Risk and returns in<i>Shari’ah</i>-compliant cross-section stocks : evidence from an emerging market

Purpose: This study aims to understand and document the impact of market-based – market returns and momentum – as well as firm-specific – size, book-to-market (B/M) ratio, price-to-earnings ratio (PER) and cash flow (CF) – factors on pricing ofShari’ah-compliant securities as explanation of variations in stock returns in an emerging market – Pakistan’s Karachi Stock Exchange. Design/methodology/approach: Initially, the authors test Fama and French (FF) three-factor model – market risk premium, size and B/M – followed by modified FF model by including additional risk factors (PER, CF and momentum) over a 10-year period (2001-2010). Findings: Our results support superiority of FF three-factor model over single-factor capital asset pricing model. However, addition of further risk factors – including PER, CF and momentum – improves explanatory power of the model, as well as refines the selection of risk factors. In this study, CF, B/M and momentum factors remain insignificant. Traditional B/M factor in FF model is replaced by PER. Practical implications: Based on the modified FF model, the authors propose a stock valuation model forShari’ah-compliant securities consisting of three factors: market returns, size and earnings, which explains 76per cent variations in cross sectional stock returns. Originality/value: To the best of the authors’ knowledge, this is the first study (which combines market-based as well as fundamental factors) on pricing of Islamic securities and identification of risk factors in an emerging market – Karachi Stock Exchange.