Economic exposure, pricing of risk and various volatility dynamics of stock returns on an emerging stock market

Abstract

Among the scholars, it is believed that the stock market performance reflects the economic and financial conditions of a country. Three dimensions of stock returns that are, economic exposure, pricing of risk and various volatility dynamics have been overlooked by existing studies on stock market. Therefore, this research examined these dimensions at the firm, sectoral and aggregate market level stock returns. Following that, the worth of firm’s character effect (firm size, firm age, firm business nature, firm trading nature and sectoral location of the firm) was also explored with respect to these three dimensions. This study focused on the stock returns of firms from 23 sectors listed on the Karachi Stock Exchange of Pakistan. For this purpose, three generalized autoregressive conditional heteroskedasticity (GARCH) models were applied: GARCH (1, 1) for capturing the economic exposure of stock returns together with different volatility dynamics; GARCH-M for pricing of risk and EGARCH for asymmetric and leverage effect. The findings of the study are as follows: first, among other macroeconomic variables, market return is found to be the most important one in explaining the stock returns. Second, the study revealed the existence of pricing of risk and leverage effect in the Pakistani stock market. Third, it is found that generally the firm level stock returns are quite volatile and volatility shocks are rather persistent but holding the property of mean reversion. Fourth, the study provided evidence of lagged effect of macroeconomic variables on stock returns. Fifth, the study found that firm’s characteristics play an important role in explaining the stock returns. Resting upon these outcomes, investors can make more informed decisions and policy makers can develop effective policies for controlling and promoting macroeconomic growth and stability in a country.