Time Varying Size and Liquidity Effects

Time varying Size and Liquidity effects in South Asian Equity
Markets: A study of blue-chip industry stocks
Bruce Hearn*
University of Leicester
Abstract
This paper contrasts the performance of the Capital Asset Pricing Model (CAPM) augmented
by size and liquidity factors with its time varying coefficient counterpart using a unique
market universe compiled from constituent stocks of blue chip indices BSE-100 (India), KSE-
30 (Pakistan), DSE-20 (Bangladesh) and Dow Jones Titans (Sri Lanka). The evidence
suggests that substantial size and liquidity effects are present in all markets with the sole
exception of Sri Lanka. Time varying liquidity beta profiles reveal that the financial sectors
of all South Asian markets have been affected by the 2008 financial crisis with exception of
Sri Lanka where the market is influenced by the prolonged civil war.
JEL classification: G11, G12, G15, O55

Keywords: Liquidity, CAPM, Kalman filter, Emerging Financial Markets, South Asia
*
Corresponding author: School of Management, University of Leicester, Ken Edwards
Building, Leicester. UK. LE1 7RH. Tel: 44(0)116 252 5520. Email: bruce.hearn@le.ac.uk
Electronic copy available at: http://ssrn.com/abstract=1566252

Time varying Size and Liquidity effects in South Asian Equity Markets:
A study of blue-chip industry stocks
1. INTRODUCTION
The enhancement of standard pricing models such as the Capital Asset Pricing Model (CAPM) with
the addition of factors offering improved explanatory power over the cross section of stock returns
has been subject to considerable attention in the literature. While pricing theory states that the cross
section of expected stock returns are related to the returns sensitivities to state variables, which
themselves are linked to investor welfare, this has led to a considerable literature investigating the
nature of the state variables themselves. Fama and French (1993) (henceforth FF) first proposed
that variations in size, defined as the valuation differences between value and growth stocks, and
variations in accounting book value and market value of stocks are two such candidates for state
variables. Furthermore the supplementing of the traditional CAPM with two additional returns-
based factors representing these proposed size and book-to-market value state variables facilitated
improvements over using the simple market-factor alone. More recently liquidity has been
proposed as such a state variable with a range of methods cited for its measurement. Pastor and
Stambaugh (2003) found evidence of increased supporting a trading volume based-liquidity factor
augmenting the FF model, while Liu (2006) introduced a new trading speed measure designed to
capture both traded turnover as well as frequency of trading elements of liquidity. Furthermore Liu
(2006) found evidence that the addition of the single liquidity factor alone to the traditional CAPM
generated increased explanatory power across the cross section of returns in excess of either the one
factor CAPM or the FF model. However there is a lack of evidence concerning the benefits of
including both the FF size and book-to-market value factors in modelling the cross section of stock
returns in Pakistan (Iqbal and Brooks, 2007) and India (Ameer, 2007). The presence of size effects
is especially likely in emerging South Asian markets given the considerable dispersion of listings
that are commonly made up from either larger internationally focussed firms or indigenous small
and medium enterprises (SMEs) which are often controlled by dominant family groups (Manos et al
(2007); Athey and Laumas (1994); Marisetty and Subrahmanyam (2010)). There is evidence of
considerable differences in trading activity and liquidity within markets across the South Asian
region. Poshakwale and Theobald (2004) and Karmakar (2010) cite differences in liquidity across
sectors within the large Indian equity market while this is a pervasive issue in Sri Lanka (Elyasiani
et al, 1998), Pakistan (Iqbal and Brooks, 2007), Bangladesh (Ahktaruddin, 2005) and the much
smaller Nepalese market (Bijay and Snowden, 1999). Consequently this empirical study
investigates whether size and liquidity effects are priced. As such I ask whether differences in cross
sectional expected returns can be better explained through including factors accounting for the
Electronic copy available at: http://ssrn.com/abstract=1566252

differences in aggregate market-wide size and liquidity effects than just the market factor of the
traditional CAPM alone.
Liquidity as a concept is very hard to define largely because its representative
characteristics transcend a number of transactional properties of markets including tightness, depth,
resiliency (Lesmond, 2005) and information (O’Hara, 2003). The literature has traditionally been
limited in only employing constructs capturing only one dimension of a multidimensional
phenomenon. This typically centres on variants of the bid-ask spread (quoted or effective) in
Amihud and Mendelsen (1986), the turnover measure of Datar et al. (1998), or measures relating to
the price impact arising from traded volume such as Amihud (2002) and Pastor and Stambaugh
(2003). However there is very little published research concerning measures capturing the trading
speed dimension of liquidity, defined as the ability to transact large quantities quickly with little
price impact (Liu, 2006; Pastor and Stambaugh, 2003). Furthermore there are serious concerns
over existing one-dimensional constructs ability to fully capture liquidity risk and over their
inaccurate estimation of the dimension they are intended to model (Pastor and Stambaugh, 2003;
Amihud, 2002). Equally deficiencies in the application of the bid-ask spread construct have been
highlighted in Lee (1993) where evidence reveals that many large trades occur outside the bid-ask
spread while many small trades are undertaken within it leading to potential bias. Further concerns
over the application of one-dimensional measures focus on their being undefined in the presence of
extremes of illiquidity as is a frequent occurrence in smaller regional markets (Lesmond, 2005). A
more recent measure developed in Liu (2006) captures the trading speed dimension of liquidity
which is defined as the standardized turnover-adjusted number of zero trading volumes over the
past twelve months. It is multi-dimensional in nature, capturing effects relating to trading speed,
trading quantity and trading cost, with an emphasis on trading speed, outlined as the continuity of
trading and the potential delay in executing an order (Liu, 2006). An additional benefit from the
use of this measure arises from its measurement robustness in the presence of significant illiquidity
(Liu, 2006) as is often present in emerging markets (Hearn and Piesse, 2009).
The literature concerning the inclusion of liquidity as a priced state variable within a
valuation framework is very recent. Pastor and Stambaugh (2003) find strong evidence from US
stock data that market-wide liquidity is a priced state variable and that the liquidity premium should
be positive. The study applied the innovations of a price impact measure of liquidity to sort stocks
within a universe into decile portfolios with the market aggregate premium being formed in the
difference between returns of the highest and lowest liquidity deciles. The explanatory power
arising from inclusion of the liquidity factor were studied through the contrast of a four factor
capital asset pricing model (CAPM) including market, size, price-to-book value and the new
liquidity factor against the Fama and French (1993) three factor model and the CAPM. Stocks with
higher sensitivity to aggregate liquidity stocks compensate investors with higher expected returns.
Evidence is also found that small stocks have greater sensitivities to liquidity innovations than large
3
stocks. Pastor and Stambaugh (2003) note that intuitively it could be expected that small and
illiquid stocks are those most affected by market aggregate drops in liquidity thereby precipitating
investors to “flee” to assets with higher liquidity. However their findings also show that size and
liquidity are not the sole determinants of liquidity betas. This finding is reinforced by the argument
explaining why stocks with a high liquidity beta are not necessarily illiquid. Investor preferences
when there are market aggregate falls in liquidity are also likely to focus on rival bonds markets. In
order to increase portfolio holdings in bonds investors may seek to sell liquid stocks in order to save
on transactions costs. Consequently in this scenario the price reaction to aggregate liquidity
changes is stronger for more liquid stocks. Equally prices of liquid stocks could have greater
sensitivity to aggregate liquidity shocks if such stocks are held in greater proportions within the
portfolios of liquidity-conscious investors. As such Pastor and Stambaugh (2003) find little basis
for liquidity betas to bear a simple relation to stock size and liquidity. Liu (2006) builds on this
background in first using a new liquidity construct to estimate stock liquidity and then including
this factor within a two factor augmented capital asset pricing model (CAPM). While the
additional liquidity factor offers strong performance in explaining the cross section of US stock
returns the findings are in contradiction to the earlier findings of Pastor and Stambaugh as the
liquidity premium solely subsumes the documented anomalies such as size and the book-to-market
effects from Fama and French (1993).
The literature relating to South Asian stock exchanges typically focuses on the Indian
equity market with some peripheral studies on Pakistan, Bangladesh and Sri Lanka. The literature
relating to the Indian market has evolved considerably over the last fifteen years with studies
relating to market microstructure and information transmission between large and small stocks (see
Poshakwale and Theobald (2004); Karmakar (2010)) as well as a larger volume of studies focussing
on the roles of family groups and control in Indian listed firms. The latter group of studies tend to
focus on capital structure decisions of Indian firms (see Chakraborty (2010); Manos et al (2007)) as
well as the contrasting sourcing of funds internally as opposed to from either banks or the stock
market (see Athey and Laumas (1994)). The little literature there is that focuses on the wider sub-
region focuses on the study of dynamic linkages between the Sri Lankan equity market and other
South East Asian nations (Elyasiani et al, 1998), corporate disclosure and informational content of
stock prices in Bangladesh (Akhtaruddin, 2005) and the application of CAPM pricing model in
Nepal (Bijay and Snowden, 1999) and Pakistan (Iqbal and Brooks, 2007). However very few, if
any studies have extended the application of CAPM methodology, including liquidity measurement,
to industry portfolios and across the wider South Asian regional markets. Consequently I am
motivated to extend the scope of this study beyond a single market to include the wider South Asian
sub-region. I also provide a unique focus on individual industry sectors and justify my
consideration of stocks that are constituent members of blue chip indices as these are most likely to
4
satisfy the asset market integration and informational assumptions inherent in the CAPM and are of
most interest to overseas investors.
The majority of the valuation literature concerns the implementation of pricing models that
assume a time invariant relationship in the systemic (market) risk of an asset. However over the
last fifteen years a separate literature concerning the time varying nature of systemic risk has
evolved from an increasing concerns of the violation of assumptions inherent in the linear model
such as normality, identity and independence of stock returns (Grout and Zalewska, 2006).
Pettengill et al (1995) studied the relationship between risk and return in “up” as opposed to
“down” markets while Bekeart and Harvey (1995) undertook a similar study using Markov-
switching regressions across a broad sample of emerging markets to examine differences between
periods of integration with world market and segmentation. Brooks et al (1998) used time varying
techniques based on the Kalman-filter approach and applied to Australian industry portfolios
finding that these techniques produced improved in and out of sample performances than other
econometric techniques. Grout and Zalewska (2006) find that the use of Kalman filter methods is
preferable to Markov-switching regressions owing to their not having to define the exact point of
the switch (Grout and Zalewska, 2006). Instead any changes in the time path of betas can be
assessed through the study of regression results which is particularly relevant in the modelling of
liquidity effects as these are prone to considerable fluctuation within emerging markets. In the light
of this evidence I use time varying techniques employing the Kalman filter framework following
Brooks et al (1998).
In this study I find evidence from the application of time series regression techniques to
industry portfolios across South Asia that aggregate size and liquidity effects are significant in all
markets with the sole exception of Sri Lanka where the former dominates significance and
explanatory power in models. Similar results are found from the application of time varying
techniques utilizing the Kalman filter. The more illiquid nature of the sub-regions smaller less
developed markets, namely Bangladesh and Sri Lanka, is reflected in the considerably reduced
levels of both significance of factors and overall explanatory power of both the CAPM and its three
factor counterpart. The evidence from the in-sample profiles of the time varying liquidity betas
reveals that while liquidity betas are largely centred on zero and insignificant for blue chip Indian
stocks they have decreased considerably since 2002 for top tier Pakistan stocks. The liquidity beta
time profile for Bangladesh is high and of variable significance while that for Sri Lanka is
pervasively high and significant. In the light of the 2008 global financial crisis the time-varying
profiles of liquidity betas of financial stocks in India, Pakistan and Bangladesh show clear and
significant upward trends while that of Sri Lanka is markedly different in being consistently high
indicating a likely different process governing liquidity in Colombo. Overall these results lend
further support for the application of the mean-variance paradigm in an emerging market context.
5
The paper is structured as follows. Section 2 reviews the institutional features of South
Asian equity markets before detailing the construction of the liquidity measures and finally
providing data descriptive statistics. Section 3 outlines the two modelling approaches used: the size
and liquidity augmented CAPM and its time varying parameter analogue. Section 4 discusses the
empirical results. The final section concludes.
2. SOUTH ASIAN EQUITY MARKETS AND LIQUIDITY MEASUREMENT
(i). South Asian securities markets

