The Risk and Return Relations: Evidence from Pakistani Stock Market

Syed Hamid Ali Shah1 and Dr. Attaullah Shah2

Syed Hamid Ali Shah is a Faculty Member at Quaid-e-Azam College of Commerce, University of hamidtoru$gmail%com 2 Dr. Attaullah Shah is a Faculty Member at the &nstitute of Management Sciences, esha!ar "mail# attaullah%shah$imsciences%edu%'(

esha!ar

"mail#

Abstract It is generally argued that risk and stocks returns relationship in emerging markets around the globe is different from that observed in developed stocks markets. Moreover, in Pakistan investors are not welldiversified due to large family ownership, group ownership, shallow market, and thin trading volume etc. This gives us fair justification to believe that both systematic and unsystematic risks are relevant, and hence beta measure of systematic risk! under-estimates the risk premium. "ifferent measures of risk such as beta, systematic risk, unsystematic risk, and total risk are used as independent variables to investigate risk and return relationship. The data set covers span of period from #anuary $, %&&' to (ctober )*, %&&+ and the sample consists of ),' non-financial firms listed on -./. It is concluded that investors in the Pakistani stock markets do not base their assets0 pricing decisions on these risk measures. The results could not confirm beta and returns relation as proposed by 12PM. It is suggested that investors shall not rely only on the results of 12PM and shall also use alternate asset pricing model in order to make right investment decisions. -ey 3ords4 12PM, returns, risk, rolling regression, time series regression, cross-section regression,

The Risk and Return Relations: Evidence from Pakistani Stock Market 1. Introduction

Given todays competitive and dynamic business environment corporate risk management is important due to its potential implications on stock prices and investors returns cannot be denied. As accepted at large, the prime ob ective o! any business !irm is the share value ma"imi#ation $Damodaran, 1%%&'( in the long run this is line )ith the interests o! almost all the stakeholders o! the !irm. *akistani stock market is one o! the emerging markets o! the )orld. +t is generally argued that risk and stocks returns relationship in emerging markets around the globe is di!!erent !rom that observed in developed stocks markets. Harvey $1%%,' in the case o! emerging markets reported the presence o! stock prices volatility, une"pected high returns and serial autocorrelation in returns. Harvey also documented presence o! leptokurtosis, ske)ness and volatility clustering in these markets. -he later characteristics )ere reported in the case o! *akistan in the .arachi Stock /"change $.S/' $see e.g., Hussain and 0ppal, 1%%1'. 2avid $233%' indicated to the issue o! determination o! e"pected risk and return !or investors in *akistani stock market. 4n the basis o! unconditional and conditional higher5moment capital asset pricing model $6A*7', she concluded that three5moment 6A*7 could e"plain the risk5return relation relatively better( ho)ever both the systematic covariance and cokurtosis contribution to e"plain asset prices in .S/ )as marginal. 7oreover, in *akistan investors are not )ell5diversi!ied !or several reasons such as !amily o)nership, group o)nership, shallo) market, and thin trading volume etc. -his gives us !air usti!ication to believe that both systematic and unsystematic risks are relevant, and hence beta $measure o! systematic risk' under5estimates the risk premium. -he results o! this study shall determine the degree o! receptiveness o! stocks returns o! *akistani listed companies to market5)ide !actors and to !actors uni8ue to a !irm or industry. +ndeed variety o! stakeholders !or e"ample, !inancial analysts, investors and business managers etc. might have interest in such analysis !or variety o! reasons. -he main purpose o! this study is to investigate, in the peculiar *akistani Stock 7arket( that )hether only the systematic risk !actor is relevant or the speci!ic risk component is also o! matter o! concern !or investors. +n

this study Sharpe $1%9,' :intner $1%99' market e8uilibrium model is estimated using di!!erent approaches to determine ho) )ell it can e"plain the stock price behavior in the *akistan largest stock market i.e. .S/. +n the simplest and per!ect environment discounted value o! !uture cash !lo)s $ho)ever never certain' can be considered the appropriate value o! a !irm $returns to investors'. -hus increasing these cash !lo)s )ill mean increasing returns but not )ithout increasing risk as argued by Shimko and Humphreys $1%%1'. -hey argued that increasing cash !lo)s by grabbing gro)th opportunities to increase value and returns, usually call !or taking more risk. 4n the other hand !inancial literature narrates that investors act such that to ma"imi#e their returns !or certain level o! risk or reduce their risks given certain level o! returns $6lark, 1%&2'. -his relationship bet)een return and risk has been the !ocus o! the literature about asset pricing in !inancial capital markets. ;lume $1%&1' said that this risk dimension in investment decision is so important that there is no need to convince people to include it in their analysis. According to the modern port!olio theory o! 7arkovit# $1%,2', e"pected rate o! return can be ma"imi#ed !or given level o! risk by pooling di!!erent assets $ho)ever )ith lesser covariance' together or putting in other )ords !or a given e"pected rate o! return its accompanying risk can be minimi#ed through diversi!ication. 4ne o! the important assumptions o! this theory is that investors evaluate risk as a )hole rather than considering the risk associated )ith an individual security. Ho)ever diversi!ication does not remove all types o! risks <, though diversi!ication helps to reduce total risk o! an investor. ;realey $1%9%' stated that variations in market5 )ide conditions cause !luctuations in !inancial assets prices and this variability o! prices cannot be completely diversi!ied. -he part o! risk )hich can be diversi!ied is termed as unsystematic risk. -his unsystematic risk is also called speci!ic risk being speci!ic to the !irm or industry in )hich the !irm operates. -he non5diversi!iable risk component is called systematic risk. -his market5)ide risk causes variation in assets prices in the )hole range o! a market and results due to changes in broad economic environment $6ohen, /d)ard, and Arthur, 1%&<'. 7oreover, it is generally believed that investment markets do not compensate !or speci!ic risk $!irm= business type associated risk' and only re)ard the systematic risk or market5)ide risk !or e"ample as modeled by Sharpe $1%9>'. ?urther, ;realey $1%9%' stated that most plausible
3

