Abstract:
Investment decisions are based on the rational return expectations and
investors require returns that are aligned with their risk and utility. This
phenomenon has been extensively discussed in the financial theory as
well as practice and the first known theory of asset pricing leads back to as early as Bachelier (1900). The current study evaluates the
performance of Fama and French Three Factor model in Karachi Stock
Exchange (KSE). It employs a multivariate regression approach after
sorting six portfolios on size and book to market. The constituent stocks
were selected to represent each and every sector of KSE. Daily returns
were employed for a period of five years starting from January 2003 to
December 2007. The six month Pakistan’s T Bill yield was used as
proxy for risk free rate to determine excess returns. The excess returns
for each portfolio were regressed on market, size and value factors. The results were encouraging for the three factor model. The three factor model was able to explain the variations in returns for most of the
portfolios and the results remain consistent when the sample was
reduced to control for the size effect. Our findings are consistent with
most of the studies that suggested the validity of three factor model in
emerging markets. These findings have substantial implications for fund managers, analysts and investors. The results suggest that size and value premium must be incorporated for asset valuations and portfolio management decisions.