The major stock markets of the South Asian region are linked through common membership of the
South Asian Federation of Exchanges (SAFE) which acts to promote regional initiatives such as the
gradual harmonization of accounting and governance standards. Membership of SAFE is also
broad and includes stock exchanges in the Indian Ocean territories of Mauritius and Maldives as
well as the remote Himalayan kingdom of Bhutan (SAFE website, 2010). However while both
Bangladesh exchanges are members, namely Dhaka and Chittagong, as are all three Pakistan
exchanges, Lahore, Islamabad and Karachi, only the two largest Indian exchanges, namely Bombay
and National Exchange, are members. India is by far the largest stock market with over 24
regulated exchanges across the country. However severe illiquidity and inactivity is a major issue
for the majority of the smaller provincial exchanges as trading remains concentrated on the Bombay
and National stock exchanges located in the commercial capital Mumbai. Technical improvements
designed to enhance operating efficiency of many of the smaller regional exchanges have failed to
stem order flow and liquidity flowing to the Bombay and National stock exchanges. This has left
many of the smaller exchanges with few options other than to establish an affiliated entity that has
membership of one of the two Mumbai markets (Pune stock exchange website (2010); Cochin stock
exchange website (2010)). This provides the local regional investment community with a choice of
trading on an illiquid local platform or having order flow routed by the local exchange’s affiliate
through to either of the two Mumbai markets for execution.
India (Bombay stock exchange)

The Bombay stock exchange (BSE) is the oldest stock exchange in Asia and traces its origins to the
1875 formation of the “The Native Share & Stock Brokers' Association”. The modern exchange
was incorporated in 1956 and migrated trading from open-outcry to computerised system in 1995
before demutualising in 2005 (BSE website, 2010). The exchange has the world’s highest number
of listings at 4,937 firms. Trading at the BSE is from 9-00am to 16-05pm through the BSE On-line
Trading (BOLT) which draws on a network of 25,000 users spread across 359 cities nationally
(BSE website, 2010). Order flow to the BSE is precipitated through a network of 795 national
brokers of which 617 are located in Mumbai itself (BSE website, 2010). The first market
6
barometer index, the SENSEX, was created in 1986 from the top 30 stocks listed on the BSE.
However this was shortly followed in 1989 by the BSE-100, otherwise known as Bombay-100,
which comprises 100 stocks from the major national exchanges of Mumbai, Calcutta, Delhi,
Ahmedabad and Madras and is calculated on a free-float market capitalization basis. The evidence
from Table 1 reveals that market capitalization and traded value are more concentrated in the
financial, energy, industrial and utilities industries with a relatively even dispersion of remaining
capitalization and value across other sectors. In line with the market being one of the largest in
Asia there is relatively little concentration in the top stocks with the largest stock only accounting
for 0.12% of total capitalization and 0.55% of traded value. Similarly the top 10 stocks only
account for a mere 3.5% capitalization and 3.41% traded value.
Table 1
Pakistan
The Pakistan financial market is served by the three stock exchanges of Karachi, Lahore and
Islamabad which were established in 1947, 1970 and 1992 respectively. While trading is electronic
on all three exchanges the transition to electronic trading from an open outcry system in Islamabad
has caused this market to achieve the highest rate of growth in new listings and order flow in the
country (ISE website,2010). However the Karachi stock exchange retains its position as the largest
and most liquid exchange in Pakistan with 651 listed firms and trading being centred on a
computerised order matching system from 9-30am to 15-30pm. The exchange supports four
barometer indices: the KSE-30, KSE-100, KSE All Share and KSI. Trading activity on the KSE
has been volatile during 2008 and particularly susceptible to domestic political uncertainties as well
as the effects of the global financial market downturn and recession with trading being suspended
completely for the last four months of 2008 (KSE website, 2010). The profile of the constituents of
the KSE-30 (see Table 1) is similar to that of India’s Bombay-100 with little concentration in the
top tier listings with largest firm only accounting for a mere 1.19% of capitalization and 2.6%
traded value. Similarly the top 10 listings only account for 10.94% capitalization and 18.47%
traded value. However capitalization and traded value are concentrated in financial, basic materials
and energy industrial sectors.
Bangladesh
The Dhaka stock exchange, established in 1954, is the oldest of the two exchanges in Bangladesh
with the Chittagong stock exchange only having been established in 1995. Trading was migrated
from open outcry in Chittagong to a internet web-based system in 2004 with trading hours between
11-00am and 15-00pm. Trading on the Dhaka stock exchange is electronic with similar hours
between 230 broker-members and in 671 listed firms. The Dhaka exchange is the largest and most
liquid of the two markets and supports two barometer indices: the DSE All Share and investor-
7
orientated DSE-20 (DSE website, 2010). The evidence in Table 1 reveals that in line with similar
smaller emerging markets (see Hearn and Piesse (2009)) there is considerable concentration of both
capitalization and traded value in the single largest stock accounting for 46.17% capitalization and
39.32% traded value. The top 5 stocks account for 78.13% of capitalization and 72.69% of traded
value providing further evidence of the small and highly skewed nature of the trading profile of the
DSE.
Sri Lanka
Share trading in Sri Lanka originally started in 1896 with the Colombo Stockbrokers Association
and was largely focussed on limited liability certificates of local plantations (CSE website, 2010).
The Colombo stock exchange (CSE) inherited the existing trading platform from the stockbrokers
association upon its incorporation in 1985. The exchange operations were automated in 1991 with
the establishment of a fully electronic central depository before the automation of trading, centred
on an order-driven platform, in 1997 with a pre-session call auction from 9-00am to 9-30am
followed by continuous auction from 9-30am to 14-30pm (CSE website, 2010). Order flow to the
exchange is routed through 15 Colombo-based stockbrokers of whom 6 are licensed dealing
members. However the fortunes of the exchange and wider stock market are closely tied to the
civil war and the exchange has experienced a dramatic resurgence of activity since the conclusion
of hostilities. The evidence from Table 1 reveals that as would be intuitively expected for a smaller
emerging market capitalization is concentrated on financial (20.59%), communications (41.83%)
and consumer non-cyclical (19.37%) industrial sectors. Traded value however is even further
concentrated on only the communications sector which accounts for 64.35% of the total across the
twenty member Dow Jones Sri Lanka Titans index. Similarly the single largest stock accounts for
21.40% of capitalization and 63.02% traded value while the top five stocks account for 67.32% of
capitalization and 84.98% traded value.
Small Regional Markets: Nepal, Maldives and Bhutan

The three exchanges of Nepal, Maldives and Bhutan are the smallest in the South Asian region and
are markedly different from their larger counterparts in the rest of the region. The Nepal stock
exchange (NEPSE) was first established in 1994 to formalise a domestic share trading market that
had been in existence since 1937. Trading was automated in 2007 alongside the imposition of
index-based circuit breakers so as to appease fears of loss of value through financial contagion.
Trading is conducted between 12-00pm and 15-00pm between the 23 member brokers and 2
licensed market makers. However the exchange suffers from considerable illiquidity (Bijay and
Snowden, 1999) with trading activity linked to ongoing civil unrest and domestic political situation.
The Royal Securities Exchange of Bhutan was established by Royal decree in 1993 under
the supervisory guidance of the Asian Development Bank (RSEB website, 2010). Listings are
8
composed of 17 local Bhutanese firms restrictions on foreign ownership are gradually being relaxed
with a view of local stocks participating in a proposed South Asian mutual fund between SAFE
member exchanges (SAFE website, 2010). Order flow is precipitated by four member-brokers who
are all major domestic financial institutions and jointly own the exchange which is run on a not-for-
profit basis and trading auctions are conducted on three days per week for one hour (RSEB website,
2010). The evidence from Table 1 reveals that as intuitively expected there is considerable
concentration of 36.25% of capitalization in a single stock and 86.95% in the top five stocks.
Capitalization is almost exclusively concentrated in financial and industrial sectors.
The Maldives stock exchange (MSE) was first established in 2002 as part of a government
privatization initiative and located inside the regulator, the Capital Market Development Authority
(CMDA). It was only in 2008 that the exchange was formally incorporated with its functions
divorced from those of the regulator. Trading is by electronic continuous auction from 9-00am to
12-00pm from Sunday to Thursday in line with Islamic calendar. The tiny order flow that does
exist is focussed by the three brokers towards the four listed firms. As intuitively expected for such
a small market capitalization and traded value is highly concentrated with the top stock accounting
for 36.31% of the former and 51.67% of the latter.
(ii). Liquidity constructs

The Bid Ask spread and commission cost
The Bid Ask spread and commission cost: The data on the end of month bid and ask quotes were
collected from Datastream. The bid-ask spread is calculated using the average of the available
monthly quotes and incorporates at a minimum a single month’s quote for that month. The average
bid-ask spread spanning the quarter is used for the estimate of the spread. This procedure
minimizes outlier problems and averages out the recording of either highs or lows in quotes
resulting from monthly sampling. Following Lesmond (2005) bid-ask spreads that exceed 80% are
trimmed as these are potentially errors. The monthly quoted spread is defined as:
Ask M Bid M Ask M 1 Bid M 1 (1)
Quoted spreadM 1/ 2
Ask M Bid M / 2 Ask M 1 Bid M 1 / 2
Liu (2006) measure

Daily price and volume data are collected from Datastream. The measure is derived from the recent
work of Liu (2006) and is defined as LMx which is the standardized turnover-adjusted number of
zero daily trading volumes over the prior x months (x = 1, 6, 12) i.e.
1/x month turnover 21x (2)
LM x Number of zero daily volumes in prior x months +
Deflator NoTD
9
where x month turnover is the turnover over the prior x months, calculated as the sum of the daily
turnover over the prior x months, daily turnover is the ratio of the number of shares traded on a day
to the number of shares outstanding at the end of the day, NoTD is the total number of trading days
in the market over the prior x months, and Deflator is chosen such that,
1
x month turnover (3)
0 1
Deflator
for all sample stocks1. Given the turnover adjustment (the second term in brackets in first
expression), two stocks with the same integer number of zero daily trading volumes can be
distinguished: the one with the larger turnover is more liquid. As such the turnover adjustment acts
as a tie-breaker when sorting stocks based on the number of zero daily trading volumes over the
prior x months. Because the number of trading days can vary from 15 to 23, multiplication by the
factor (21x/ NoTD) standardizes the number of trading days in a month to 21 which makes the
liquidity measure comparable over time. LM1 can be interpreted as the turnover-adjusted number
of zero daily trading volumes over the prior 21 trading days, which is the approximate average
number of trading days in a month. The liquidity measure, LMx is calculated at the end of each
month for each individual stock based on daily data. Daily data is available for all markets across
entire sample period.
(iii). Data: Sources