@isk here is de!ined as the degree o! uncertainty o! an outcome that can be assigned )ith some ob ective or sub ective probability and thus can be 8uanti!ied( more speci!ically here it is the variance o! past rates o! return.

addition to a port!olio is the asset that sho)s the minimum covariance )ith the market but i! other)ise desired by an investor( say !or e"ample opting !or a security that varies e"actly )ith the market. ?ama and 7c;eth $1%&<' supported the traditional 6A*7 in their empirical study. Ho)ever other studies have sho)n that beta is not the only relevant !actors and other !actors such as si#e, earnings=price ratio, cash5 !lo)=price ratio, book5to5market e8uity ratio, and past sales gro)th signi!icantly e"plain variation in average stock returns $see !or e"ample, ;all, 1%&1( ;an#, 1%11( ;asu, 1%&&( 6han, Hamao, and :akonishok, 1%%1( ?ama and ?rench, 1%%2, 1%%9a( :akonishok and Shapiro, 1%1>'. -o udge the reliability o! beta, *ettengill, Sundaram, and 7athur $1%%,' proposed !ollo)ing procedure. -hey argued that there is the probability that reali#ed return can be lo)er than the risk5!ree return. +n !act, i! investors are certain that reali#ed return )ould be greater than the risk5!ree rate then they )ould not hold risk5 !ree assets. Given beta as risk measure postulates that relatively high beta assets )ill have high risk and vice versa. And )hen the reali#ed market returns are greater than risk5!ree return $so called up market condition' then beta shall be positively related to the reali#ed returns. And i! the reali#ed market returns are negative $so called do)n market condition' then beta shall be negatively related to reali#ed returns. 6onsistent )ith this conditional !rame)ork in 0S stock market, they sho)ed strong support !or beta. 7ore recently -ang and Shum $233>' investigated data o! Singapore stock market !rom April 1%19 to December 1%%1 and reported that beta is signi!icantly related to e"5post returns but have little e"planatory po)er. Addition o! stocks ske)ness and kurtosis provided ho)ever little incremental bene!its. ;ut )hen they applied the conditional !rame)ork $up and do)n markets' the e"planatory po)er increased more than 133 times. 7oreover their results indicated positive $negative' relation bet)een beta and reali#ed returns )hen market e"cess returns )ere positive $negative'. -he results hold )hen other stock characteristics such as unsystematic risk, total risk and kurtosis are added separately to the beta and return relation during up and do)n markets )ith increased e"planatory po)er. -hey also reported that unsystematic risk has an impact in pricing risky assets. -hey concluded that )hen pricing risk, assets beta as )ell as other stock characteristics shall also be considered as investors do not necessarily hold diversi!ied port!olios.

Section 1 introduces the study. Section 2 describes the relevant and brie! literature revie) o! the topic. Section < introduces the methodology and Section > discusses the results and concludes. 2. Literature Review ;achelier $1%33' stated that past, present and !uture discounted events are related to !inancial assets prices ho)ever do not e"plain changes in prices o! these assets. :ater, building on the idea o! the ;achelier, 7arko)it# $1%,2' proposed his !amous theory o! port!olio diversi!ication. 7arkp)it# $1%%1' narrated that the idea o! port!olio theory blinked in his mind )hile he )as reading Athe theory o! investment valueB > by Cilliams $1%<1'. According to the modern port!olio theory o! 7arkovit#, the e"pected rate o! return can be ma"imi#ed !or given level o! risk by pooling di!!erent assets $ho)ever )ith lesser covariance' together or putting in other )ords !or a given e"pected rate o! return its accompanying risk can be minimi#ed through diversi!ication. 4ne o! the important assumptions o! this theory is that investors evaluate risk as a )hole rather than considering the risk associated )ith an individual security. He stated that by adding securities that have lesser covariance )ill reduce risk o! the port!olio in more noticeable !orm. He e"plained that individuals can identi!y set o! port!olios, !or a given level o! risk )ith the highest e"pected returns such that this given risk )ill be the lo)est !or these returns. -he resultant curve o! these port!olios is termed as e!!icient !rontier and these are the most economical set o! port!olios !or individuals )ho care about the tradeo!! bet)een risk and e"pected return. -he idea o! diversi!ication by the investors )as also coined by Arro) $1%,<'. +n the conte"t o! his theory o! general e8uilibrium )ith incomplete asset markets, Arro) contended that in a complete asset market individuals can cover any loss. He added that individual may )illingly opt !or risk i! an economy e"hibits such characteristics. +n a manner he suggested to hold diversi!ied port!olios. 4n the basis o! their empirical investigation /vans and Archer $1%91' sho)ed that by adding ust ten or more securities the e!!ect o! diversi!ication is achieved thus concluded that diversi!ication process takes place 8uickly.

William (1938) stated that value of stock shall equal to discounted value of future dividend streams. And due to the inherent uncertaint in it! "arko#it$ took this value as expected value.

