Size and Value Premium in Karachi Stock Exchange

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.