Daily stock closing, bid and ask prices, total number of shares outstanding, traded volumes,
dividend per share in local currency and converted into UK£ were obtained for all markets from
Datastream. These data formed the basis of calculation of the daily return variance, or volatility,
market capitalization, defined as total number of shares outstanding multiplied by daily closing
price, and various liquidity constructs. The total returns series for each stock were sourced direct
from Datastream for all markets. Exchange rate and UK- Gilt/Treasury yield data are sourced from
Datastream. The one-month UK-Gilt/Treasury Bill yield rate represents the risk free rate although
this is adjusted to take account of monthly excess returns as opposed to the quoted equivalent
annualised rates. The conversion of the total returns series and prices into sterling and the use of
UK - Gilt/Treasury yield rate assume long term parity between local currencies and sterling. Only
stocks with a primary listing on the individual regional market were used. All estimation was
undertaken in an international currency, UK£ sterling, to achieve greater international
comparability with the literature.
(iv). Data: Summary statistics relating to liquidity measures
1
In line with Liu (2006) a deflator of 1,000 is used in constructing estimates for LM1
10
The evidence from Table 2 shows that there are considerable differences both between industrial
sectors and across countries. India and Pakistan both have the largest market capitalizations, traded
volumes and lowest percentage zero returns across industrial sectors in contrast to the much lower
values for Bangladesh and Sri Lanka. However the industry sector market capitalizations across the
Pakistan market are substantially lower and percentage daily zero returns (price rigidity) are higher
across industrial sectors than those in India. The higher average traded volumes of the Pakistan
market are likely to be a reflection that these relate the top thirty stocks as opposed to the much
broader one hundred stock constituents of the Indian BSE-100 index. These results would indicate
that the stock markets in both India and Pakistan are used much more as sources of external finance
by firms and attract higher numbers of investors than the much smaller markets of Bangladesh and
Sri Lanka. However despite the effects of the prolonged civil war and political instability, as
reflected in higher levels of price-rigidity (inactivity) of the Sri Lankan market compared to
Bangladesh, levels of market capitalization and traded share volumes are notably higher in
Colombo in contrast to Dhaka. This would provide some indication that despite the civil conflict
the stock market plays a greater role in external business financing in Sri Lanka than in the more
conservative culture of Bangladesh which has a higher incidence of poverty and less well
developed market institutions (Akhtaruddin, 2005).
Table 2
3. EMPIRICAL MODELS
This section considers two conditional modelling strategies, namely the three-factor linear CAPM
and its time varying parameter counterpart.
(i). Size and Liquidity Augmented CAPM

The standard Fama and French (1993) model augments the traditional CAPM with size (SMB) and
price to book value returns-based factors that proxy the hypothesized underlying state variables.
Following in the spirit of the Fama and French model I augment the one-factor CAPM with size
(SMB) and liquidity (ILLIQ) factors in order to create a size-liquidity three factor model in line
with Shum and Tang (2005) and Martinez et al (2005). Therefore, the expected excess returns on a
portfolio p of emerging market stocks can be written as
E rpt r ft p E rmt r ft si E SMB hi ILLIQ (4)
In line with the above this can be transformed in order to test historical data into the following
equation:
rit r ft i i (rmt r ft ) si SMBt hi ILLIQ t it (5)
where the variables are described above and it is an independently identically distributed (iid)
disturbance term. The model is estimated on a time series basis using standard Ordinary Least
11
Squares (OLS) techniques, as opposed to the Fama and Macbeth (1973) rolling cross section
approach, with the expectation that the Jensen alpha, or regression intercept, should not be
statistically different from zero given the theoretical relationship between an individual portfolios
expected returns and those of the market (Markowitz, 1959). However Scholes and Williams (1977)
provide evidence against the employment of standard OLS techniques with findings that beta
estimations are biased downwards for securities infrequently trading and upwards for those traded
more often. Dimson (1979) builds on this evidence in the inefficiency of beta estimation in thinly
traded stocks and proposes a correction technique based on the aggregation of betas from lagged
and leading regression coefficients. Dimson and Marsh (1983) propose a second correction
technique which uses a trade-to-trade method measuring and matching returns between individual
stocks or portfolios and the market index between the times of the last trades in successive months.
I justify the use of standard OLS techniques here in order to closely follow the literature of Pastor
and Stambaugh (2003), Liu (2006) and Martinez (2005) who use these techniques extensively in
their studies involving multifactor CAPM models capturing liquidity effects. However the
limitations of standard OLS techniques must be taken into account particularly when they are
applied to the very small and illiquid markets such as Bangladesh and especially Sri Lanka.
(ii). Time varying parameter CAPM model

Following Brooks et al (1998) the time varying parameter analogue of the linear CAPM employs
the Kalman filter and relies on the notion of “state space” in estimating the conditional constant
term and market beta of the multifactor analogue of CAPM. This is represented by an observation,
or measurement/signal, equation and a transition, or state, equation, that in combination express the
structure and dynamics of a time varying system. A state space model is specified where an
observation at time t is a linear combination of a set of variables, known as state variables, which
compose the state vector at time t. Assuming the number of state variables is m and the (m x 1)
vector is θt then the observation equation can be represented by:
2
yt zt t t , t ~ N (0, ) (6)
where z t is assumed to be known (m x 1) vector, and t is the observation error. The disturbance
t is assumed to be normally distributed with zero mean. The set of state variables is defined from
the minimum set of information from past and present data and future values of time series are
completely determined by the present values of the state variables, known as the Markov property.
The state space model incorporates unobserved variables within, and estimates them alongside the
observable model, in imposing a time varying structure of the CAPM beta. The conditional betas
are estimated using the following observation, or signal equation:
Kalman Kalman Kalman
Rit t it RMt si SMB hi ILLIQ t , t ~ N (0, ) (7)
12
where Rit and RMt are the excess returns of individual portfolio and market portfolios at time t and
t is disturbance term. The exact form of the related transition equation depends on the form of
stochastic process the betas are assumed to follow and in this case a simple random walk process is
imposed as outlined in Brooks et al (2000). The transition equation is defined:
Kalman Kalman
it it 1 t, t ~ N (0, Q) (8)
Kalman Kalman
it it 1 t, t ~ N (0, Q) (9)
sitKalman sitKalman
1 st , st ~ N (0, Q) (10)
hitKalman hitKalman
1 ht , ht ~ N (0, Q) (11)
Together equations 7 and the combination of 8 to 11 constitute a Kalman filter state space model.
However a set of prior conditional values are necessary for the Kalman filter to forecast the future
value and is expressed as:
Kalman Kalman
0 ~ N( 0 , P0 ) (12)
Kalman Kalman
0 ~ N( 0 , P0 ) (13)
s0Kalman ~ N (s0Kalman , P0 ) (14)
h0Kalman ~ N (h0Kalman , P0 ) (15)
Brooks et al (1998) cite that this technique uses the first two observations to establish the prior
conditions and then recursively estimates the entire series providing conditional estimates of
Kalman
it , sitKalman , hitKalman and Kalman
it .
4. RESULTS
(i). Summary statistics relating to size-liquidity sorted portfolios
Table 3 presents the descriptive statistics for the nine size-illiquidity sorted portfolios and the
returns-based valuation factors. The mean and median returns across all portfolios in panel A are
positive while there is a noticeable increase in standard deviation from small size to large size
portfolios which is likely to result more from the effects of price-rigidity, i.e. severe illiquidity, in
the small size portfolios rather than a genuine increase in volatility across the sample. Levels of
skewness and kurtosis are generally not overly revealing in terms of likely non-Normality of returns
distributions except in the case of the small size-medium illiquidity portfolio which has a skewness
of 2.320 and kurtosis value of 15.237. However the Jarque-Bera statistics are large across all
portfolios but are substantially large in medium-size low illiquidity (71.260) and small size-medium
illiquidity portfolio (806.397). Notably the Jarque-Bera statistics are generally larger in the small
as opposed to the large size portfolios indicating that returns are much more erratic for smaller
sized firms than for firms with higher market capitalizations.
13
The dispersion of stocks across portfolios caused by the size-liquidity sorting process in
forming the nine portfolios can be seen in panel B. There is a relatively even dispersion of stocks
across all nine portfolios although Indian stocks clearly overwhelmingly dominate the large and
medium sized portfolios. Pakistan stocks in contrast tend to be concentrated in the medium and
small sized portfolios while those of Bangladesh and Sri Lanka are concentrated in the small size
portfolios with Bangladesh stocks dominating the small size-low illiquidity portfolio and those of
Sri Lanka having a greater concentration in the small size high illiquidity portfolio. This reveals
that there are differences between the two smallest markets of Sri Lanka and Bangladesh with the
former being more illiquid than the latter despite both being relatively unattractive as venues for
raising large amounts of external finance by indigenous firms, which explains the concentration of
stocks from both markets in small size portfolios.
The evidence from panel C reveals that there is little correlation between the returns-based
factors mitigating concerns over potential multicollinearity arising from their inclusion together
within time series CAPM regressions at later stage. The positive values for mean returns of the
market and size (SMB) factors indicate a good fit with theory where returns increase in tandem
with increases in size. Equally the negative mean returns value for illiquidity factor (ILLIQ) is as
expected with returns decreasing as illiquidity increases (see Pastor and Stambaugh, 2003).
Table 3
Table 4 presents the descriptive statistics for the industry sector portfolios for each market. These
reveal that while mean returns for all industrial portfolios are positive their standard deviations are
generally large. However considerable differences exist between the industrial portfolios of the
larger Indian market than that of the other South Asian markets. Levels of skewness and kurtosis
are generally lower across all Indian industry portfolios indicating near Normality for industrial
sector returns in contrast to industrial portfolios in all other South Asian markets which commonly
exhibit substantial skewness. This result is further exemplified by the Jarque-Bera statistics which
are comparatively small in Indian industry portfolios rising to much larger values in Pakistan and
Bangladesh industries and then to extreme values in Sri Lanka. This provides further evidence of
the violation of Normality distributional assumptions for returns in Sri Lanka and is in line with the
extremes of illiquidity and price-rigidity evidenced earlier in Table 1.
Table 4
(ii). Performance of traditional CAPM against three-factor CAPM

The performance results from the application of the traditional CAPM and its size and liquidity
augmented counterpart are provided in Table 5. The addition of the size and liquidity factors infers
considerable improvement in explanatory power and the loss of statistical significance of the Jensen
alpha, αp, terms across every size-illiquidity sorted portfolio. The lack of significance in the Jensen
14
alpha upon the addition of the size and liquidity factors infers that these returns based factors are
good proxies for the underlying size and liquidity effects as being state variables affecting investor
welfare within the universe of cross section of stock returns. Its lack of significance implies a good
fit with theory (Markowitz, 1959) and that assumption of asset market integration holds for the
stocks included within the universe, itself taken from the constituents of the top tier blue chip
indices in each of the South Asian countries. The greatest increases in explanatory power though
arise from the inclusion of the additional factors for the three small size portfolios. Here the
increases are particularly evident with R2 of 24.52%, 35.02% and 42.51% for small low, medium
and high illiquidity portfolios increasing to 67.35%, 59.42% and 80.51% respectively. However it
should be noted that across sizes the statistical significance of the liquidity factor is considerably
lower on each of the three medium illiquidity portfolios as opposed to either low or high illiquidity
portfolios. The positive sign of the size betas for the three small portfolios is as expected with
returns increasing as firm size increases. However the negative sign of the size betas for medium
and large (big) size portfolios is indicative of a likely reverse size effect documented by Martinez et
al (2005) for the Spanish stock market. As such returns across the medium and large (big) size
portfolios actually decrease as firm size increases which is not expected and infers poor hedging
opportunities for investors (Martinez et al, 2005). A similar unexpected reverse liquidity effect can
be seen from the positive coefficients of the liquidity betas on each of the medium and high
illiquidity portfolios across all size categories. This in turn would infer that returns actually
increase as illiquidity increases indicating poor hedging opportunities for investors. This can also
be seen as a failing of the application of standard mean-variance methodology in medium and
highly illiquid stocks and that a different valuation methodology would be preferable.
Table 5
(iii) Modelling market portfolios