-obin $1%,1' e"plained in the light o! separation theorem $assuming that investors can borro) or lend at risk !ree rate' that )hich e!!icient port!olio is the optimal one, !or investors given level o! risk propensity. He stated that individuals )ould allocate !unds to cash or risk !ree assets sub ect to his=her risk pre!erences $degree o! their risk propensity'. -obin added that the single optimal risky port!olio is the market port!olio )hich is port!olio )ith the ma"imum e"pected return and minimum associated risk, and all other port!olios on the e!!icient !rontier )ill have relatively higher risk or lo)er e"pected return. Although -obin did simpli!y the process o! port!olio selection but 7orkovit# model )as still not !ully utili#ed. Soon a!ter, Sharpe $1%9>', 7ossin $1%99', and :itner $1%9,' made their historic contributions that produced the capital asset pricing model $6A*7'. -he simple 6A*7 e8uation can be stated asD @i E @! F G $@m5@!' Chere @i is return on stock +( @! is the risk !ree rate( @m is the return on market port!olio( and G is the systematic risk $beta' o! stock i. Hote that $@m I @!' is the market risk premium. 6A*7 signi!ies relationship bet)een !inancial assets risk and return. According to this model, security re8uired rate o! return is independent o! speci!ic risk !or it can be diversi!ied and eliminated by investors. -hese investors are rational and hold the e!!icient port!olios. 0nder the 6A*7, systematic or market risk is the relevant risk that relates return o! individual and=or port!olio o! risky securities to that o! market port!olio in linear !ashion. -he 6A*7 model assumes that $i' investors are risk averse, $ii' have homogeneous e"pectations o! ma"imi#ing e"pected utility, $iii' they may borro) or lend unlimited amounts o! risk !ree asset at a constant rate, $iv' all assets are divisible and priced e!!iciently, and $v' markets are per!ect and !rictionless !or all investors. .ing $1%99' investigated the returns o! 9< shares !rom about si" di!!erent industries !or the period 1%2&51%93 and reported that share prices co5varied )ith the overall market return. 4ther !inancial management scientists tried to rela" these assumptions and thus resulted in producing modi!ied versions o! 6A*7. ;rennan $1%&3' sho)ed in the presence o! ta"es that the original 6A*7 is valid. 7ayers $1%&2' reported that the model structure is the same is that o! the 6A*7 )hen non5traded stocks are

incorporated in the market port!olio. ;lack $1%&2' introduced his most cited #ero5beta 6A*7 )hile rela"ing the assumption o! riskless borro)ing availability. ;lack $1%&>' and Solnik $1%&>' conducted their studies )hile encompassing international investments in their studies and concluded that 6A*7 is reliable. -he model is reported to be robust even i! the assumption pertaining to investors homogenous return e"pectations are rela"ed $Cilliam, 1%&&'. -he practical outcome o! these studies no) is that people hold pool o! versions o! risk !ree, risky assets and assets that move )ith the market to insure their e"pected returns. 7any other studies ho)ever e"amined the stock returns co5movement )ith one another )ith the vie) o! their sensitivity to the overall market, !or e"ample @oll and @oss $1%13' and 6hen, @oll and @oss $1%19'. -hese studies introduced multi !actors models rather than using single !actor model o! Sharpe $1%9>'. Similarly 6A*7 cannot e"plain e"pected return and risk relationship in a dynamic setting and )ill ask !or more betas. +n this conte"t 7erton $1%&<' devised an intertemporal 6A*7. He elaborated that an investor )ho is currently e"posed to one interest rate and in !uture he= she e"pects some other interest rate )ill have di!!erent port!olios demands and cannot rely upon a single hori#on e"pectations. -he discussion though very brie!ly, ho)ever, describes that there are methodological de!iciencies to e"press correctly the relationship bet)een e"pected returns and the market risk !actor. -he various interested parties )ill have to make use o! one or the other !orm o! 6A*7 or A*- till one more valid and reliable model introduces. 7ore relevant to this study( !rom the above revie) one thing becomes very clear and it is the convergence o! understanding that there is one component o! total risk )hich is diversi!iable and there is another component kno)n as systematic risk )hich in non5diversi!iable. +t is this systematic risk )hich is priced by the market. ?ama and 7ac;eth $1%&<' investigated 0S stock market data !rom 1%<, to 1%91 and concluded that on average, there is a positive tradeo!! bet)een risk and return )hich is systematically a!!ected only by beta. -here!ore they contended that these results support 6A*7. Ho)ever as the risk and return )as not

signi!icant across sub5periods so this )as the case o! )eak support( as )as so argued by Sch)ert $1%1<'. @einganum $1%11' against the e!!icacy o! 6A*7 !ound that the cross5sectional di!!erences in estimated

port!olio betas based on common market indices and the di!!erences in returns o! these port!olios are not reliably related. -hey observed that the returns are not signi!icantly higher !or high5beta port!olios relative to lo)5beta port!olios. +n line )ith the 6A*7, Ha)a)ini and 7ichel $1%12' in the ;russels stock market observed that investors returns are e"plained by systematic risk but not by unsystematic risk. Ha)a)ini, 7ichel, and Jiallet $1%1<' reported that average returns are related to systematic risk o! the port!olio( ho)ever they also observed negative relation bet)een beta and returns due to the poor per!ormance o! the ?rench stock market. +n -heir study, -inic and Cest $1%1>' sho)ed that in the month o! 2anuary risk premium is higher and )hen they e"cluded 2anuary data reported that risk premiums are statistically insigni!icant. :akonis hok and Shapiro $1%19' included !irm si#e in the risk and return analysis and concluded that si#e signi!icantly e"plain the relationship but systematic or alternative $residual standard deviation' risk measure cannot e"plain the cross 5sectional variation in returns. Haugen and ;aker $1%%1' investigated @5@ relationship o! the largest 1333 0S stocks !or the period o! 1%&2 I 1%1% and reported that lo)5risk stocks have abnormally high returns. -hese results contradict )hat the 6A*7 elucidates. ?ama and ?rench $1%%2' sho)ed that beta is insigni!icantly related to average monthly returns o! HKS/ stocks and concluded that 6A*7 is no more reliable and that market capitali#ation and the ratio o! book value to market value are the more appropriate !actors. ?ama and ?rench $1%%9b' re ected beta to su!!iciently e"plain returns. 6hui and Cei $1%%1' used data o! Hong .ong, .orea, 7alaysia, -ai)an and -hailand stock markets to analy#e the risk and return link and !ound that stock returns are more related to si#e e!!ect and book5to5market ratio. 0sing the conditional !rame)ork procedure o! *ttengill et al. $1%%,'( +sakov $1%%%' investigated the S)iss stock market and reported that beta is statistically signi!icant and carried the e"pected sign and there!ore concluded that beta is still reliable. -he above stated studies generally sho) that beta is reliable under conditional 6A*7 but under unconditional 6A*7 beta lacks in po)er to e"plain variation in reali#ed stock returns. -his study is an e!!ort to e"plore this @5@ relationship under both situations.

