Estimating Liquidity Augmented Three Factor Model for PSX

Abstract

Objectives: Several risk factors have been identified as crucial determinants of cross-sectional variations in assets’ returns in three, four, and five-factor models. This paper aims incorporates liquidity, in two separate measures with volume and volume as percentage of outstanding shares, in standard three factor model by considering hundred companies from Pakistan Stock Exchange (PSX).

Research Gap: Previous relevant literature for PSX considers other factors but could not found for estimating three factor model with liquidity factor. However, these types of models are developed for other markets.

Methodology: It takes data of 100 selected companies of PSX to estimate standard three factor and liquidity-augmented three factor models. Portfolio construction and estimations are carried out as per the methodology developed by Fama and French in factor models.

The Main Findings: Based on the estimations of these liquidity augmented three factor models, it is concluded that investors in PSX require premium against investment in illiquid portfolios along with the other risk factors such as market, size, and value.

Practical implications of findings: The better choice for risk-avert rational investors is to construct a portfolio with big size, low book to market value, and liquid assets’ companies.