Country and industry portfolios were formed from the simple price-weighted averages of stock
returns across stocks aggregated into either industries or countries. The time invariant CAPM, size-
illiquidity augmented CAPM models were applied to the portfolios with results reported in Table 6.
Average Returns in India

The results from the application of the three factor size-liquidity augmented model as opposed to
the traditional CAPM on Indian industry portfolios reveal a good fit between the model and
underlying data. Explanatory power is generally high for the size-liquidity CAPM across all
portfolios ranging from 50.16% in technology to 85.75% for financial sector and 95.13% for the
aggregate overall BSE-100 portfolio. The results indicate an improvement in all cases in
explanatory power upon the addition of the size and liquidity factors to the traditional one-factor
CAPM. While increases in explanatory power typically range from 5 to 10% they are as high as
15
13% for the financial industry. Equally the Jensen alpha terms in all time series regressions are not
statistically significant, albeit with the exception of limited significance in financial and basic
materials sectors, inferring stocks from across the Indian industrial sectors are largely integrated
with the underlying market universe. Notably in the case of all Indian industry portfolios the
negative coefficient on size beta indicates a pervasive reverse size effect across all Indian stocks.
The high statistical significance of size betas provides further evidence that the reverse size effect is
an important feature of the Indian market. The evidence regarding the presence of liquidity effects
is more mixed as there are an equal number of portfolios with negative as well as positive liquidity
beta coefficients. However the majority of those portfolios with reverse liquidity effects, i.e. with
positive liquidity betas, (e.g. communications, technology, consumer cyclical and consumer non-
cyclical) have coefficients that are not statistically significant indicating that the reverse liquidity
effect is largely negligible.
Table 6
Average Returns in Pakistan

The results for Pakistan industries reveal that there is a considerable reduction in explanatory power
in both the traditional and augmented CAPM models. The traditional CAPM models have
especially low explanatory power between 10 and 15% across industrial sectors with the exception
of basic materials and consumer cyclical that are as low as 3.6% and 6.74% respectively.
Interestingly the Jensen alpha terms are all not statistically significant, thereby inferring Pakistan
industry stocks are well integrated with underlying universe, despite the lack of explanatory power.
The addition of the size and liquidity factors however brings about dramatic increases in
explanatory power from the negligible levels in the traditional model to adjusted R2’s commonly
above 30%. The Basic Materials and Consumer Cyclical industry portfolios are the only exceptions
with explanatory power of 24.54% and 26.84% respectively. However while the positive size betas
are in accordance to theory (Markowitz, 1959) the positive illiquidity betas in every industry
portfolio and their high statistical significance indicates the presence of a strong reverse liquidity
effect where expected returns increase alongside increases in illiquidity.
Average Returns in Bangladesh

The results for Bangladesh industry portfolios indicate that while there is an increase in explanatory
power arising from the addition of size and liquidity factors the levels of explanatory power overall
are very low being under 1% for traditional CAPM and between 10 and 20% for its size-liquidity
counterpart. However the strongest indication of a degree of segmentation between Bangladesh
stocks and those of the universe arises from the statistical significance of Jensen alpha terms.
While these are significant for all industry portfolio regressions using the CAPM the levels of
significance only marginally decrease from the addition of the size and liquidity factors. The size
16
and liquidity factors are significant in explaining returns for Consumer non-cyclical and the overall
Bangladesh portfolios, while the liquidity factor alone is significant in financial stocks. However
neither factor is significant in industrial stocks, which also have an extremely low adjusted R 2 of
0.83%. A similar poor performance is shown in the consumer cyclical industry portfolio where the
size factor is significant and has an explanatory power of 2.72%. However despite the poor fit of
the models the positive size beta and generally negative liquidity beta is as expected from theory
indicating a lack of any reverse size or liquidity effects. The large values of both the size and
liquidity betas would indicate that these effects largely drive the returns generating process for
Bangladesh industries.
Average Returns in Sri Lanka

The evidence for Sri Lankan industry portfolio would suggest that these stocks are better integrated
into the universe than those of Bangladesh as can be seen from the very low significance of Jensen
alpha terms. There is also a marked improvement in explanatory power as compared to Bangladesh.
The explanatory power for the traditional CAPM model across all portfolios is commonly under
10% and increases substantially upon the addition of size and liquidity factors. However the large
value of the size beta as well as its statistical significance would indicate that size effects play an
important role in the returns generating process for Sri Lankan industries. This is in contrast to the
very low statistical significance and value of the liquidity betas. However the positive sign of the
size beta across industry portfolios is as would be expected while the positive liquidity beta is not
and infers the presence of a reverse liquidity effect. Consequently there is a likely reverse liquidity
effect in Sri Lanka.
(iv) Modelling industry portfolios with time varying techniques

