Asset Pricing Anomalies: The Role of Liquidity, Volatility and Investor Sentiment - Evidence from Pakistan Stock Exchange (PSX)

Abstract

This thesis examines the existence of anomalous returns and their risk modeling from various perspectives in Pakistan Stock Exchange (PSX). Anomalous returns are empirical results that are unexplained by the theory of “Efficient Market Hypothesis” (EMH). EMH states that returns are a linear function of risk and it is impossible to earn superior returns without taking extra risk. However, empirical evidence shows that there exist numerous anomalies and risk-return models failed to provide a good description of returns. To study the risk modeling of returns, first, this study focuses on the role of liq uidity in explaining the anomalous returns in PSX. In emerging markets such as Pakistan, liquidity is considered as an important risk factor and returns are assumed to be associated with liquidly. However, traditional risk-return model(s) such as “Capital Asset Pricing Model” (CAPM) do not explicitly incorporates the liquidity factor. To test wether liquidity is priced in PSX, portfolios are constructed as test assets by using size and volatility related information. It is identified that portfolios constructed based on size and volatility generate 30% to 50% annualized returns in PSX during the period from 1994 until 2015. By measuring liquidity as the average of zero return days in a month and then using the “Liquidity Augmented Capital Asset Pricing Model” (LCAPM), findings reveal that these enormous returns are not violation of EMH. Instead, a reward to investors for bearing the market and illiquidity risk. Secondly, emerging markets are considered to be weakly integrated with the global markets. Hence, it is assumed that there exists better investment opportunities for international investors in emerging markets. Therefore, in this study it is explored that whether PSX provides risk adjusted opportunities to international investors after controlling for the global risk factors. Results show that PSX provides risk adjusted returns to international investors. Thirdly, momentum anomaly is considered to prevail across the global markets.However, in emerging markets such as Pakistan, on average this anomaly has histori cally low returns due to the high volatile nature of such markets. Therefore, this study explores whether volatility is linked with the poor performance of momentum strategy. To test this, the momentum strategy is adjusted for volatility and then compares the performance of traditional momentum strategy with volatility/variance scaled momentum strategies during the period from 1994 until 2016. By using simple descriptive analyses, results show that the scaled momentum strategies outperform traditional strategy in terms of higher raw returns and the Sharpe Ratios (SR). In addition, rationalizing the returns of traditional and scaled momentum strategies in the framework of standard asset pricing models reveal that the scaled strategies pro duce larger risk adjusted returns than the traditional momentum. Furthermore, the probability of negative returns for scaled momentum strategies reduce in comparison to traditional momentum strategy. Lastly, this thesis examines the ability of investor sentiment to predict conditional volatility and excess returns at aggregate market and industry level in PSX by using daily data from 2001 until 2015. The results show that sentiment induced investors overreact to information which results in excess demand. As a result, investor sentiment predicts lower future expected returns. However, this miss pricing corrects in the next period which brings the sentiment induced prices towards the equilibrium level. It has also been confirmed that bullish (bearish) sentiment increases (decreases) volatility which in-turn affect the mean variance relationship. However, the commonality of the effect of investor sentiment via conditional volatility has not been uniform across industries.