DOES LIQUIDITY IMPROVE THE CARHART FOUR-FACTOR MODEL? EVIDENCE FROM THE PAKISTAN STOCK EXCHANGE

Abstract

This study investigates the explanatory power of the Carhart four-factor model and its liquidity augmented version to explain cross sectional stock returns on the Pakistan Stock Exchange (PSX). The analysis is carried out using a sample of 266 non-financial companies for the period July 2012 to June 2022. Sixteen portfolios based on the firm characteristics were built and the liquidity factor based on the turnover based factor proposed by Datar, Naik and Radcliffe (1998). Time-series regressions, Fama–MacBeth two-pass procedure with Newey–West adjusted standard errors, Gibbons–Ross–Shanken (GRS) and Wald tests were used to evaluate model performance. The empirical results reveal that the traditional Carhart model has little explanatory power, since neither the market factor nor the size, value and momentum factors result in risk premiums that are consistent or statistically significant. The addition of the liquidity factor does not significantly influence the model performance, and the liquidity factor is not significant in both time-series and cross sectional analysis. The results indicate that the Carhart framework does not fully explain the stock return behaviour in the Pakistan Stock Exchange and liquidity is not an additional priced risk factor over the sample period. The study adds to the literature on multifactor asset pricing in emerging markets, and emphasizes the importance of considering alternative sources of systematic risk in future studies.

Key words: Asset Pricing, Carhart four factor model, Liquidity, Emerging Market.