The time varying coefficient model based on the augmented CAPM was only estimated including
market, size and illiquidity factors. Maximum likelihood convergence was achieved in every case
across all industries and markets although there are some differences between which factors were
included in enabling convergence to be achieved. Generally the results from Table 7 are in line
with those from the time-invariant time series regressions earlier in Table 6. The overall mean
values from the mean of the time-varying coefficients for size and liquidity are negative across
Indian industry portfolios, which is in line with earlier regression results. The large values of the
overall means of liquidity beta, as opposed to the smaller size beta, provide evidence that liquidity
drives returns more than size in Pakistan. A similar result is found in Sri Lanka while the overall
mean of size coefficient is greater than that of liquidity in Bangladesh. These results would provide
some support that illiquidity factor does have an important role in valuation using this time varying
methodology.
Table 7
17
Figures 1 to 4 provide time series plots of the evolution of the liquidity betas for the overall market
portfolios for each of the four South Asian countries, namely the BSE-100 in India, KSE-30 in
Pakistan, DSE-20 in Bangladesh and the Dow Jones Titans in Sri Lanka. The evidence from these
figures reveals that there are considerable differences in the size and significance of liquidity effects
both over time and between markets. The liquidity beta profile for India is largely centred on zero
with some variation either side and with a consistently negative lower standard error band
indicating a lack of statistical significance of the liquidity beta in the aggregate Indian market. In
contrast Pakistan has experienced a marked decrease in size as well as significance of liquidity beta
since the very high levels above 1.5 in 2002 to a value largely centred on zero by 2008/2009.
Bangladesh has a liquidity beta that exhibits sharp differences and changes in its time profile,
although the standard error band is persistently negative indicating a lack of statistical significance.
The liquidity beta of Sri Lanka is markedly different from other sample group countries. This
shows a considerable increase in the liquidity beta from a value generally centred on zero between
2002 and 2003 to a value generally centred on 1 from 2004 until mid-2009 when the value sharply
decreases. Given the evidence in literature concerning the Sri Lankan market performance being
strongly affected by the civil war this substantial decrease in mid-2009 may be indicative of the
impact on liquidity arising from the conclusion of hostilities.
Figures 1 - 4
Figures 5 to 8 provide similar time series plots for the evolution of liquidity betas for the financial
sector portfolios in each of the four countries. These are markedly different from those of the
overall markets. The liquidity beta for Indian financial stocks is negative for the entire sample
period and actually decreases in absolute value from just under a value of -0.2 in 2002 to a value
nearer -1 in 2008/2009. However the lower standard error band remains negative which according
to theory infers a lack of statistical significance for this effect. The liquidity profile for Pakistan’s
financial stocks is similar to that for the aggregate market portfolio and reveals a gradual decrease
in value from over 1.5 in 2002 to a value centred on zero between 2006 and 2009. However the
liquidity beta for Bangladesh financial stocks is very different to that of the overall market. This
shows a gradual increase in liquidity beta from a value centred on zero between 2002 and 2005 to a
final value over 0.2 in 2009. The profile of the liquidity beta of Sri Lankan financial stocks is
typically high and subject to short lived periods of extreme fluctuation such as in 2004 and then
more recently at the very end of the sample period in mid-2009. Interesting all profiles, with sole
exception of Sri Lanka, exhibit a considerable change since the start of the global financial crisis in
early 2008. The evidence would suggest that Indian and Bangladesh financial stocks have been
affected more than those of Pakistan with negligible effect on Sri Lanka.
Figures 5 - 8
18
(v) Costs of equity estimation
The evidence from Table 8 reveals that the cost of equity estimates using both time invariant
CAPM and its time varying Kalman filter counterpart are generally high across the South Asian
region. However these are lowest across all industrial sectors in the larger and more developed
Indian market where values calculated from regression range from 23.74% in energy to 55.13% in
technology. Costs of equity calculated from the time varying method are subject to greater
variation and in India range from 16.85% in communications to 55.03% in diversified. There is
some contrast between the two methods with regression based estimates for communications and
diversified being 31.94% and 52.42% respectively. Costs of equity are notably higher in Pakistan
with regression based estimates varying from 42.12% for energy to 74.36% for consumer cyclical
and similarly using time varying techniques from 21.84% for basic materials to 52.50% for
consumer cyclical. The cost of equity estimates for the two smaller markets of Bangladesh and Sri
Lanka are noticeably more volatile further questioning the application of mean-variance valuation
techniques in these two markets. Costs of equity in Bangladesh vary from 32.72% in consumer
non-cyclical to 11.73% in consumer cyclical and similarly using time varying techniques from
13.86% for industrial to 44.31% in consumer non-cyclical. Estimates in Sri Lanka are subject to
even greater variation between 15.55% for energy and 93.45% for industrial using regression-based
techniques to ranging between 12.65% for energy to a more reasonable 28.75% for industrial and
32.95% for consumer non-cyclical.
Table 8
5. CONCLUSIONS
This study proposes a size and liquidity augmented capital asset pricing model to explain the cross
section of expected returns in South Asian emerging stock markets, an area which has previously
been largely excluded from empirical research in finance. The constituent stocks from the blue
chip investor-orientated indices were used from the large well developed Indian stock market
alongside Pakistan and the smaller less well developed Bangladesh and Sri Lankan markets.
The performance of the size and liquidity augmented three-factor CAPM is contrasted
against its time varying coefficient counterpart with similar results. While size effects alone drive
the returns generating process in Sri Lanka, a combination of size and liquidity effects are relevant
in Bangladesh and Pakistan. Size effects are prevalent across Indian industries too but the
additional liquidity factor is relevant in only a few industries. The three-factor CAPM provides the
best fit across Indian and then to a much lesser extent Pakistan industries while explanatory power
is considerably lower for the less developed markets of Bangladesh and Sri Lanka. These
differences are further reflected in cost of equity estimates which are highest in Bangladesh and Sri
19
Lanka before marginally decreasing to levels across Pakistan industries to the lowest levels in
Indian industry sectors.
The evidence from the time varying profiles of liquidity betas reveals that while the
financial sectors of India, Pakistan and Bangladesh have all been noticeably affected by the onset of
the 2008 global financial crisis and recession, Sri Lanka has been largely unaffected owing
primarily to the market being heavily influenced by the prolonged insurgency and civil war.
However while aggregate exposure to liquidity has remained the same across the Indian market it
has decreased substantially across the sample period for Pakistan, while increasing steadily for the
aggregate Sri Lankan market with a sharp drop recently following the conclusion of hostilities. The
exposure of Bangladesh overall to aggregate market illiquidity exhibits substantial variation over
the sample period. These results indicate that there is considerable segmentation between South
Asia’s stock markets with the smaller less well developed markets of Sri Lanka and Bangladesh
being subject to very different influences from those prevalent in the largest and most
internationally focussed markets of Pakistan and India.
20
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23
Table 1 Market Capitalisation and Turnover profiles, 2008
India Pakistan Bangladesh Sri Lanka Maldives Bhutan
(Bombay 100) (Karachi 30) (Dhaka 20) (DJ Titans)*
Listed Firms 100 (4,937 Total) 30 (651 Total) 20 (671 Total) 20 (234 Total) 4 17
Proportion market capitalisation to total (%)
Top 1 0.12 1.19 46.17 21.40 36.31 36.25
Top 5 1.54 5.05 78.13 67.32 100.00 86.95
Top 10 3.50 10.94 95.77 86.16 96.96
Top 20 13.56 36.65 100.00 100.00 100.00
Proportion Turnover value to total (%)
Top 1 0.55 2.60 39.32 63.02 51.67 -- --
Top 5 1.39 18.47 72.69 84.98 100.00 -- --
Top 10 3.41 35.77 94.19 92.19 -- --
Top 20 9.96 58.10 100.00 100.00 -- --
Proportion Sector Market Capitalisation to total (%)
Financials 17.60 29.68 36.15 20.59 36.31 25.16
Comm. 3.86 7.92 -- -- 41.83 -- -- 0.97
Basic Materials 8.59 10.19 -- -- -- -- -- -- 1.73
Cons cyclical 6.31 1.95 8.95 -- -- 34.68 0.69
Cons non-cyclical 10.49 -- -- 47.23 19.37 2.42 2.52
Diversified 0.44 -- -- -- -- 10.80 26.59 0.74
Energy 20.92 43.18 -- -- 5.58 -- -- -- --
Industrial 11.11 1.93 7.67 1.83 -- -- 68.19
Technology 9.53 -- -- -- -- -- -- -- -- -- --
Utilities 11.15 3.95 -- -- -- -- -- -- -- --
Proportion Sector Traded Value to total (%)
Financials 29.39 36.69 29.70 7.95 51.67 -- --
Comm. 4.13 1.19 -- -- 64.35 -- -- -- --
Basic Materials 8.46 21.78 -- -- -- -- -- -- -- --
Cons cyclical 1.65 5.08 14.81 -- -- 37.41 -- --
Cons non-cyclical 3.93 -- -- 41.27 16.24 10.92 -- --
Diversified 0.94 -- -- -- -- 5.70 0.00 -- --
Energy 16.49 22.67 -- -- 2.97 -- -- -- --
Industrial 14.31 9.44 14.22 2.79 -- -- -- --
Technology 5.83 -- -- -- -- -- -- -- -- -- --
Utilities 14.86 0.55 -- -- -- -- -- -- -- --
Source: Compiled by authors from Bloomberg and Datastream and websites of Royal Bhutan Securities Exchange and Maldives Stock Exchange
Notes: (1) DJ Titans indicates the blue chip Dow Jones Titans index; (2) Data unavailable for Nepal
24
Table 2 Summary Statistics
Local market £UK equivalent
Country Sector No. Zero Return Price Volume (‘000) Market Cap. (m) Price Market Cap. (m) Bid-Ask
Firm (%) spread (%)
India 15,687.81 125,600.73
Financials 20 7.97 [4.55] 290.83 [144.49] 3.67 [1.74] 1,576.65 [535.48] -- --
(Bombay [7,359.60] [44,560.74]
100) 29,104.77 146,425.49 1,873.71
Comm. 5 5.31 [4.55] 230.97 [158.32] 3.04 [2.05] -- --
[13,988.13] [85,682.87] [1194.85]
28,518.60 91,298.32
Basic Mat. 12 11.80 [4.76] 195.72 [120.36] 2.46 [1.48] 1,147.79 [232.12] -- --
[5,010.90] [19,182.28]
1,2891.78 87,524.92
Cons cyc. 9 14.56 [4.55] 736.28 [219.7] 9.28 [2.88] 1,094.7 [289.95] -- --
[8,221.55] [23,953.26]
14,551.55 111,284.02
Cons non-cyc. 12 5.67 [4.55] 431.32 [341.13] 5.52 [4.23] 1,418.37 [386.14] -- --
[3,191.00] [31,197.94]
3,864.58 31,326.32
Diversified 3 6.41 [4.76] 509.46 [163.81] 6.30 [1.94] 387.82 [163.25] -- --
[1,059.45] [13,264.13]
27,149.79 410,845.66
Energy 7 8.21 [4.55] 339.56 [327.39] 4.31 [3.91] 5,169.37 [3298.4] -- --
[6,998.65] [277,705.99]
18,160.34 63,703.09
Industrial 18 6.86 [4.55] 266.37 [96.16] 3.34 [1.17] 799.01 [74.59] -- --
[7,010.88] [6,010.50]
22,513.5 194,393.14 2,428.25
Technology 7 6.22 [4.55] 544.36 [326.39] 6.97 [4.44] -- --
[11,750.08] [131,700.39] [1589.83]
28,149.07 191,478.84 2,401.13
Utilities 7 6.01 [4.55] 255.80 [175.84] 3.26 [2.13] -- --
[7,288.55] [104,105.63] [1216.68]
20,178.39 132,417.58
Overall 100 8.36 [4.55] 355.86 [157.28] 4.50 [1.94] 1,665.87 [412.39] -- --
[6,552.68] [34,089.23]
Pakistan Financials 119,226.17 16,700.49
11 23.92 [13.04] 42.63 [12.57] 0.37 [0.11] 140.03 [16.71] 0.1499 [0.0329]
(KSE 30) [27,180.40] [1,791.24]
Basic Mat. 132,868.85 19,414.28
5 13.72 [8.70] 80.34 [69.27] 0.72 [0.68] 173.67 [125.98] 0.2010 [0.0134]
[79,648.65] [13,392.40]
Cons cyc. 74,367.24
3 29.78 [19.78] 61.40 [25.55] 4,833.56 [2,550.26] 0.53 [0.23] 41.93 [24.27] 0.1184 [0.0147]
[38,710.23]
Energy 113,385.38 65,822.61
6 18.53 [9.09] 151.19 [130.87] 1.41 [1.24] 576.2 [110.24] 0.0978 [0.0114]
[9,031.38] [12,319.14]
Industrial 211,541.27 10,839.40
2 13.77 [9.09] 44.21 [37.60] 0.39 [0.34] 94.69 [73.71] 0.1948 [0.0307]
[117,155.10] [7,833.83]
Utilities 415,548.27 33,577.49
2 15.35 [11.36] 31.43 [32.53] 0.30 [0.29] 323.85 [317.44] 0.1230 [0.0152]
[182,324.50] [33,666.38]
Overall 158,209.25 30,851.83
30 19.68 [9.09] 71.24 [35.40] 0.64 [0.32] 274.19 [66.25] 0.1308 [0.0239]
[52,986.45] [6,975.06]
25
Local market £UK equivalent
Country Sector No. Zero Return Price Volume (‘000) Market Cap. (m) Price Market Cap. (m) Bid-Ask
Firm (%) spread (%)
Bangladesh Financials 5 14.74 [9.76] 237.00 [199.00] 566.56 [361.70] 1,803.2 [671.95] 2.06 [1.68] 15.04 [6.27] -- --
(DSE 20) Cons cyc. 4 23.75 [19.57] 75.28 [66.90] 929.16 [56.28] 808.63 [532.68] 0.72 [0.73] 7.33 [4.32] -- --
Cons non-cyc. 2 14.82 [13.04] 720.16 [600.98] 204.13 [119.6] 4,472.18 [2478.44] 6.41 [4.91] 38.37 [20.22] -- --
Industrial 3 14.78 [13.34] 319.47 [260.88] 267.51 [44.98] 1,287.89 [1078.83] 3.02 [2.70] 12.13 [11.17] -- --
Overall 14 17.33 [13.04] 275.71 [174.85] 584.95 [112.30] 1,815.89 [748.16] 2.48 [1.45] 15.69 [6.51] -- --
Sri Lanka Financials 7 36.83 [33.33] 69.86 [53.49] 1828.34 [721.95] 5277.84 [3346.34] 0.38 [0.31] 28.02 [18.69] 0.0250 [0.0187]
(DJ 20) 7589.21 21516.04
Cons non-cyc. 2 32.87 [30.43] 55.22 [49.94] 0.30 [0.28] 111.48 [80.16] 0.0111 [0.0113]
[5907.13] [14584.05]
Diversified 4 43.95 [45.45] 187.58 [151.34] 472.64 [129.35] 8030.80 [7645.90] 0.95 [0.75] 42.13 [45.15] 0.0382 [0.0293]
2396.41
Energy 2 36.377 [32.15] 52.84 [54.65] 6024.56 [5067.23] 0.31 [0.28] 32.46 [29.25] 0.0122 [0.0120]
[1340.07]
Industrial 3 54.96 [48.91] 441.49 [33.42] 773.89 [309.97] 976.75 [393.06] 2.56 [0.18] 5.49 [2.27] 0.0266 [0.0191]
Overall 20 43.96 [35.71] 133.03 [59.43] 3868.91 [647.5] 10099.27 [3506.65] 0.76 [0.32] 52.63 [19.38] 0.0250 [0.0187]
Source: Compiled by authors from Bloomberg, Datastream and National stock exchanges
26
Table 3 Summary statistics for equally weighted monthly excess returns on 9 size-illiquidity and size-price-to-book value portfolios for period 2001 to 2009
Portfolio S/L S/M S/H M/L M/M M/H B/L B/M B/H
Panel A: Portfolios sorted on Size-illiquidity
Summary statistics for portfolios
Mean 0.03520 0.03486 0.03605 0.02905 0.02807 0.01993 0.01717 0.01827 0.01968
Median 0.04232 0.03158 0.02509 0.03215 0.03202 0.01858 0.01499 0.02451 0.02060
Std. Dev. 0.07943 0.08719 0.08192 0.11241 0.10463 0.07721 0.11414 0.09472 0.09254
Skewness -0.536 2.320 0.746 0.316 -0.038 0.470 0.401 -0.398 -0.099
Excess Kurtosis 4.413 15.237 3.918 6.839 3.635 4.693 5.014 2.893 3.411
Jarque-Bera statistic 14.802 806.397 14.441 71.260 1.928 17.652 22.118 3.039 0.980
Panel B: Average Number of stocks per size-illiquidity sorted portfolio

India 4.973451 2.23009 3.39823 13.39823 9.69027 5.60177 18.17699 12.13274 10.53982
Pakistan 5.99115 2.64602 3.63717 2.76106 1.69912 6.21239 0.10619 0.21239 2.69912
Bangladesh 5.840708 4.18584 1.95575 0.42478 0.00000 0.00000 0.00000 0.00000 0.00000
Sri Lanka 3.327434 4.85841 5.92920 1.69912 0.95575 1.53097 0.00000 0.00000 0.10619
Overall Mean 20.13274 13.92035 14.92035 18.28319 12.34513 13.34513 18.28319 12.34513 13.34513
Panel C: Summary statistics for factors

