Idiosyncratic Risk and Expected Return of Portfolio Investment Evidence from Stock and Commodity Markets of Pakistan

Abstract

The central theme of this research study is related with the role of idiosyncratic risk in commodity and stock returns of Pakistan being emerging markets of the world. In the framework of asset pricing, literature suggests that idiosyncratic risk is independent to the specific assets therefore it has no role in explaining the returns. However, modern portfolio theory suggests that in under diversified portfolio, idiosyncratic risk has the positive relationship with stock returns, while the negative association of idiosyncratic risk has also been reported by different scholars. To settle this conflict through Pakistani context, the current study investigates the role of idiosyncratic risk empirically in these two financial markets. Stock market is divided into two sectors i.e. financial sector including returns of financial companies and non-financial sector comprising data of non-financial companies. The daily and monthly data are taken from January 2005 to 2016 for analysis. For commodity market of Pakistan which is totally independent from stock market, separate daily data set is taken from 2011 to 2016. As the data is of quantitative in nature therefore various statistical tools are applied for this purpose. Cross sectional regression is used for testing the association between expected conditional idiosyncratic risk and returns. Conditional idiosyncratic risk is estimated through Egarch model for both markets. The empirical results showed that conditional idiosyncratic risk and return of non-financial, financial and commodity returns has significant positive relationship after controlling the different factors such as value, momentum and size etc. whereas the lag idiosyncratic risk has no relationship with returns of stocks and commodities. The empirical evidence confirms the findings of previous studies. In the end it is suggested that investors can develop profitable portfolio after considering the idiosyncratic risk.