As stated in the introduction that the purpose o! this article is to measure systematic, unsystematic, and total risk o! the rates o! return o! the sample securities and investigate i! risks other than beta are involved in pricing securities in the *akistani stock marketL -he unsystematic securities risk measure shall suggest about the relative volatility )hereas the systematic risk measure shall un!old the tendency o! covariance o! these securities )ith the market. Chereas the total risk shall e"plain i! the individual investors are not diversi!ied then this risk measure shall have more e"planatory po)er in the )orld o! 6A*7. . Methodolo!"

*.) .ample and "ata .ources Ceekly Data !or the study on the variables o! interest is do)nloaded !rom the website of -arachi .tock /5change -./!. Data o! 1%> non5!inancial !irms listed on .S/ )ere ac8uired !or a period o! 2>> )eeks !rom 2anuary 3,, 233> to 4ctober 1<, 2331. 3.2 The Model -his study uses multiple methods to investigate risk and return $@5@' relation. +n the !irst method the ?ama and 7c;eth $1%&<' procedure is adopted. -he procedure is termed as cross5sectional regression. -he second method is based on the rolling regression $@@G' estimation. -ime series regression is also used to predict @5@ relationship. -he methods are brie!ly e"plained in the !ollo)ing te"t. .2.1 #ross$sectional Re!ression

+n step one the entire length o! sample, 2>> )eeks, is divided into t)o sub5periods and individual securities betas, total risk $-@', systematic risk $S@', and unsystematic risk $0@' !or the !irst &2 )eeks o! the total )eeks are calculated !rom 2anuary ,, 233> to 7ay <3, 233,. -he procedures and !ormulae used to compute these values are described in the !ollo)ing te"t. 7oreover, the rate o! return o! stocks and the market rate o! returns calculated through !ormulae are also stated.

Sharpe $1%9>' market model is used to measure risk component. As per this model e"pected return o! a security is a linear !unction o! a constant rate $risk !ree rate' and the e"pected return on a market !actor. -he pro"y .S/1335+nde" is used to represent the theoretical market port!olio. -he model isD @it E M F G @mt F Nit 555555555555555555555555 $A' @it is the rate o! return o! stock i at time t. M is the y5 intercept. G is the slope o! the regression line and represent relative systematic risk component o! the total risk o! a security. @m is the market rate o! return at time t and Nit is the error term o! the regression at time t. /8uation $A' produces a regression line. -his line is called characteristic line and sho)s relationship bet)een individual assets return and market return !or the particular nature o! systematic and unsystematic risks o! that security. Holding @m e8ual to #ero, the y5intercept M is then the security rate o! return. G measures securitys rate o! return volatility )ith respect to the change in overall market rate o! return. G, thus is an inde" o! systematic risk o! the security. G i! e8uals one then a security re8uired rate o! return )ill be e8ual to the market rate o! return. G greater than one mean that the security is riskier than market port!olio and its re8uired rate o! return shall be higher than the market rate o! return and vice versa. Oit, the error term represents the component risk attributable to characteristics uni8ue to the !irm or industry. +n the regression results the coe!!icient o! determination $@2' sho)s percentage changes in the security returns e"plained by changes in the market inde". -hus it is used to measures the percentage o! total risk accounted !or by systematic risk $6lark, 1%&2'. @eturns on securities and markets are computed as e"plained belo). @it E ln$*tF1= *t' 555555555555555555555555555555 $;' Here *tF1 and *t represent end o! period t, and beginning o! period t stock prices respectively. @m E ln$7tF1= 7t' 55555555555555555555555555555 $6' 7tF1 is the inde" value at the end o! time period t and 7t is the inde" value at the beginning o! period t.

-otal risk $-@' is calculated as variance o! the security and it is calculated through the !ollo)ing !ormulaD Pi2 E Q $@it I @i'2= n51 Pi2 is the variance o! security i $variance o! market' @it is the rate o! return o! stock i $rate o! return o! market inde"' at time t. @i is the average rate o! return o! security i $average market inde" return'. Systematic risk $S@' can be calculated either by multiplying beta s8uare )ith variance o! market or by multiplying @2 )ith variance o! individual security. +n this study the later procedure is adopted to compute S@. S@ is subtracted !rom the -@ to calculate the unsystematic risk $0@' $2ames and *hilip, 1%&1'. +n step t)o, individual securities and market returns are calculated !or the period !rom 2une 9, 233, to 4ctober 1<, 2331 )ith the help o! the !ormulae as stated above. -hen 1&1 sets o! cross5sectional regressions are run to predict the securities returns )ith the help o! various risk measures estimated in step one above. +ndividual securities returns are taken as dependent variable. ?inally in step three, average o! the )eekly slopes $coe!!icients' o! ;eta, -@, and 0@ are computed and tested )ith the help o! t5statistics. .2.2 Rollin! Re!ression

