications for Pakistani investors who are willing to invest in KSEbecause it provides an insight to investors regarding capital structure and stock return relation as well asregarding two important market anomalies (value premium and size premium). The study highlights theimpact of firm specific factors like market capitalization, Book Value-to-Market value ratio (BV/MV) andDebt to Equity ratio (D/E) on stock returns apart from the impact of market specific factors like return ofmarket portfolio. The paper provides evidence against CAPM as well as Fama and French (1993) threefactor model validity in context of Pakistan’s market. It would help investors to identify which factoractuallyexplanatory in determining the returns of stocks held by them.LITERATURE REVIEWWhen there was a lot of empirically supported evidence against the validity of CAPM; Fama and French(1992) examined the combined impact of market beta, size, E/P ratio, B/M ratio and Leverage upon thecross section of avg. stock returns during the time horizon ranging from 1936 to 1990, for three stockmarkets namely NASDAQ, NYSE and Amex. Their study found β insignificant. On the contrary whenthe authors studied individually size, Earning/Price ratio, B/M ratio and leverage were found significantfor average cross-section stock returns. However when tested in combination size and B/M remainedsignificant and nullified the impacts of E/P and Leverage upon average returns.Fama and French (1992)therefore concluded that in a rational market there are multiple factors associated with risk rather a singlefactor like CAPM(Black, 1972; Sharpe 1964; Linter, 1965).Copyright © 2012. Academy of Knowledge Process8
International Journal of Contemporary Business StudiesVol: 3, No: 4. May, 2012 ISSN 2156-7506Available online at http://www.akpinsight.webs.comFama and French (1993) three-factor-model was basically an extension to Fama and French (1992) studyfor stocks as well as bonds through time-series regression analysis. In total five factors were studied; forstocks 3 factors were found significant 1) Return on market portfolio, 2) firm size and 3) book to marketvalue; however for bonds the two factors 4) term premium and 5) default premium were foundinsignificant. As a consequent of these findings Fama and French (1993) developed an asset pricingmodel known today as “Fama and French Three-Factor Model” which includes one old risk factor calledmarket beta identified by Sharpe (1964) and Linter (1965) in addition to two new factors identified byFama and French (1992) called size and value (so three factor model is an enhancement of CAPM).According to Fama and French (1993) three-factor model; expected return of a portfolio in addition torisk-free-rate is caused by its sensitivity to three factors. (a) Excess return being given by market (Rm –Rf); (b) return on small capitalization minus large capitalization (SMB) (c) High Book-to-market minusLow Book-to-market (HML).Fama and French (1995) study argues that returns for high book to market equity stocks are greater thanstocks with low B/M equity. They explained the reasoning behind it through understanding the propertiesof high and low B/M equity firms. Their study concluded that companies with high book to market equitynormally remain in distress on regular basis and the companies with low book-to-market normally earnprofits on a regular basis. Therefore the high return for high book-to-market stocks is justified as thoseinvestors are compensated for carrying risky and non-profitable securities.Malin and Veeraraghavan (2004) suggest that size premium is found in France and Germany as thesemarkets exhibit the quality of outperforming small stocks by big stocks; however the researcher found anopposite behavior of stocks in UK market because in UK market large stocks produce larger returns ascompared to small stocks. As far as the second factor in three-factor model known as “value premium“ isconsidered their results show that low book to market value firms (growth stocks) guarantee higherreturns as compared to high book to market stocks (value stocks) for France, Germany and UK marketsby rejecting three factor model.Doan,Lin, and Zurbruegg (2010) studied returns of stocks being traded on US and Australian indices.They found that Australian stock returns are sensitive to co-skewnesswhereas US stock returns are moresensitive to co-kurtosis. The reason of this discrepancy in two markets is explained by the size-effectbecause Australian firms are small in size as compared to US firms listed on the indice that is in-line withthree-factor model.Javid and Ahmad (2009) examined the macroeconomic sources of variation in returns of stocksforKarachi Stock Exchange for the period of 1993-2004. They discovered that some factors had significantimpact in determining the returns of stocks like “consumption growth, inflation risk, call money rate andterm structure” whereas “market return, exchange risk and oil prices risk” had minimal role in pricing of astock.Hanif and Bhatti (2010)realized that validity of CAPM needs to be tested in context of Pakistanimarket. Therefore they conducted the study on KSE for the period of 2003-2008 and their results arguethat CAPM measured the returns of securities with accuracy only for a limited number of companies. Formajority of the companies CAPM fails to measure the expected returns; as actual returns deviate frommodel based returns.The basic assumption of CAPM that high risk entails high return fails when it is tested on Greek stockmarket for the period of 1998-2002. The research indicates that securities with high beta does not entail ahigh return as compared to stocks with low beta. (Michailidis, Tsopoglou, Papanastasiou&Mariola, 2006)Copyright © 2012. Academy of Knowledge Process9
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International Journal of Contemporary Business Studies

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