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CHAPTER 1

INTRODUCTION

1.1 Background
Researchers have been fascinating to explore the eminent role that equity markets enact in the
economy that helps in the efficient allocation of the resources.
The most Important Aspect of Stock Market is Stock efficiency with focus on efficient pricing
which helps in channel for savings profitable purpose and thus helps in allocation of overall
optimal resource’s.
The financial research has been focused on defining the asset return’s behavior with a
determined focus on returns of the risky assets. There are several theories on the subject with
the fundamental work done by Sharpe (1964), Linter (1965), and later on by Black (1972).
For further work on asset pricing models the Capital Asset Pricing Model (CAPM) was served
as Initial point.
The basics of asset’s fair pricing models was set down by Classical work done by Markowitz’s
portfolio selection while Capital Asset Pricing Model (CAPM) is the initial point of modeling
asset’s pricing which is based on mean-variance portfolio efficiency.
According to Ross (1976) arbitrage pricing theory which explains equity returns through a
number of factors but it’s focus has not been efficient portfolios. Many researches have used
APT to identify these factors because these factors have not been explicitly defined.
Due to poor performance of CAPM in explaining realized returns, Fama and French, three-
factor model was developed to explain realized returns. Due to limitation of Empirical record,
CAPM was exposed to lot of criticism. For example, the model requires the ability to explain
all of the returns for a portfolio consisting of various stocks. Fama and French, three-factor
asset pricing model was also developed to figure out most of the anomalies of the CAPM.
Fama and French (1992 has suggested an alternative model, on the basis of an APT outline
that include SMB (Small portfolios minus big) known as, size factor, HML (Higher minus low
book to market portfolios). Fama and French (1993) constructs a pricing model based on three
factors which is comprises of the market risk factor along with size and value factors. Fama and
French model which is expansion of CAPM, focus on characterize the returns with three factors
discussed earlier. The Fama and French Three Factor Model is an asset pricing model that further
Explain capital asset pricing model (CAPM) by prepending size and value factors to the “Market
Risk Factor” in CAPM.

Fama and French in Explaining security returns have been focused on three factors (1996).
These factors are the market premium (market excess return), the size premium (difference in
returns between portfolios of small capitalization firms and big capitalization firms; SMB, small
minus big) and the book-to-market premium (difference in returns between portfolios of high
book-to-market and small book-to-market firms; HML, high minus low).
Fama and French (1995) argued that book to market equity and slopes on HML represents relative
distress. They further argued that those firms that are weak and have low earnings have high book
to market ratio and positive slopes on HML, whilst firms which have consistent high earnings have
low BE/ME and negative slopes on HML. According to research conducted by Chan and Chen
(1991) shows that Covariation in returns related to relative distress that is not captured by the
market return and is recompensed in average returns .
The purpose of this study is to check the applicability of Fama and French three factor model
using Pakistani equity market data.

Literature review
Sahil jain (2013) conducted a study on Bombay Stock exchange utilizing Fama French Three

Factor Model. The everyday stocks information of 27 stocks was used as the unit of examination.

Using SENSEX as the benchmark index. Their findings are many folds: 9 stocks of auto and

banking carried out well. 5 stocks achieve as per outlooks (Oil and gas stocks. And the 6 stocks of

Communication and steel performed dreadfully.

Monthly stock returns over the period 2003 to 2010 of the Istanbul Stock Exchange (ISE) to

examine the legitimacy of the Fama and French three-factor resource evaluating model.

Acknowledged returns demonstrate that portfolios containing substantial firms have higher normal

abundance returns than portfolios containing littler measured firms. By and large, portfolios

containing low book-to-showcase proportion firms perform superior to those containing high
book-to-advertise proportion firms. Nine portfolios are built by size and book-to-advertise

proportion of firms so as to clarify he minor departure from overabundance portfolio returns by

utilizing market chance factor, measure hazard factor and book-to market proportion chance

elements. Measure factor has no impact on portfolios having huge size firms yet can clarify the

overabundance return minor departure from portfolios having little and medium-sized firms.

Book-to-advertise proportion factor affects portfolios with high book-to-showcase proportion

firms. Fama and French three-factor show has control on clarifying minor departure from

overabundance portfolio returns however this power is not solid all through the trial on the ISE.

Aamir Rafique and Tanveer Taj study the influence of market risk premium (MRP), size effect,
Value effect represented by book to market ratios (B/M) and momentum factor (WML) on Karachi
stock Exchange spanning over 2005 to 2012 of 102 stocks. The relationship between variables is
estimated by ordinary least square(OLS). The confirmation suggested that the greater part of the
factors considered had no disturbing impact on clarifying the stock returns.

Nazhat Abbas gives solid evidence on the descriptive power of Fama French three factor model
in explaining cross-sectional average return for Pakistan’s equity market. The firms that traded on
Karachi Stock Exchange spanning over 10 years from 2004 to 2014. Value Premium, size premium
and market premium variables are used to test the model. 6 portfolios ( 3 book-to-market and 2
size portfolios) were formed . And concluded that the three-factor model better explain cross-
sectional average returns.
Jean-François L’Her Tarek Masmoudi Jean-Marc Suret Using Fama French three factor model
the risk factors(size, market, momentum and book to market) and annual premium growth of
Canadian Stock Exchange in the period 2001 of july. The primary confirmation of regularities in
variables' conduct are as per the following: the size factor returns are generously more prominent
in January than in different months, while the momentum factor returns are constantly critical,
with the exception of in January. Book-to-market factor returns are certain (negative) and
exceptionally (scarcely) huge in down-business sectors (up-business sectors).
Nicklas Rehnby conducted a stydy on the comparison of Fama French three factor model, Capital
asset pricing model and Carhart´s four-factor model using Swedish stock market as data sample to
examine which of the model can best clarify the portfolio access return. The outcomes demonstrate
that the three-factor model enhances illustrative control for portfolio returns in contrast with the
CAPM, and the four-factor model gives a little change in the illustrative power contrasted with the
three-factor model. The outcomes likewise show that all models have a low illustrative power
when the market is unpredictable.

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