@olling regression is estimated using least5s8uare estimation techni8ue. +t !its a linear e8uation !or time series data by estimating coe!!icients over more than one time, ho)ever a !i"ed length o! sample is utili#ed each time. +n doing so !irst observation o! the previous sample is dropped and ne) observation at the end o! that sample is included to estimate coe!!icient o! the ne) sample. -his techni8ue is usually used to test model stability overtime as it can capture time varying characteristics o! parameters. Due to !luctuations and variations in economic conditions, the assumption that model parameters remain constant overtime is, ho)ever, not admissible. +n estimating e"pected returns )ith the help o! 6A*7, the proponents o! this model argue that beta is instable and hence rolling regression techni8ue is a pre!erable )ay to capture its time varying nature. 0nder this techni8ue, step one $e"plained in section <.2.1' is repeated. -hen numbers o! regressions are run by rolling the initial regression period !or)ard, that is each time ne) )eek is added and the !irst )eek o! the

previous regression is discarded such that up to period 2>< rd total 1&1 regressions are run and the coe!!icients are averaged and reported in -able 2. *anel A o! the table reports results generated )ith the help o! stata. +n addition to the above the )hole period o! the study is divided in three sub sets. -hen step 1 is repeated !or !irst &2 )eeks $2an ,, 233> to 7ay <3, 233,' and thirty nine e8ually )eighted port!olios, )ith e8ual port!olio si#es $!ive stocks in each' are !ormed on the basis o! betas estimated in the !irst step. -he port!olios )ere so !ormed )hile arranging betas in descending order. -hus the last port!olio stocks betas )ere the smallest and those !or the !irst port!olio the stocks )ere holding the largest betas. *ort!olios returns are regressed against the market returns and slopes o! these port!olios are estimated and S@, 0@, and -@ o! port!olios are also computed !or the period !rom )eek &< rd to )eek 191th $2an 9, 233, to April 19, 233&'. +n the !inal stage, returns o! these <% port!olios are matched )ith their corresponding port!olios betas and S@ obtained !rom the estimation period. -he process is repeated in the )ay that each time the !irst )eeks observation o! the initial regression is dropped and ne) )eek o! the testing period is added. -he process is repeated !or the )hole testing period till 4ct 1<, 2331. -he )eekly returns o! the port!olios are then regressed on their corresponding estimated risk coe!!icients. *ort!olios )eekly returns are used in the regression such that )e estimated one set o! set o! slope coe!!icients !or parameters. . . Time Series Re!ression

-he )hole time period is divided in three sub5periods $almost o! e8ual numbers o! )eeks'. ;etas, S@, 0@, and -@ are estimated in the !irst period $2anuary ,, 233> to 7ay <3, 233,'. -hen securities are ranked on the basis o! beta values in descending order. +n the second period <% port!olios o! same si#es are !ormed. *ort!olios returns are calculated !or the testing period. -hese time varying betas, S@, 0@, and -@ are matched )ith the corresponding returns o! the port!olios. *ort!olio returns are used as dependent and S@, 0@, and -@ are used as independent variables in the so called stacked cross5sectional regression. -he slope coe!!icients o! the variable$s' i! appears greater than #ero then it can be in!erred that the variable$s' is priced by the market.

%.

Results and &iscussion

-his section contains the results obtained !rom the three di!!erent methods. +n addition results o! concurrent regression estimation are also presented. -he concurrent regressions are based on observations on securities returns and estimated beta values o! the same period $2anuary ,, 233> to 7ay <3, 233,'. -able 1 reports results o! cross5sectional regression using stata so!t)are. ?irst column contains the e8uations( second column sho)s average value o! the coe!!icients o! independent variables along )ith respective average standard errors and t values. -hese results indicate that beta, total risk and systematic risk could not e"plain the security returns. -hese !indings are not in line )ith the 6A*7. Ho)ever the !indings are not uni8ue particularly in the case o! a negative and insigni!icant beta. ?or e"ample Ha)a)ini et al., $1%1<' reported negative beta !or poor per!orming ?rench stock market. Humbers o! di!!erent studies reported such instances. ?ama and 7c;eth $1%&<' though reported positive and signi!icant beta !or the )hole period but the beta )as insigni!icant in the sub5period regressions. -here are studies those re ected the practicality o! beta and suggested that other measures can e"plain returns more e!!iciently $see e.g. 6han, Hamao, and :akonishok, 1%%1( ?ama and ?rench, 1%%2, 1%%9a'. Ho)ever alternative reason !or the evidence o! insigni!icant and=or negative beta in so called unconditional regression estimation is given by *ettengill et al., $1%%,'. -hey proposed an alternative, conditional !rame)ork, method to test @5@ relationship. -he insigni!icant coe!!icient o! -@ suggests that probably there are some other !actors )hich are valued by investors in the *akistani stock markets. Ta'le 1: #ross$Sectional Re!ressions ( R$R Relationshi)

E*uation @i E MoFM1 GF Ni

#oeff. Std. Errors t$Stat Remarks 53.3313 3.3131 53.1331 +nsigni!icant

@i E MoFM1S@F Ni 53.>,,9 3.&,32 53.91 +nsigni!icant @i E MoFM1 -@F Ni 53.331% 3.3322 53.>< +nsigni!icant HoteD -otal 1&1 regressions !rom 2une 9, 233, to 4ctober 1<, 2331 are run !or each o! the above e8uations and then the average values o! the coe!!icients o! beta $G', systematic risk $S@' and total risk $-@' and standard errors along )ith t statistics are reported.

