Testing Five Factor CAPM on Pakistan’s Stock Exchange: How Risk and Return and Interlinked?

Abstract

The study is conducted to test Five-Factor CAPM on the Karachi Stock Exchange which includes the impact of market risk (RM), size effect (SMB) in terms of market capitalization, the value effect (HML) in terms of the book to market ratio, profitability (RMW) in terms of earning per share and investment (CMA) in terms of annual growth in assets. Data for RM, SMB, HML, RMW, and CMA is taken from Karachi Stock Exchange from the year 2000 to 2015. Four windows having different years from the year 2000 to 2015 are constructed to conduct the research by using Fama and Macbeth's (1973) Methodology. Overall results show that all the independent variables RM, SMB, HML, RMW, and CMA have significant impact on the excess return of portfolios. By taking into account the various factors for portfolio returns for the first windows all the indicators have insignificant outcomes accepting the null hypothesis; factors have an impact on stock returns (Fama & French, 2015). Due to the volatility in the stock prices of small companies the stated facts are inconsistent with the argument that small firms outperform big firms. It means big firms provide lower stock returns compared to small companies. The value stocks which have a high book-to-market ratio yields more returns with respect to growth stocks that have a high book-to-market ratio (Fama & French, 1992). Profitability also has a significant impact on the returns of portfolios, the companies who earn more profitability (Robust) provide more return as compared to the companies who have poor or less profitability (Weak). The investment made by the companies during the year also has a significant impact on returns. The companies having high annual assets growth rates by reinvesting their retained earnings in new ventures or projects, generate fewer returns as compared to companies having low annual asset growth rates. So from the above discussion, it is established that Five-Factor CAPM model holds in Karachi Stock Exchange (KSE).