Risk and Returns in Shari’a Compliant Cross-section Stocks: Developing an Asset Pricing Model

Islamic banking and finance industry is expanding world over with an unprecedented growth. Global volume of Shari’a compliant assets have reached to a level of US $ 1,460/- Billion by the end of 2012, displayed growth of 19% during the year 2011 and 21% during year 2010. To address the issue of investment in marketable equities (which are primarily based on profit and loss sharing principle) Shari’a screening filters have been developed and we have at least nine Islamic Indexes operating worldwide. In Pakistan KSE-Meezan Index (KMI-30) was launched in 2008. This study is intended to understand and document the impact of market index on pricing of Shari’a Compliant securities and explain variations in stock returns on Karachi Stock Exchange (KSE) and also include the testing of the impact of size, book to market (B/M), price to earnings (PER), cash flow yield (CFY) and momentum in variation of stock returns to confirm robustness of earlier studies conducted globally, in return mechanism on a special Sample of Shari’a compliant companies on ten years monthly data from 2001 to 2010. We have tested basic equation of CAPM and S-CAPM with certain modifications of variables. We have also tested FF three factors and modified FF by inclusion of PER, CFY and momentum. Results confirm the CAPM anomalies of size, B/M, CFY and PER. Results of S-CAPM were slightly better than CAPM. Through modified FF we documented a valuation model for Shari’a compliant securities based on four factors including market index, size, PER and risk premium of losers, explaining 78% variations in returns of cross section stocks. In our study B/M, CFY and momentum turned insignificant.