+t is generally argued that )hen testing reliability o! beta on the 6A*7, port!olios returns shall be pre!erred due to its lo)er estimation errors and contained speci!ic risks. -here!ore these results are reported in *anel5; o! -able 2. Here port!olios returns are used as dependent variable. Ho)ever results reported in -able 2 are not di!!erent !rom those reported in -able 1. Systematic risk and relative measure o! systematic risk $beta' both are not used by investors )hen pricing assets. Ta'le 2: Rollin! Re!ressions ( R$R Relationshi)

E*uation Panel + @it EMoFM1S@it @it EMoFM1-@it @it EMoFM1Git @it EMoFM1S@itFM20@it #oeff. Std. Errors t$Stat Remarks Panel @pit EMoFM1Gpit @pit EMoFM1GpitFM2-@pit #oeff. Std. Errors t$Stat Remarks

#oeff. 51.&2>9 53.2<>, 53.3331 ,1 51.>>31 1.1931 51.2> +nsigni!ican t #oeff. 53.33,> ,1 53.33,9 3.33>< 51.<1 +nsigni!ican

Std. Errors 1.11>< 3.1,<2 3.3321 ,2 53.2333 3.1,<, 51.<3 +nsigni!ican t Std. Errors 3.33<& ,2 3.311< 1.9<&1 3.3, +nsigni!ican

t$Stat Remarks 51.>9 51.,< 53.<1 +nsigni!icant +nsigni!icant +nsigni!icant

t$Stat Remarks 51.>, +nsigni!icant

t t HoteD *anel A presents average values o! coe!!icients o! 1&1 regressions $rolling' estimated )ith stata. +n panel ;, using stata, average values o! coe!!icients o! beta, beta and -@ !rom &, regressions are reported( here rolling regression procedure is used and port!olio returns are taken as dependent variable. -able < carries test statistics o! time series regression. ?our di!!erent e8uations, )ith respect to independent variable, are estimated. -hese e8uations are sho)n in the !irst column !rom the le!t. Second and third columns

present estimated values o! constant terms )ith their associated t5statistics respectively. +n all cases the constant term is positive but insigni!icant. -his is in line )ith the 6A*7. 6olumn !our and !ive $!rom le!t to right' sho)s coe!!icient o! S@ carries negative sign and is insigni!icant )hether used separately or )ith -@. Jalues o! test statistics on -@ are reported in column si" and seven. *ort!olios returns are once regressed against -@ alone and then against -@ as )ell S@ at the same time. +n each case -@ is negatively and insigni!icantly associated. Again these !indings are not di!!erent !rom those reported in -able 2. -he last t)o columns suggest that unsystematic risk is negatively but insigni!icantly related to port!olio returns. Ta'le : Time Series Re!ression ( R$R Relationshi) t( E*uation @pit E MoFM1 S@pit MoFM1 S@pit F M2 -@pit MoFM2 -@pit 3.3329 MoFM< 0@pit 3.&, 5 53.9& 3.339% HoteD -otal numbers o! observations )ere ,&&2. 6oe!!icients o! systematic $S@', unsystematic $0@', and total risk $-@' along )ith their respective t5statistics are reported. -able > presents average values o! coe!!icients, standard errors, and t5statistics o! the variables used in the e8uations as sho)n in the le!t most column o! the table. All the coe!!icients are insigni!icant and thus the variables in the e8uations are unable to predict individual securities returns. Chether it is S@, 0@ or -@ none o! them are incorporated by investors )hen pricing assets in *akistan. Ta'le %: #oncurrent Re!ression ( R$R Relationshi) E*uation @it E MoFM1 S@it @it EMoFM1 -@it #oeff. 3.11>> Std. Errors t$Stat Remarks 2.121< 3.>2 +nsigni!icant 53.3< +nsigni!icant 3.33<& 5 3.333% 3.&, 5 3.3> M1 5 Stat 5 5 5 3.3323 5 M2 Stat 5 5 5 3.11 5 5 5 t( M< Stat 5 t(

53.33>1 3.1>>9

HoteD -otal &2 regressions !rom 2anuary ,, 233> to 7ay <3, 233,are run !or the t)o e8uations. Average values o! the coe!!icients o! systematic risk $S@' and standard errors along )ith t statistics are reported. .. #onclusion +n this study )eekly returns data o! the .S/5133 inde" $market return' and o! 1%> non5!inancial !irms listed on .S/5133 inde" !or the period !rom 2anuary ,, 233> to 4ctober 1<, 2331 is used to investigate @5@ relationship. Di!!erent measures o! risk such as beta, S@, 0@, and -@ are used as independent variables to e"plain port!olio and individual securities returns. ?ama and 7c;eth $1%&<' procedure )ith some variation is adopted and di!!erent estimation methods are used. +t is concluded that investors in the *akistani stock markets do not base their assets pricing decisions on these risk measures. -he results could not con!irm @5@ relation as proposed by 6A*7. Alternatively it can be in!erred that ?ama and 7c;eth $1%&<' approach does not )ork in *akistan stock market. -hese results in *akistani stock market are not di!!erent !rom those arrived at in earlier studies. Ahmed and Raman $1%%%' used GA@6H57 model and observed volatility clustering in *akistani stock market. ?indings o! this study o!!er no support !or the applicability o! standard 6A*7, instead this study support the predictive po)er o! a higher5moment conditional 6A*7. +8bal and ;rook $233&' re ected the validity o! unconditional 6A*7, they documented the presence o! non5linear nature in the @5@ relationship in *akistani e8uity market. +8bal, 2aved, ;rooks and Galagedera $2331' through empirical analysis compared risk and return models and could not !ound evidence in !avor o! 6A*7. -hey supported conditional version o! risk and return models and conditional variables such as trading volume, dividend to price ratio )ere reported to have more predictive po)er in @5@ relationship. +n this study they used monthly data !rom 4ctober 1%%2 to 7arch 2339 and the sample included 131 stocks listed on .S/. 2avid and Ahmad $2331' could not determine support !or 6A*7. -he results o! the study sho)ed that conditional 6A*7 )as more appropriate. 7ore speci!ically, they documented that conditional coske)ness could better e"plain asset pricing )hereas conditional covariance and cokurtosis had little e"planatory po)er.2avid $233%' concluded that 6A*7 lack the po)er to e"plain risk and e"pected return association in .S/. +n this study she considered both higher moments and autoregressive

