Risk and Returns in Shari’a 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.