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 Karachi Stock Exchange which include impact of market risk (RM), size effect (SMB) in terms of market capitalization, value effect (HML) in terms of 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 year from year 2000 to 2015 are constructed to conduct the research by using Fama and Macbeth (1973) Methodology. Overall results shows that all the independent variables RM, SMB, HML, RMW and CMA have significant impact on the excess return of portfolios. By considering the various factors for portfolio returns for the first windows all the indicators have insignificant outcomes accepting the null hypothesis; factors have impact on stock returns (Fama & French, 2015). Due to the volatility in the stock prices of small companies the stated facts are in consistent with the argument that small firms outperform big firms. It means big firms provide lower stock return comparatively to the small companies. The value stocks which have high book to market ratio yields more returns with respect to growth stocks which have high book to market ratio (Fama & French, 1992). Profitability also has 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 have significant impact on returns. The companies having high annual assets growth rate by reinvesting their retained earnings in new ventures or projects, they generate less returns as compared to companies having low annual asset growth rate. So, from above discussion it is established that Five Factor CAPM model hold in Karachi Stock Exchange (KSE).