process o! the returns. Hani! and ;hatti $2313' investigated <93 stocks during the period !rom 233<531. -hey observed evidence in support o! 6A*7 but !or 21 stocks and !or limited period. Hani! $2313' investigated tobacco stocks listed on .S/ !or the period 233>53&. -hey reported that the beta )as instable and its value )as higher !or )eekly data relative to beta estimated )ith monthly data. 6orrelation bet)een actual monthly returns and e"pected returns !rom 6A*7 )as stronger than that !or )eekly data. 7ore recently, Rubair and ?aroo8 $2311' used 6A*7 and reported e"istence o! )eak correlation bet)een actual returns and e"pected returns. +t is suggested that !urther studies should be conducted to investigate ho) investors price assets in stock market in *akistan. 7oreover in these studies other methodologies $e.g. the one proposed by *ettengill et. al., 1%%,' and variables $e.g. si#e, book to market ratio, and macroeconomic !actors' should be used to determine )hat !actors cause variations in the returns o! both individual securities and port!olios. Studies on di!!erent data sets $e.g. daily, monthly, semi5annually, and annually' and e"tended data sets may also prove bene!icial. +t is suggested that investors in *akistan shall not rely only on the results o! 6A*7 and shall also use alternate asset pricing model in order to make right investment decisions.

RE/ERE0#ES Ahmad, /. and ;adar5u5Raman, $1%%%', AJolatility and Stock @eturn at .arachi Stock /"changeB, Pakistan /conomic and .ocial 6eview, <&$1', pp. 2,I<&. Arro), .. 2. $1%,<' trans. $1%9>', S-he @ole o! Securities in the 4ptimal allocation o! @isk bearingS, 6eview of /conomic .tudies, <1,pp.1&5&1. Attiya, K. 2. $233%', A-est o! Higher 7oment 6apital Asset *ricing 7odel in 6ase o! *akistani /8uity 7arketB, /uropean #ournal of /conomics, 7inance and 2dministrative .ciences , 1,, pp. 1>>5192. ;achelier, :. $1%33', A-heorie de la SpeculationB, Annales de l/cole Hormale Superieure de *aris. ;all, @. $1%&1', AAnomalies in relations bet)een securities yields and yield5 surrogatesB, #ournal of 7inancial /conomics, 9, pp.13< I 129.

;an#, @. $1%11', A-he relationship bet)een return and market value o! common stocksB, #ournal of 7inancial /conomics, %, pp.< I 11. ;asu, S. $1%&&', A+nvestment per!ormance o! common stocks in relation to their price I earnings ratioD A test o! the e!!icient market hypothesisB, #ournal of 7inance, <2, pp.99< I 912. ;lack, ?. $1%&2', A6apital 7arket /8uilibrium )ith @estricted ;orro)ingS, #ournal of 8usiness, >,$<',pp.>>>5>,,. ;lack, ?. $1%&>', A+nternational 7arket /8uilibrium )ith +nvestment ;arriers S, #ournal of 7inancial /conomics,1$>',pp.<<&5,2. ;lume, 7. /. $1%&1', S4n the Assessment o! @iskS, The #ournal of 7inance, 29$1',pp. 1513. ;realey, @. A. $1%9%', SAn +ntroduction to @isk and @eturn !rom 6ommon StocksS, 6ambridgeD -he 7+*ress, 7assachusetts +nstitute o! -echnology. ;rennan, 7. 2. $1%&3', S-a"es, 7arket Jaluation and 6orporate ?inancial *olicyS, 9ational Ta5 #ournal, 2<,pp.>1&5>2&. 6han, :. Hamao, K. :akonishok, 2. $1%%1', A?undamentals and stock returns in 2apanB, #ournal of 7inance, >9, pp.1&<% I 1&1%. 6hen, Hai5!u, @oll, @. and @oss, S. A. $1%19', S /conomic ?orces and -he Stock 7arketD -esting the A*and Alternative Asset *ricing -heoriesS, #ournal of 8usiness, ,%, pp.<1<5>3<. 6hui, A. and Cei, 2. $1%%1', A;ook5to5market, !irm si#e, and the turn5o!5the5year e!!ectD /vidence !rom *aci!ic5;asin emerging marketsB, Pacific-8asin 7inance #ournal, 9, pp. 2&, I 2%<. 6lark, ?. 2. $1%&2', S+nvestmentsD Analysis and 7anagementS, He) KorkD 7cGra)5Hill ;ook 6ompany. 6ohen, 2. ;., /d)ard, D. R., and Arthur, R. $1%&<', S+nvestment Analysis and *ort!olio 7anagementS, Home)ood, +llinoisD Do) 2ones5+r)in +nc. Damodaran, 1%%& /van, 2. :. and Archer, S. H. $1%91', SDiversi!ication and the @eduction o! DispersionD An /mpirical AnalysisS, 2ournal o! ?inance, pp.&91591. ?ama, /. and ?rench, .. $1%%2', A-he cross5section o! e"pected stock returnsB. #ournal of 7inance, >&, pp.>2& I >9,.