Mean Std. Dev. Skewness Excess Kurtosis MARKET SMB ILLIQ
MARKET 0.02737 0.07384 -0.108 3.549 MARKET 1.0000
SMB 0.01333 0.07999 -0.544 5.602 SMB -0.5049 1.0000
ILLIQ -0.00559 0.05336 -0.058 6.021 ILLIQ -0.3127 0.4667 1.0000
27
Table 4. Summary statistics for individual market and sector portfolios and factors
Financials Comm. Basic Cons Cons non- Diversified Energy Industrial Technology Utilities
Materials cyclical cyclical
India Mean 0.03743 0.00447 0.04051 0.03560 0.01356 0.04243 0.02860 0.02986 0.02695 0.02883
Std. Dev. 0.13041 0.12684 0.13891 0.11887 0.08138 0.17009 0.11672 0.12491 0.15524 0.12337
Kurtosis 0.268 0.236 0.371 0.344 -0.375 1.047 0.464 -0.208 0.147 0.001
Skewness 4.323 2.844 4.112 4.033 2.856 8.980 4.857 3.625 3.667 4.302
Jarque-Bera 9.590 1.159 8.411 7.257 2.747 189.033 20.300 2.653 2.501 7.977
Pakistan Mean 0.03321 -- -- 0.02640 0.03426 -- -- -- -- 0.01859 0.03018 -- -- 0.01343
Std. Dev. 0.12337 -- -- 0.12889 0.18445 -- -- -- -- 0.10990 0.19595 -- -- 0.13983
Kurtosis 0.042 -- -- 1.384 0.356 -- -- -- -- 0.319 1.768 -- -- 2.085
Skewness 4.916 -- -- 9.896 3.844 -- -- -- -- 4.297 11.946 -- -- 11.545
Jarque-Bera 17.313 -- -- 259.977 5.742 -- -- -- -- 9.847 435.708 -- -- 425.699
Bangladesh Mean 0.02417 -- -- -- -- 0.01468 0.03085 -- -- -- -- 0.01489 -- -- -- --
Std. Dev. 0.08829 -- -- -- -- 0.08589 0.14171 -- -- -- -- 0.08300 -- -- -- --
Kurtosis 1.248 -- -- -- -- 1.576 2.489 -- -- -- -- 0.964 -- -- -- --
Skewness 6.021 -- -- -- -- 9.298 16.154 -- -- -- -- 4.258 -- -- -- --
Jarque-Bera 72.300 -- -- -- -- 233.532 931.418 -- -- -- -- 24.946 -- -- -- --
Sri Lanka Mean 0.01318 -- -- -- -- -- -- 0.02669 0.02345 0.01159 0.03472 -- -- -- --
Std. Dev. 0.09345 -- -- -- -- -- -- 0.14680 0.13095 0.09195 0.23314 -- -- -- --
Kurtosis 1.417 -- -- -- -- -- -- 2.863 2.929 1.484 7.595 -- -- -- --
Skewness 7.422 -- -- -- -- -- -- 16.685 17.081 8.209 72.101 -- -- -- --
Jarque-Bera 129.887 -- -- -- -- -- -- 1,036.138 1,095.102 169.226 23,568.460 -- -- -- --
28
Table 5 Time series regressions using equally weighted monthly contemporaneous market excess returns for 9 portfolios formed on size and illiquidity for
period: 2002 – 2008, for all sample markets.
Portfolio S/L S/M S/H M/L M/M M/H B/L B/M B/H
Panel A: CAPM-adjusted performance
ˆ (%) 0.0204 (3.20) 0.0155 (2.18) 0.0161 (2.63) -0.0082 (-1.62) -0.0067 (-1.74) -0.0008 (-0.20) -0.0205 (-4.54) -0.0128 (-3.20) -0.0106 (-2.32)
ˆ 0.5399 (4.54) 0.7046 (4.18) 0.7277 (5.41) 1.3646 (10.64) 1.2710 (22.15) 0.7605 (7.86) 1.3763 (11.80) 1.1377 (18.13) 1.1069 (22.99)
2
Adj R (1) 0.2452 0.3502 0.4251 0.8018 0.8028 0.5249 0.7910 0.7847 0.7781
Panel B: Three-factor Size and Illiquidity CAPM performance
ˆ -0.0008 (-0.14) 2.20E-05 (0.02) 0.0057 (1.50) 0.0009 (0.28) -0.0016 (-0.34) -0.0025 (-0.41) -0.0060 (-1.64) -0.0020 (-0.74) 0.0019 (0.44)
ˆ 0.7937 (6.41) 1.0556 (6.36) 1.0805 (22.45) 1.1127 (19.07) 1.1555 (16.05) 0.9136 (8.07) 1.0479 (18.68) 0.9362 (17.24) 0.9530 (20.48)
ŝ 0.7682 (4.83) 0.5449 (3.12) 0.3504 (7.10) -0.3210 (-5.21) -0.1760 (-1.70) 0.0471 (0.38) -0.5055 (-11.39) -0.3840 (-6.50) -0.4513 (-9.17)
-0.7363 (-8.59) 0.2345 (2.12) 0.7130 (7.55) -0.3375 (-3.56) -0.0851 (-1.09) 0.5630 (5.17) -0.2296 (-3.33) 0.0377 (0.32) 0.4116 (6.86)
ĥ
Adj R2 (4) 0.6735 0.5942 0.8051 0.8852 0.8185 0.6705 0.9181 0.8572 0.8840
Notes: (1) Numbers in parentheses are t-statistics.
(2) One month T-bill risk free rate for month t, which is taken as the one month UK Gilt rate in this case
29
Table 6 Time series regressions for equally weighted monthly excess returns on country portfolios with size and illiquidity for 2002 to 2009
Financials Comm. Basic Cons Cons non- Diversified Energy Industrial Technology Utilities Overall
India
ˆ (%) -0.0036 (- -0.0312 (- -0.0019 (- 6.59E-05 -0.0110 (- -0.0026 (- -0.0009 (- -0.0116 (- -0.0134 (- -0.0092 (- -0.0071 (-
0.63) 4.12) 0.25) (0.01) 2.40) 0.23) 0.13) 2.49) 1.23) 1.30) 2.49)
ˆ 1.5025 1.3056 1.5505 1.2985 0.9008 1.6475 1.0793 1.5164 1.4756 1.3902 1.3577
(9.89) (13.55) (12.54) (10.65) (12.88) (6.81) (10.10) (16.97) (8.44) (12.04) (20.35)
Adj R2 (1) 0.7213 0.5740 0.6764 0.6475 0.6650 0.5072 0.4614 0.8019 0.4881 0.6896 0.8853
Panel B: Three-factor CAPM performance
ˆ 0.0124 -0.0168 (- 0.0038 0.0089 -0.0049 (- 0.0053 0.0129 -0.0011 (- -0.0110 (- 0.0007 0.0025
(2.28) 2.17) (0.64) (1.23) 1.00) (0.51) (1.88) 0.28) 1.01) (0.10) (1.14)
ˆ 1.1156 1.0444 1.3655 1.1304 0.7846 1.3196 0.7977 1.2752 1.5342 1.1528 1.1367
(12.76 (8.51) (10.15) (8.96) (12.52) (8.20) (8.91) (21.19) (6.54) (11.30) (29.07)
ŝ -0.5649 (- -0.5097 (- -0.1972 (- -0.3135 (- -0.2179 (- -0.2659 (- -0.4896 (- -0.3691 (- -0.0953 (- -0.3479 (- -0.3391 (-
6.89) 4.03) 1.55) 3.57) 3.75) 1.64) 5.07) 5.70) 0.53) 3.49) 9.41)
ĥ -0.3446 (- 0.0777 -0.3410 (- 0.0148 0.0136 -0.8076 (- -0.0609 (- -0.1740 (- 0.4899 -0.2084 (- -0.1570 (-
3.15) (0.45) 1.72) (0.13) (0.12) 3.48) 0.60) 2.04) (2.70) 1.56) 2.82)
Adj R2 (4) 0.8575 0.6396 0.7057 0.6743 0.6929 0.5897 0.5443 0.8573 0.5016 0.7433 0.9513
Pakistan
ˆ (%) 0.0153 -- -- 0.0163 0.0154 -- -- -- -- 0.0036 0.0055 -- -- -0.0036 (- 0.0107
(1.53) (1.32) (1.02) (0.43) (0.37) 0.35) (1.26)
ˆ 0.6517 -- -- 0.3686 0.6875 -- -- -- -- 0.5450 0.9013 -- -- 0.6253 0.5997
(3.80) (2.17) (3.72) (3.83) (2.79) (2.30) (3.71)
Adj R2 (1) 0.1445 -- -- 0.0360 0.0674 -- -- -- -- 0.1263 0.1074 -- -- 0.1010 0.1513
ˆ -0.0030 (- -- -- 0.0079 -0.0192 (- -- -- -- -- -0.0107 (- -0.0148 (- -- -- -0.0060 (- -0.0052 (-
0.22) (0.45) 1.24) 1.08) 0.77) 0.49) 0.46)
ˆ 1.1217 -- -- 0.7460 1.3622 -- -- -- -- 0.9213 1.6166 -- -- 0.9583 1.0621
(7.22) (3.59) (6.48) (5.10) (4.98) (3.33) (6.72)
ŝ 0.6387 -- -- 0.2757 1.2258 -- -- -- -- 0.4990 0.6896 -- -- 0.0551 0.5487
(2.91) (0.87) (4.48) (2.25) (2.69) (0.25) (2.47)
ĥ 0.5341 -- -- 1.0024 0.0187 -- -- -- -- 0.4571 1.4959 -- -- 1.3402 0.7178
(2.45) (3.51) (0.06) (2.96) (2.23) (3.51) (3.57)
Adj R2 (4) 0.3703 -- -- 0.2454 0.2684 -- -- -- -- 0.3081 0.3783 -- -- 0.3380 0.4520
30
Financials Comm. Basic Cons Cons non- Diversified Energy Industrial Technology Utilities Overall
Bangladesh
ˆ (%) 0.0163 -- -- -- -- 0.0148 0.0292 -- -- -- -- 0.0123 -- -- -- -- 0.0177
(1.93) (1.80) (2.32) (1.42) (2.61)
ˆ 0.2845 -- -- -- -- -0.0070 (- 0.0599 -- -- -- -- 0.0935 -- -- -- -- 0.1301
(3.01) 0.05) (0.59) (0.99) (1.64)
Adj R2 (1) 0.0481 -- -- -- -- 0.0003 0.0009 -- -- -- -- 0.0069 -- -- -- -- 0.0092
ˆ 0.0102 -- -- -- -- 0.0069 0.0065 -- -- -- -- 0.0121 -- -- -- -- 0.0094
(1.23) (0.77) (0.52) (1.10) (1.19)
ˆ 0.2985 -- -- -- -- 0.1514 0.2684 -- -- -- -- 0.0832 -- -- -- -- 0.2119
(2.54) (1.67) (1.69) (0.76) (2.36)
ŝ 0.2266 -- -- -- -- 0.2805 0.8252 -- -- -- -- 0.0081 -- -- -- -- 0.3006
(1.45) (2.00) (2.19) (0.04) (2.12)
-0.4865 (- -- -- -- -- 0.0222 -1.0749 (- -- -- -- -- -0.0654 (- -- -- -- -- -0.3655 (-
ĥ
2.67) (0.11) 3.09) 0.38) 2.23)
Adj R2 (4) 0.1047 -- -- -- -- 0.0272 0.1718 -- -- -- -- 0.0083 -- -- -- -- 0.0883
Sri Lanka
ˆ (%) 0.0019 -- -- -- -- -- -- 0.0084 0.0140 0.0059 0.0088 -- -- -- -- 0.0066
(0.33) (0.97) (0.97) (0.82) (0.84) (1.20)
ˆ 0.4111 -- -- -- -- -- -- 0.6672 0.3437 0.2075 0.9449 -- -- -- -- 0.4792
(2.75) (2.63) (3.39) (1.51) (1.47) (2.56)
Adj R2 (1) 0.0974 -- -- -- -- -- -- 0.1046 0.0289 0.0190 0.0813 -- -- -- -- 0.1196
ˆ -0.0099 (- -- -- -- -- -- -- -0.0062 (- 0.0007 0.0015 -0.0326 (- -- -- -- -- -0.0101 (-
1.56) 0.70) (0.06) (0.21) 1.06) 1.30)
ˆ 0.6285 -- -- -- -- -- -- 0.9693 0.6219 0.3760 1.7574 -- -- -- -- 0.8120
(3.37) (2.84) (3.94) (2.79) (1.74) (3.37)
ŝ 0.4205 -- -- -- -- -- -- 0.5162 0.4672 0.1443 1.4667 -- -- -- -- 0.5892
(2.58) (2.13) (2.99) (0.92) (1.51) (2.44)
-0.0557 (- -- -- -- -- -- -- 0.0873 0.0999 0.3961 0.0452 -- -- -- -- 0.0461
ĥ
0.21) (0.20) (0.28) (1.42) (0.10) (0.18)
Adj R2 (4) 0.1737 -- -- -- -- -- -- 0.1554 0.0823 0.0804 0.2617 -- -- -- -- 0.2846
Notes: (1) The risk free rate is the three month UK treasury/ Gilt rate adjusted for monthly values.
(2) Numbers in parentheses are Newey-West HAC covariance adjusted t-statistics.
31
Table 7 Time varying CAPM model parameters
Country Overall Overall High/ low 2002 2003 2004 2005 2006 2007 2008 Convergence
Mean (Iterations)
India Constant 0.001858 0.0676/ -0.0417 0.002421 -0.0041 0.003593 -0.00685 0.007122 0.009849 0.002454 16
(Bombay 100) Market Beta 1.220096 1.5078/ 1.011 1.377759 1.379 1.329501 1.217754 1.108143 1.037394 1.140509
Size Beta -0.33823 -0.2231/ -0.772 -0.4683 -0.39065 -0.28224 -0.27332 -0.28832 -0.28306 -0.33265
Illiquidity Beta -0.15377 0.2114/ -0.8503 -0.11483 -0.40304 0.049374 -0.1781 -0.28727 -0.144 -0.0313
India Constant 0.008995 0.0852/ -0.1361 -0.00335 0.01193 0.037978 0.01959 0.010578 -0.00888 0.000762 36
Finance Market Beta 1.200141 1.3206/ 1.1146 1.29654 1.211272 1.17368 1.194726 1.176245 1.221168 1.155111
Size Beta -0.43186 0.7322/ -1.6388 -0.33191 -0.65414 -0.7725 -1.12843 0.12381 0.060705 -0.2309
Illiquidity Beta -0.44561 0.0505/ -0.9964 -0.15999 -0.169 -0.49642 -0.3206 -0.42183 -0.54726 -0.8578
India Constant -0.00561 0.1021/ -0.0909 -0.00297 -0.00574 0.000179 -0.00701 0.00633 0.004022 -0.03775 47
Industrials Market Beta 1.40786 1.6164/ 1.1252 1.452279 1.524269 1.555312 1.525048 1.438581 1.264421 1.198838
Size Beta -0.2632 0.3172/ -1.2254 -0.6609 -0.35937 -0.24054 0.004403 -0.06537 -0.22781 -0.15628
Illiquidity Beta -0.18818 0.5363/ -0.9502 0.042392 -0.49496 -0.40378 -0.45318 -0.4859 0.078021 0.330192
India Constant -0.01219 0.0909/ -0.0923 -0.03864 -0.0126 -0.01675 -0.0081 -0.00271 -0.02958 0.03032 13
Consumer Non- Market Beta 1.014098 1.1287/ 0.8985 0.910782 0.930421 0.983162 1.000936 1.070678 1.066688 1.091385
Cyclical Size Beta -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- --
Illiquidity Beta -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- --
India Consumer Constant 0.013612 0.1344/ -0.1422 0.024018 -0.01719 0.022323 0.012877 0.047843 0.014034 -0.00185 20
Cyclical Market Beta 1.103651 2.2094/ -0.01 1.817567 1.731422 0.921078 0.679556 0.521601 0.671257 1.340115
