Market Varying Conditional Risk-Return Relationship

Abstract

Unlike previous studies conducted on Pakistan, this article attempts to test the validity of conditional relationship between beta and cross-sectional returns of individual securities listed in Karachi Stock Exchange (KSE), wherein the up and down market periods are separated. The risk-return relationship is also tested using the conventional CAPM to compare the results of both models. The return on market portfolio and risk free asset is proxied by KSE-100 share index return and three months T-bill. Fama and McBeth (1973) and Pettengill, et al. (1995) methods are used to test conventional and conditional risk-return relationship, respectively. The analysis is performed on individual stocks of thirty companies over the period 2004 to 2012. Findings indicate a consistent and significant positive risk return relationship in up market periods where market excess returns are positive; whereas, an inverse risk-return relationship is not proved in down market periods where market excess returns are negative. Furthermore, the study finds no support for symmetry between up and down market periods. The major implication of the analysis is that beta can be a useful measure of risk only in up markets periods.