?ama, /. and ?rench, .. $1%%9b', A-he 6A*7 is )anted, dead or aliveB, #ournal of 7inance, ,>, pp.1%>& I 1%,1. ?ama, /. ?rench, .. $1%%9a', A7ulti!actor e"planations o! asset pricing anomaliesB, #ournal of 7inance, ,1, pp.,, I 1>. ?ama, /. 7ac;eth, 2. $1%&<', A@isk, return, and e8uilibriumD /mpirical testsB, #ournal of Political /conomy, 11, pp.93& I 9<9. Hani!, 7. T ;hatti, 0. $2313', AJalidity o! 6apital Assets *ricing 7odelD /vidence !rom .S/5*akistanB Harvey, 6. @. $1%%,', A*redictable @isk and @eturn in /merging 7arketsB, The 6eview of 7inancial .tudies, 1, pp. &&<I119. Haugen, @.A. and ;aker, H.:. $1%%1', A-he e!!icient market ine!!iciency o! capitali#ation5)eighted stock port!oliosB, #ournal of Portfolio Management, 1&, pp.<, I >3. Ha)a)ini, G. and 7ichel, *.A. $1%12', A -he pricing o! risky assets on the ;elgian stock marketB, #ournal of 8anking and 7inance, 9, pp.191 I 1&1. Ha)a)ini, G. 7ichel, *.A. and Jiallet, 6.2. $1%1<', A An assessment o! the risk and return o! ?rench common stocksB, #ournal of 8usiness 7inance and 2ccounting, 13, pp. <<< I <,3. Hussain, ?. and 0ppal, 2. $1%%1', A-he Distribution o! Stock @eturn in /merging 7arketD -he *akistani 7arket. Pakistan /conomic and .ocial 6eview, <9$1', pp.>&I,2. +8bal, 2. ;rooks, @. and Galagedera, D. A. 0. $2331', A-esting 6onditional Asset *ricing 7odelD An /merging 7arket *erspectiveB, 3orking Paper *:&+. 7onash 0niversity, Australia. +8bal, 2. ;rooks, @., and Galagedera, D. A. 0. $233&', AAsset *ricing )ith Higher 6o5 movement and Alternate ?actor modelsD -he 6ase o! /merging 7arketsB, Corking *aper, 7onash 0niversity. +sakov, D. $1%%%', A+s beta still aliveL 6onclusive evidence !rom the S)iss stock marketB, /uropean #ournal of 7inance, ,, pp. 232 I 212. 2ames, /. H. and *hilip, L. -. $1%&1', ASystematic and 0nsystematic @isk o! @ates o! @eturns Associated )ith Selected ?orest *roducts 6ompaniesB, .outhern #ournal of 2gricultural /conomics, pp. 1<,51<1. 2avid, A.K. and Ahmad, /. $2331', A-he 6onditional 6apital Asset *ricing 7odelD /vidence !rom .arachi Stock /"changeB

2avid, K. and Ahmad, /. $2331', A7ulti57oment Asset *ricing ;ehavior o! the :isted !irms at .arachi Stock /"changeB, *+D/ Corking *aper >&. .ing, ;. ?. $1%99', A7arket and +ndustry !actors in Stock *rice ;ehaviorS, #ournal of 8usiness, <%$1', pp.1<%51%3. :akonishok, 2. and Shapiro, A.6. $1%19', ASystematic risk, total risk and si#e as determinants o! stock market returnsB, #ournal of 8anking and 7inance, 13, pp.11 , I 1<2. :akonishok, 2. Shapiro, A.6. $1%1>', AStock returns, beta, variance and si#eD An empirical analysisB, 7inancial 2nalysts #ournal, >3, pp.<9 I >1. :intner, 2. $1%9,', A-he Jaluation o! @isk Assets and the Selection o! @isky +nvestments in Stock *ort!olios and 6apital ;udgetsB, 6eview of /conomics and .tatistics, >&$1', pp. 1<I<&. :intner, 2. $1%99', A-he Jaluation o! @isk Assets and Selection o! @isky +nvestments in Stock *ort!olio and 6apital ;udgetsB, 6eview of /conomics and .tatistics, >&$1', pp. 1<I>&. 7arko)it#, H. 7. $1%%1', S?oundations o! *ort!olio -heoryS, The #ournal of 7inance, >9$2', pp. >9%5>&&. 7ayers, D. $1%&2', AHon5marketable Assets and 6apital 7arket /8uilibrium under 0ncertaintyB, im 2ensen, 7. $1%&2' 7ossin, 2. $1%99', A/8uilibrium in a 6apital Asset 7arketB, /conometrica, <>, pp.&91I&1<. *ettengill, G.H., Sundaram, S. and 7athur, +. $1%%,', A-he conditional relation bet)een beta and returnsB, #ournal of 7inancial and ;uantitative 2nalysis, <3, pp.131 I 119. @einganum, 7. $1%11', AA ne) empirical perspective on the 6A*7B, #ournal of 7inancial and ;uantitative 2nalysis, 19, pp. ><% I >92. @oll, @. and @oss, S. A. $1%13', AAn /mpirical +nvestigation o! the Arbitrage *ricing -heoryS, #ournal of 7inance, *$, pp.)&<*-))&*. Sch)ert, G. $1%1<',BSi#e and stock returns, and other empirical regularitiesB, #ournal of 7inancial /conomics, 12, pp.< I 12. Sharpe, C. ?. $1%9>', A6apital Asset *ricesD A -heory o! 7arket /8uilibrium under 6onditions o! @iskB, #ournal of 7inance, 1%$<', pp. >2,5 >>2.

Sharpe, C. ?. $1%9,', A6apital Asset *ricesD A -heory o! 7arket /8uilibrium under 6onditions o! @iskB, #ournal of 7inance, 1%$<', pp. >2,5>>2. Solnic, ;. H. $1%&>', AAn /8uilibrium 7odel o! +nternational 6apital 7arketS, #ournal of /conomic Theory, 1$>', pp.,335,2>. -inic, S. and Cest, @. $1%1>', A@isk and returnD 2anuary vs. the rest o! the yearB, #ournal of 7inancial /conomics, 1<, pp.,91 I ,&>. -obin, 2. $1%,1', A:i8uidity *re!erence as ;ehavior to)ards @iskB, 6eview of /conomic .tudies, 9&, p.22. Cilliams, 2. ;. $1%<1', S-he -heory o! +nvestment JalueS, $Harvard 0niversity *ress, 6ambridge'. Cilliams, 2. -. $1%&&', S6apital Asset *rices )ith Heterogeneous ;elie!sS, #ournal of 7inancial /conomics,,, pp.21%5<%. Rubairi, H. 2. and Sha#ia, ?. $2311', A -esting the Jalidity o! 6A*7 and A*- in the 4il, Gas and ?ertili#er 6ompanies :isted on the .arachi Stock /"change, Pakistan 8usiness 6eview, pp. ><%5 >,1.