Implementation of Fama and French Five Factor Model: A Case of Pakistan Stock Exchange

Abstract

The continuous development in the asset pricing is providing new empirical models and techniques to check the relationship between risk and return on stocks but it might be challenging to pick one model to use for the users. Investors and investment portfolio managers are always in search of such financial models that may quantify risk in an appropriate manner and can translate the risk into expected returns on equity investment options. Different models and techniques have been applied by the researchers and analysts from time to time to analyze this relationship; among them CAPM is the most famous and widely used technique. Later on, [1] extended the CAPM by adding two more factors in it; Size and Value. Subsequently, [2] introduced Five-Factors Pricing Model (FF5F); which is a development of the earlier models, by adding two new factors; investment level and profitability position. This study is intended to investigate whether a Fama and French five factor asset pricing model (FF5F) can explain average returns of stocks on Pakistan stock exchange (PSX) in a better way than the three factor model (FF3F) and CAPM or there is a need to include more factors in it. The study will be conducted on a sample of all listed non-financial firms’ stock with persistent trading on the PSX by constructing portfolios based upon basic factors identified by [3]. The analysis will be performed by regression analysis. This study will be helpful to the investors, investment advisers and fund managers to entrench their operating strategies and methodologies by adding the expounding power of size, beta, and value along with the momentum of portfolio returns to allow them to devise some trading policies to minimize losses and to maximize returns. In addition to this, policy makers can ensure that some proper measures are already in place to improve market liquidity and viability to improve the breadth and depth of the whole market.