Testing multifactor capital asset pricing model in case of Pakistani market

The analysis of this study explores a set of macroeconomic variables along with market return as the systematic sources of risks explaining variations in expected stock returns for 49 stocks traded at Karachi Stock Exchange for the period 1993-2004. Some of these economic variables are found to be significant in explaining expected stock returns. The test of conditional multifactor CAPM is carried out by specifying conditional variance as a GARCH (1,1)-M process. The results of the conditional multifactor CAPM-with-GARCH-M model reveal that conditional model shows very marginal improvement in explaining risk-return relationship in Pakistani Market during the sample period. As regards the risk premium for variance risk, the results are not so supportive, only for a few stocks significant compensation for variance risk to investors is observed. The model is then extended to allow variability in economic risk variables and conditioning information is taken as lagged macroeconomic variables that influence business conditions in Pakistan. The results show evidence in support of conditional multifactor CAPM. The economic variables that are observed to perform relatively well in explaining variations in assets’returns include consumption growth, inflation risk, call money rate, term structure. However, the market return, foreign exchange risk and oil price risk, which explain a significant portion of the time series variability of stock returns, have limited influence on the asset pricing. Therefore we can conclude that expected returns variation could be explained by macroeconomic variations and this variability has some business cycle correlations.