Size Beta -0.29588 1.1158/ -1.0169 -0.32581 -0.38438 -0.62854 -0.54663 0.323298 -0.21905 -0.16911
Illiquidity Beta -0.01147 1.4343/ -1.5045 0.532869 -0.39308 0.215519 -0.17121 -0.03192 -0.36911 -0.16788
India Constant 0.009457 0.4812/ -0.1775 0.003597 -0.00022 0.020791 -0.00605 -0.01171 0.033049 0.027051 23
Energy Market Beta 0.934012 1.4244/ 0.6021 0.770646 0.768799 0.735623 0.798966 0.997507 1.038716 1.233058
Size Beta -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- --
India Constant -0.00573 0.2045/ -0.2395 -0.01735 -0.06765 0.025083 0.013692 0.00834 -0.01236 0.01547 64
Technology Market Beta 1.387208 2.5707/ 0.6708 2.33073 1.905068 1.273232 1.163933 1.274461 0.978976 0.978292
Size Beta -0.34652 -0.1245/ -1.3289 -0.57808 -0.39606 -0.31684 -0.30016 -0.31285 -0.3069 -0.29942
India Constant -0.00745 0.1058/ -0.0756 -0.02918 0.006023 0.015566 -0.0282 -0.03425 0.008084 -0.00456 26
Utilities Market Beta 1.213032 2.2287/ 0.4482 0.941293 1.327921 1.28546 1.047767 1.311967 1.586159 1.236123
Size Beta -0.30445 0.4267/ -1.1547 -0.05615 -0.44288 -0.89733 -0.14396 -0.07726 -0.00572 -0.43692
Illiquidity Beta -0.16797 -0.0786/ -0.5949 -0.28465 -0.2841 -0.20043 -0.1062 -0.113 -0.1012 -0.10497
32
Mean (Iterations)
India Constant 0.001762 0.2366/ -0.2345 0.031848 0.025423 -0.03703 -0.03379 0.041308 0.03782 -0.03883 31
Diversified Market Beta 1.328739 1.7561/ 0.6842 0.960609 1.238971 1.538233 1.470606 1.543277 1.303964 1.280652
Size Beta 0.071397 1.6318/ -1.6507 0.043013 -0.07351 0.70736 1.389241 -0.40446 -0.64329 -0.26681
Illiquidity Beta -0.26258 1.9605/ -2.3906 0.442607 -0.96251 -0.97168 -1.53184 0.661185 0.595418 -0.06581
India Constant -0.01164 0.0624/ -0.1104 -0.02378 -0.02858 0.007427 -0.00669 0.005874 0.00023 -0.03565 25
Communications Market Beta 0.719811 2.0615/ -0.7976 1.215485 0.888583 0.720414 -0.12834 -0.02911 1.446304 1.054095
Size Beta -0.84992 0.2182/ -1.9755 -1.00121 -0.30311 -0.35636 -1.20931 -1.63881 -1.04507 -0.41017
Illiquidity Beta -0.41261 2.7665/ -4.3471 -0.24089 -1.32527 -0.2522 -1.89949 -1.36628 1.216147 0.773566
India Constant -0.00148 0.316/ -0.1605 0.020593 0.019806 -0.03229 -0.03426 0.001584 0.025754 -0.00432 12
Basic Materials Market Beta 1.609153 2.4357/ 0.8456 1.439096 1.665587 1.76781 1.497407 1.534791 1.267938 1.801763
Size Beta -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- --
Bangladesh Constant -0.00318 0.1586/ -0.1211 0.005674 -0.00496 0.003135 -0.03796 -0.01327 0.002478 0.023406 47
DSE-20 Market Beta 0.57542 1.1526/ 0.0522 0.242181 0.263836 0.576534 0.949011 0.82571 0.623619 0.615561
Size Beta 0.264153 0.4514/ 0.0073 0.254768 0.267323 0.327001 0.341755 0.306458 0.231605 0.221732
Illiquidity Beta -0.24713 2.0103/ -1.8995 -1.18948 -0.33842 -1.06718 0.276479 0.468866 -0.41682 0.527748
Bangladesh Constant -0.01405 0.1751/ -0.1417 0.052905 -0.01391 -0.01435 -0.08046 -0.01551 0.005964 -0.03094 22
Consumer Market Beta 0.394488 1.0469/ -0.4681 -0.15163 -0.01241 0.443391 0.781394 0.545107 0.698135 0.466591
Cyclical Size Beta 0.245801 2.8992/ -2.1071 -0.6848 -0.04762 -0.14417 0.860729 0.056483 0.551977 0.880974
Illiquidity Beta -0.21962 1.9726/ -1.6332 -0.56599 -0.46735 -0.82688 -0.64753 -0.22517 -0.07587 0.591048
Bangladesh Constant 0.003644 0.312/ -0.1873 -0.00216 -0.02196 0.032361 -0.08088 -0.03574 0.043386 0.082565 23
Consumer Non- Market Beta 0.766393 4.623/ -3.4664 -1.05684 1.069154 0.180721 0.734223 0.620382 1.395493 1.99955
Cyclical Size Beta 0.797596 5.6303/ -2.4504 0.854663 1.038062 0.758999 1.12785 0.145813 0.250713 1.349472
Bangladesh Constant 0.002128 0.3041/ -0.2196 -0.00649 0.007343 0.00167 -0.06337 -0.02655 0.042166 0.044941 30
Finance Market Beta 0.315289 0.8482/ -0.3057 -0.07359 0.036986 0.507105 0.653232 0.43395 0.401313 0.330659
Size Beta 0.015203 0.3127/ -0.5325 0.152309 0.012757 0.031806 -0.00782 0.109323 0.068815 -0.04135
Illiquidity Beta -0.06082 0.4163/ -0.3928 -0.17768 -0.3189 -0.26769 -0.15464 0.042653 0.112403 0.197068
Bangladesh Constant 0.001922 0.3041/ -0.2196 -0.00168 0.007987 -0.01589 -0.05145 -0.02094 0.042676 0.05669 30
Industry Market Beta 0.316863 0.8482/ -0.3057 -0.09659 0.075863 0.545369 0.63581 0.42713 0.402107 0.313265
Size Beta 0.00651 0.3127/ -0.5325 0.122051 0.027559 0.012014 0.016231 0.097702 0.065384 -0.08243
Illiquidity Beta -0.0574 0.4163/ -0.3928 -0.20367 -0.31063 -0.27909 -0.12301 0.044012 0.109873 0.215639
33
Mean (Iterations)
Sri Lanka Constant 0.009546 0.1713/ -0.2259 0.047133 -0.03005 0.040741 0.028875 -0.0062 -0.00186 0.008267 24
Dow Jones Market Beta 0.389255 2.8239/ -1.8077 0.146149 0.55832 -0.60461 0.260789 0.805448 0.70705 0.891201
Titans Size Beta -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- --
Illiquidity Beta 0.537294 1.5542/ -0.9093 -0.54907 -0.19509 0.220711 1.175198 0.78372 1.22852 0.979579
Sri Lanka Constant 0.022255 0.3361/ -0.186 -0.02638 0.020857 0.090396 0.073636 0.018432 -0.04547 0.011862 24
Consumer Non- Market Beta 0.461158 3.201/ -2.6365 0.44915 0.807551 -1.6515 0.01708 1.752111 0.726884 0.691912
cyclical Size Beta 0.426397 4.6499/ -1.8158 1.245583 0.688611 -1.31317 -0.76329 1.545507 1.264223 0.035241
Illiquidity Beta 0.261062 3.7993/ -2.3728 -0.32677 0.229921 -0.24243 1.800751 0.325779 0.421107 0.177589
Sri Lanka Constant 0.00157 0.7548/ -0.2429 -0.03416 -0.02314 0.11329 0.006028 -0.02097 -0.03531 0.010752 73
Diversified Market Beta 0.49432 0.8259/ 0.1807 0.411812 0.492876 0.334206 0.292684 0.458101 0.57022 0.769696
Size Beta 0.742464 1.3782/ 0.4736 1.060372 0.979856 0.654266 0.676557 0.686443 0.665316 0.554971
Sri Lanka Constant 0.002144 0.3388/ -0.2436 0.004535 0.029176 -0.00083 0.009345 -0.02935 -0.02171 0.040874 33
Energy Market Beta 0.343631 0.4683/ 0.178 0.288736 0.272098 0.308025 0.290586 0.362319 0.424017 0.411663
Size Beta 0.108613 1.256/ -0.3305 0.753114 0.228356 -0.17926 -0.16776 0.008202 0.142283 -0.05778
Illiquidity Beta 0.556262 2.943/ -2.0498 -0.55796 0.790229 1.52458 1.667839 -0.25832 0.428292 0.381826
Sri Lanka Constant 0.00945 0.1425/ -0.1488 -0.01148 0.008606 0.038274 0.052689 -0.00154 -0.01141 0.005432 23
Financial Market Beta 0.419168 1.3446/ -1.7926 0.878731 0.3468 -1.13879 0.16948 1.088299 0.731388 0.664915
Size Beta 0.333965 1.9883/ -0.9901 0.533896 0.677071 -0.5333 -0.03311 0.867261 0.829388 0.026304
Illiquidity Beta 0.265712 2.0641/ -1.6353 -0.55657 -0.0133 0.046403 0.836686 0.242431 0.64585 0.679324
Sri Lanka Constant -0.00448 0.3575/ -0.595 0.085726 -0.12412 -0.03461 0.012988 0.005103 -0.00828 0.044883 17
Industrial Market Beta 0.970746 10.2446/ -4.5042 0.119169 1.527081 0.281823 0.609799 1.389024 1.609768 1.547318
Size Beta -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- --
Illiquidity Beta 1.482003 3.052/ -0.9827 -0.43395 1.196764 1.13654 2.158662 2.082261 2.675229 1.586852
Pakistan Constant 0.003288 0.1978/ -0.1459 -0.01076 0.008462 0.002193 0.037288 -0.00702 -0.00249 -0.01497 22
KSE 30 Market Beta 0.717358 1.1198/ 0.4003 0.647665 0.488744 0.603862 0.678764 0.713397 0.884795 0.888081
Size Beta 0.42405 1.5449/ -0.1245 0.848286 0.402116 0.186768 0.189668 0.070103 0.1501 0.716525
Illiquidity Beta 0.45784 1.6576/ -0.6022 1.283328 1.330592 0.693298 0.101261 0.309673 0.129425 -0.2939
Pakistan Constant 0.00342 0.1752/ -0.2419 -0.01577 0.006731 0.002759 0.040124 0.001936 0.001412 -0.00243 23
Financial Market Beta 0.878652 1.2559/ 0.4395 0.696072 0.562257 0.791106 0.821002 0.94185 1.084009 1.123751
Size Beta 0.540229 1.5178/ 0.0908 0.743475 0.628377 0.382359 0.328852 0.266138 0.335783 0.750201
Illiquidity Beta 0.315624 1.9719/ -0.5978 1.255364 1.050598 0.543874 0.157857 -0.0895 -0.09117 -0.33166
34
Mean (Iterations)
Pakistan Constant 0.007679 0.2654/ -0.2712 0.04946 0.044084 0.012283 0.070291 -0.01938 -0.01432 -0.07777 39
Industrial Market Beta 0.533389 2.1306/ -1.0821 0.848081 0.486733 0.603093 0.318795 0.428266 1.313367 0.155677
Size Beta -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- --
Illiquidity Beta 0.955144 4.875/ -1.0048 3.180069 1.795599 0.14634 0.120086 0.04848 0.635715 0.273161
Pakistan Constant 0.014072 0.2164/ -0.1551 0.046695 0.045744 0.01058 0.041722 -0.01558 -0.01062 -0.03447 82
Basic Materials Market Beta 0.34939 1.3182/ -0.775 -0.48565 -0.17645 0.369403 0.530467 0.498505 0.810814 0.649781
Size Beta 0.132016 1.6301/ -0.3894 0.034476 -0.06945 -0.18904 -0.25328 -0.07859 0.182268 0.705108
Illiquidity Beta 0.761048 2.2412/ -0.1986 1.7593 1.780321 1.13858 0.206687 0.415413 0.273215 0.080081
Pakistan Constant -0.00499 0.3977/ -0.3552 -0.09369 0.005296 0.000561 0.053748 0.002745 -0.00096 -0.03229 15
Consumer Market Beta 0.802787 0.968/ 0.6488 0.762674 0.764027 0.776652 0.852944 0.757229 0.799105 0.852916
Cyclical Size Beta 1.192442 3.5545/ 0.1556 3.045218 1.610934 0.825087 0.842158 0.72483 0.512618 0.732988
Pakistan Constant 0.005344 0.3636/ -0.2748 0.031029 0.003078 -0.00187 0.041582 -0.0279 -0.00452 -0.01586 11
Energy Market Beta 0.563219 1.2594/ -0.5024 0.903954 0.543106 0.436154 0.630622 0.534196 0.844221 0.430306
Size Beta -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- --
Pakistan Constant -0.03119 0.3365/ -0.3041 -0.07299 -0.00348 -0.05071 -0.01837 -0.02409 -0.03996 -0.0334 19
Utilities Market Beta 0.940271 4.6671/ -1.3216 2.47263 1.242253 0.618278 0.748137 0.819729 1.047473 0.133446
Size Beta 0.180984 1.855/ -0.2072 1.07031 -0.12353 0.045627 0.051701 -0.04314 0.07779 0.096546
Notes: Means calculated both annually and across entire sample period. High/ Low values given for the entire sample period
35
Table 8 Cost of Equity estimates derived from multi-factor regression (original)
Regression Cost of Time varying coefficient
Equity (%) Cost of Equity (%)
India Financials 36.46 42.64
Communications 31.94 16.85
Basic Materials 52.33 62.82
Cons cyclical 39.01 38.46
Cons non-cyclical 27.43 40.05
Diversified 52.42 55.03
Energy 23.74 36.99
Industrial 44.83 51.81
Technology 55.13 48.37
Utilities 40.73 43.52
Bombay-100 39.93 43.11
Pakistan Financials 51.69 42.12

