Liquidity Preference Models in Asset Pricing: Evidence From Pakistan Stock Exchange

Abstract

Equity investors are yet unable to crack the puzzle of priced factors that help in predicting the expected returns through their rational decision-making using available asset pricing models. The financial economists, theorists, researchers, financial experts, and equity analysts keep on exploring the price discovery factors and liquidity is very much persistent to emerging markets. This dissertation aims to discover the price with the presence of liquidity factor (LF) in asset pricing models on Pakistan Stock Exchange (PSX). Researchers have identified the appropriate asset pricing model for assessing liquidity factor (LF) and to explain the liquidity proxies in context of companies listed in Pakistan Stock Exchange (PSX). For this price discovery phenomenon, KSE All share companies have been selected from January 2000 to December 2016 by avoiding survivorship bias. Through portfolio construction, it has been found that the risk premia are explained by augmenting liquidity factor in capital asset pricing model (CAPM), Fama-French three factor and Fama-French five factor models. The results are computed on the basis of the highly significant liquidity proxy “Return to Turnover”. The results in are in two panels, Panel A reports the unrestricted model in which the lambda coefficient is included that has captured its value from the system of equations while in Panel B, the restriction has been imposed and coefficient is set to 0. The results support the existence of LF in CAPM. The LF is positive and significant in both unrestricted and restricted models. Meanwhile, the results, by augmenting LF in both Fama-French models are positive and significant. It is suggested that the investors should buy the stock of the companies or portfolios having low Turnover Ratio, CV of Turnover Ratio, CV of Trading Volume and high Return to Turnover (R to TR) while the investors should short their position for the companies or portfolios having high Turnover Ratio, CV of Turnover Ratio, CV of Trading Volume and low Return to Turnover ratio in context of Pakistan Stock Exchange. The results benefit brokerage houses to take benefit of this price discovery or impact on portfolio performance in times and investors can devise the optimal investment strategies in their portfolio choice decisions, whether investment portfolio based on liquidity yield higher returns. Moreover, this study gives direction to the financial institutions for evaluating the performance of portfolios in the bullish and bearish market by computing the spread in the long term and short term.