Academic journal article International Journal of Business

A Five-Factor Asset Pricing Model: Empirical Evidence from Egypt

Academic journal article International Journal of Business

A Five-Factor Asset Pricing Model: Empirical Evidence from Egypt

Article excerpt

(ProQuest: ... denotes formulae omitted.)


One of the most debatable topics in financial literature is identifying determinants of stock returns. The literature has progressed from a single-factor model to multi-factor models. Currently, there is practical evidence that stock returns can be determined by a combination of several risk factors rather than one sole factor. Both institutional and individual investors in Egypt use different variables in the stock selection process. These variables include, but are not limited to price-based ratios (e.g., book-to-market equity, earnings-to-price, sales-to-price and dividends-to-price ratios), investment factors (e.g., investment-to-assets and assets growth ratios), prior returns (momentum and reversal), profitability ratios, leverage ratios and liquidity factor.

With a large variety of variables, determining a well specified asset pricing model, to explain variations in stock returns, becomes very complicated and confusing. The choice of a model based on risk factors or firm characteristics becomes unclear to both academics and practitioners in Egypt.

The Capital Asset Pricing Model (CAPM), developed independently by Sharpe (1964) and Lintner (1965), is the first model built to determine the expected rate of returns on risky assets. An essential argument is on the sole role of the systematic risk in the model. Researchers notice that different patterns of stock returns are not explained by the CAPM; they are called anomalies. But none knows whether they are actual anomalies or a result of an incomplete model being tested for market inefficiencies. The most prominent anomalies are firm size (Banz, 1981; Reinganum, 1981; Fama and French, 1992, 1993, 1996), earnings-to-price (Basu, 1977; Ball, 1978; Reinganum, 1981; Fama and French, 1992), book-to-market equity (Rosenberg et al., 1985; Chan and Chen, 1991; Fama and French, 1992, 1993, 1996), leverage (Bhandari, 1988; Fama and French, 1992), momentum (Jegadeesh and Titman, 1993; Rouwenhorst, 1998, 1999), liquidity (Amihud and Mendelson, 1986; Datar et al., 1998; Amihud, 2002; Chan and Faff, 2005), dividend-to-price (Zhang, 2007; Al-Mwalla et al., 2010) and asset growth (Chen and Zhang, 2009; Fama and French, 2014). Despite the fact that the CAPM is widely used by market practitioners in Egypt, it has come under attack from several directions. First, recent research testing weak form efficiency in the Egyptian stock market shows that stock prices do not completely reveal all historical information, thus rejects the random walk hypothesis (Al-Jafari and Altaee, 2011). Therefore, the CAPM, which is based on an efficient market assumption, does not fit well in an inefficient stock market. Second, the Egyptian market index EGX30which is weighted by market capitalization and adjusted by free float for the most active 30 companies-cannot be regarded as a good representative of the securities universe. EGX30 is concentrated around different securities, e.g. Commercial International Bank (CIB) represents 35.75% of EGX30 index market capitalization as of the end of July 2015 (Egyptian Stock Exchange website).Therefore, the Egyptian market index may not be a good representative of the mean-variance efficient portfolio. Third, during market downturn (when the market return is lower than the risk free rate), market risk premium reports a negative sign, providing unreasonable results. Consequently, it seems clear from the previous studies that beta does not tell the whole story of risk. There seems to be risk factors affecting stock returns beyond the onedimensional measurement of market sensitivity. Therefore, market practitioners attempt to add an arbitrary value to the risk free rate to determine their required rate of return. The motivating point is that, there is no supporting theory to rationalize the choice of the variables to be incorporated in the CAPM in addition to beta.

The latest study on the Egyptian stock market (Shaker and Elgiziry, 2014) evaluates different asset pricing models, namely the CAPM, Fama and French threefactor model (thereafter, FF3 model), momentum-augmented FF3 model, Liquidityaugmented FF3 model and momentum and liquidity-augmented FF3 model. …

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