Basic Materials 28.02 21.84
Energy 42.12 22.80
Utilities 30.15 40.34
KSE-30 46.67 33.02
Bangladesh Financials 19.74 13.97

Industrial -- -- 13.86
DSE-20 16.91 29.42
Sri Lanka Financials 32.90 21.31

Diversified 32.44 32.95
Energy 15.55 12.65
Dow Jones Titans 42.17 19.64
Notes: (1) Annualized cost of equity estimates generated at 05/2009 from the total risk premium
(2) The UK Gilt/ Treasury 1 Month rate is used in each case for risk free rate
36
-4
-3
-2
-1
0
1
2
3
4
-1.5
-0.5
0.5
-1
0
1
01/01/2002
01/03/2002 01/01/2002
01/05/2002
01/04/2002
01/07/2002
01/09/2002 01/07/2002
01/11/2002
01/10/2002
01/01/2003
01/03/2003 01/01/2003
01/05/2003 01/04/2003
01/07/2003
01/09/2003 01/07/2003
01/11/2003 01/10/2003
01/01/2004
01/03/2004
01/01/2004
01/05/2004 01/04/2004
01/07/2004
01/07/2004
01/09/2004
SE Lower Band
01/11/2004 01/10/2004
SE Lower Band
01/01/2005
01/01/2005
01/03/2005
01/05/2005 01/04/2005
01/07/2005
01/07/2005
01/09/2005
01/11/2005 01/10/2005
Illiquidity Beta
01/01/2006
Illiquidity Beta
01/01/2006
01/03/2006
01/05/2006 01/04/2006
01/07/2006 01/07/2006
01/09/2006
01/11/2006 01/10/2006
01/01/2007
SE Upper Band
01/01/2007
01/03/2007
01/04/2007
SE Upper Band
01/05/2007
01/07/2007 01/07/2007
01/09/2007
01/10/2007
01/11/2007
01/01/2008 01/01/2008
01/03/2008
01/04/2008
01/05/2008
01/07/2008 01/07/2008
01/09/2008
01/10/2008
Figure 1. Time varying liquidity beta for India (Bombay 100)
01/11/2008
Figure 3. Time varying liquidity beta for Bangladesh (DSE 20)
01/01/2009 01/01/2009
01/03/2009
01/04/2009
01/05/2009
37
Illiquidity Beta
-1.5
-0.5
0.5
-2
-1
1.5
2.5
0
1
2
3
-1.5
-0.5
0.5
1.5
2.5
-1
0
1
2
01/01/2002
01/04/2002
01/07/2002
01/10/2002
01/01/2003
01/04/2003
01/07/2003
01/10/2003
01/01/2004
01/04/2004
01/07/2004
SE Lower Band
01/10/2004
SE Lower Band
01/01/2005
01/04/2005
01/07/2005
01/10/2005
Illiquidity Beta
Illiquidity Beta
01/01/2006
01/04/2006
01/07/2006
01/10/2006
SE Upper Band
01/01/2007
SE Upper Band
01/04/2007
01/07/2007
01/10/2007
01/01/2008
01/04/2008
01/07/2008
Figure 2. Time varying liquidity beta for Pakistan (KSE 30)
01/10/2008
01/01/2009
Figure 4. Time varying liquidity beta for Sri Lanka (DJ-Titans)
01/04/2009
Figure 5. Time varying liquidity beta for India Financials Figure 6. Time varying liquidity beta for Pakistan Financials
0.4 3
2.5
0.2
2
0
01/01/2003
01/04/2003
01/07/2003
01/10/2003
01/01/2004
01/04/2004
01/07/2004
01/10/2004
01/01/2005
01/04/2005
01/07/2005
01/10/2005
01/01/2006
01/04/2006
01/07/2006
01/10/2006
01/01/2007
01/04/2007
01/07/2007
01/10/2007
01/01/2008
01/01/2002
01/04/2002
01/07/2002
01/10/2002
01/04/2008
01/07/2008
01/10/2008
01/01/2009
01/04/2009
1.5
-0.2
1
Illiquidity Beta
-0.4
0.5
-0.6
0
-0.8
-0.5
-1
-1
-1.2
-1.5
-1.4 -2
SE Lower Band Illiquidity Beta SE Upper Band SE Lower Band Illiquidity Beta SE Upper Band
Figure 7. Time varying liquidity beta for Bangladesh Financials Figure 8. Time varying liquidity beta for Sri Lanka Financials
1 5
0.8
4
0.6
3
0.4
2
0.2
1
0
0
-0.2
-1
-0.4
-2
-0.6
-0.8 -3
-1 -4
SE Lower Band Illiquidity Beta SE Upper Band SE Lower Band Illiquidity Beta SE Upper Band
38

Time Varying Size and Liquidity Effects

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Time Varying Size and Liquidity Effects

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Time varying Size and Liquidity effects in South Asian Equity

Markets: A study of blue-chip industry stocks

JEL classification: G11, G12, G15, O55

Electronic copy available at: http://ssrn.com/abstract=1566252

Electronic copy available at: http://ssrn.com/abstract=1566252

2. SOUTH ASIAN EQUITY MARKETS AND LIQUIDITY MEASUREMENT

(i). South Asian securities markets

India (Bombay stock exchange)

Small Regional Markets: Nepal, Maldives and Bhutan

(ii). Liquidity constructs

Liu (2006) measure

(iii). Data: Sources

(iv). Data: Summary statistics relating to liquidity measures

(i). Size and Liquidity Augmented CAPM

(ii). Time varying parameter CAPM model

s0Kalman ~ N (s0Kalman , P0 ) (14)

h0Kalman ~ N (h0Kalman , P0 ) (15)

(ii). Performance of traditional CAPM against three-factor CAPM

(iii) Modelling market portfolios

Average Returns in India

Average Returns in Pakistan

Average Returns in Bangladesh

Average Returns in Sri Lanka

(iv) Modelling industry portfolios with time varying techniques

Panel B: Average Number of stocks per size-illiquidity sorted portfolio

Panel C: Summary statistics for factors

Pakistan Financials 51.69 42.12

Bangladesh Financials 19.74 13.97

Sri Lanka Financials 32.90 21.31

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