Risk and Returns in Shariah Compliant Cross-Section Stocks : Evidence from an Emerging Market

Purpose: This study is intends to understand and document the impact of market-based — market returns and momentum — as well as firm-specific — size, book to market ratio (B/M), price to earnings ratio (PER) and cash flow (CF) — factors on pricing of Shari'a compliant securities as explanation of variations in stock returns in an emerging market — Pakistan's Karachi Stock Exchange. Methodology: Initially, we 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 ten year period (2001 to 2010). Findings: Our results support superiority of FF three-factor model over single-factor capital asset pricing model (CAPM). However, addition of further risk factors — including PER, CF and momentum — improve explanatory power of the model as well as refine the selection of risk factors. In our 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, we propose a stock valuation model for Shari'a compliant securities consisting of three factors: market returns, size, and earnings which explains 76% variations in cross sectional stock returns.Originality/Value: To the best of our 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