Abstract:
This study evaluates the ability of Fama French three-factor model to predict the returns of companies listed in the Karachi Stock Exchange (KSE). The first part of the study divides the four and a half year sample period of KSE into three categories namely, bull, neutral and bear. These categories indicate the market condition prevalent in KSE in a particular month.
In the second part of the study, a sample of 20 companies from different sectors of KSE were selected and combined to make a portfolio. Over a period of four and a half years (June 2004- Dec 2008), the returns of the portfolio were compared with the returns of KSE 100 index, which was assumed to represent market returns in general.
In the next step, the selected portfolio was sorted according to company size and then returns of smaller companies were compared with returns of bigger companies and checked if it conformed to the claims of Fama French Model.
The selected portfolio was sorted according to the third factor of Fama French Model, which is book to market ratio. Here again the returns of companies with high book to market ratio were compared with returns of companies having low book to market ratio.
All the three factors were applied separately on the bull market period, neutral period and bear period. Our findings supported the notion of the three factor model in bull period only. For neutral and bear period, the three factor model was not able to explain the variations in returns for the selected portfolio. The results of the study are consistent with most of the previous studies and shows that Fama French model proves valid for bull period only. The results confirm that Fama French model can be a useful tool for portfolio managers and investors in predicting company returns during bull periods in emerging markets like the KSE.
