Asset Pricing Dynamics in Karachi Stock Exchange: A Comparative Study of CAPM, ICAPM, Fama – French and Momentum Factor Models

Abstract

Asset pricing models provide a meaningful measure of the expected return of an asset which the investor gets by taking on a certain level of risk. Financial theorists have proposed various asset pricing models that describe the relationship between risk and expected return. The paradoxes revealed in the statistical results of various empirical tests have influenced the development of modified asset pricing models, with the aim to improve the ability of the asset pricing model to explain the relationship between risk and expected return of an investment in risky assets. It is important for an investor to be able to quantify an appropriate rate of return that would compensate for taking on risk. An exhaustive literature exists in support and against the validity of various asset pricing models and the empirical evidence has shown that the relevance of these asset pricing models differs in developed and emerging markets. KSE is an emerging market where literature based on the asset pricing proposition is rare as compared to developed markets. This research study is a comparative study of four most widely used asset pricing models, being applied to KSE: Capital asset pricing model (CAPM) , Fama and French-three factor model( FF, 1992), Intertemporal capital asset pricing model (ICAPM), and Carhart-four factor model. The purpose of this study is to explore the asset pricing dynamics in an emerging stock. The four models that are tested in this study have shown explanatory power in developed economies. However, the emerging markets have special features that are distinct from developed markets. These include market making activities by few large investors, nonsynchronous trading, loose monitoring controls and small market size.The research evidence highlights the fact that in emerging markets, the market index is misrepresented due to thin trading. Active trading exists in only a few stocks. Moreover the market index is value weighted and is therefore dominated by the stocks which are actively traded in the market. These factors lead to an insignificant market risk premium. The failure of CAPM in emerging markets may be due to the fact that the market index does not reflect the overall market’s dynamics. This is the reason why market risk premium is insignificant in all of the four models tested in this study. Fama and French three factor model performs better in emerging markets because this model takes into account the factors based on firm characteristics, i.e. size and value premium. Carhart’s four factor momentum model is also relevant because this model takes into account the trading strategies related to loser and winner stocks in addition to the stocks firm characteristics. ICAPM performs well due to the fact that it takes into account the changing investment opportunity set and the affects of business and financial risks on the stocks. This research would facilitate financial managers and investors to make appropriate analyses of the risk and return relationship of their investment strategies, enabling them to make rational investment decisions and maximize their returns as asset pricing propositions are an important input for estimation of investment appraisals, project feasibility and cost of equity valuations.