Rational of the study

The future is uncertain. Investors do not know with

certainty whether the economy will be growing rapidly or be in recession. As such, they do not know what rate of return their investments will yield. Therefore, they base their decisions on their expectations concerning the future. Fama and French in 1992 tested stock returns over the 1963 to 1990 period; they found that the size and market to book value variables are powerful predictors of average stock returns. The risk and return have great impact on stock prices. This effect can be either an increase or decrease in stock prices. This impact may be the systematic risk factors or due to the unsystematic risk factors. The risk factor can be minimized but it cannot be eliminated entirely. Risk and return are interlinked, higher the risk depicts higher the return and leads to an increase in stock prices. Lower the risk depicts lower the return and leads to a decrease in stock prices. Hussain (1997) examined relationship between returns and

stock market volatility for Pakistan equity market using daily data. Ahmed prices and Rosser (1995) describes that volatile future tends market to be

also

reflect Stock

optimism market

regarding volatility

economic

development.

persistent; that is periods of high volatility as well as low volatility tend to last for months.

Fama and French (1998) describes that high beta describes that a firm is more risky. The measure of non-diversifiable risk is the beta coefficient. Measures the volatility of an asset return compared may be to volatility that of overall market are returns. The higher the potential return, the higher the potential loss and negative returns possible for all investment types.

Problem Statement
Literature describes that there is strong relation between risk and return, and they have great impact on stock return, some times this impact is positive and some times it is negative. This study investigates how risk affects the stock prices and its relationship with the stock returns. This study also evaluates how volatility affects the stock returns.

Scope and Limitation

The The study scope is of comprises this study of upon is the Karachi to stock last exchange years have the

(KSE) no other stock exchange is included in this study. limited five those covers monthly have stock prices 60 fifteen trading. companies This study

atleast 1 percent of market capitalization and also they regular months effect of risk on the stock prices and also relationship of risk and return between these stocks. This study will be applicable and helpful for other researches related to this topic.

Definition of the Terms

Standard Deviation Risk is defined as the variability of returns, and such variability is measured by the standard deviation, commonly expressed by the symbol , or sigma. Standard deviation is a measure of the dispersion of the returns that approximate a normal probability indicates a a portfolio distribution. with less A risk small than standard similar deviation identifies tight probability distribution and

portfolios with a larger standard deviation. Volatility It is a statistical measure of the tendency of market or security to rise or fall sharply within a period of time. It is a variable in option pricing formulas that denote the extent to which the return of the underlying asset will fluctuate between now and the expiration of the option. Systematic risk Systematic risk, which is also called market risk or undiversifiable risk, is the portion of an assets risk that cannot be eliminated through diversification. The systematic risk indicates how including a particular asset in a diversified portfolio will contribute to the riskiness of the portfolio.

Unsystematic risk Unsystematic risk, which is also called firm-specific or diversifiable risk, is the portion of an assets total risk that can be eliminated by including the security as part of a diversifiable portfolio.

Beta Coefficient Beta Coefficient is a statistical measure of the systematic or market related risk in a security, portfolio, or other asset. Risk Risk is defined as a variability of returns, and such variability is measured by the standard deviation, commonly expressed be less by than the the the symbol expected from (sigma). In Risk as we the were of

probability that the actual return from an investment will return. as effect, viewing risk investment the variability

return form an investment.

CHAPTER 2 LITERATURE REVIEW

Fama and French in (June 1992): They tested stock returns over the 1963 to 1990 period; they found that the size and market to book value variables are powerful predictors of average impact stock on returns. The risk and return can be have great an stock prices. This effect either

increase or decrease in stock prices. This impact may be the systematic risk factors or due to the unsystematic risk factors. The risk factor can be minimized but it cannot be eliminated entirely. Risk and return are interlinked, higher the risk depicts higher the return and leads to an increase in stock prices. Lower the risk depicts lower the return and leads to a decrease in stock prices. Fama and French (1998) describes that high beta describes that a firm is risky. The measure of non-diversifiable risk is the beta return coefficient. compared may be to Measures the volatility of overall of an asset volatility that market are

returns. The higher the potential return, the higher the potential loss and negative returns possible for all investment types. The capital asset pricing model (CAPM) was introduced by Treynor (1961), Sharpe (1964) and Lintner (1965). CAPM divides the risk of holding risky assets into systematic and unsystematic risk (specific risk). Systematic risk is the risk of holding the market portfolio. As the market moves, each individual asset is more or less affected. To

the extent that any asset participates in by such general market moves, that asset entails systematic risk. Specific risk is the risk, which is unique to an individual asset. It represents the component of an asset's return, which is uncorrelated with general market moves.

Systematic risk can be measured using beta. According to CAPM, the expected return of a stock equals the risk-free rate plus the portfolio's beta multiplied by the expected excess return of the market portfolio (Treynor, 1961). CAPM model describe that says CAPM a the is relationship used in the the between pricing risk of of and risky a

expected security

return or

securities.

that

expected

return

portfolio equals the rate on a risk-free

security plus a risk premium. If this expected return does not meet or beat the required return then the investment should not be undertaken. The standard deviation of an individual stock does not

indicate how that stock will contribute to the risk and return of a diversified portfolio. Thus, another measure of risk is needed a measure of a securitys systematic risk. This measure is provided by the Capital Asset Pricing Model (CAPM)(Brigham, 2000). The expected market risk premium (the expected return on a stock portfolio There is are minus also the treasury that bill yield) is positively related to the predictable volatility of stock returns. market evidence unexpected to the stock returns negatively related unexpected

change in the volatility of stock returns (French, Schwert and stambaught, 1996). Management is assumed to know more about the firms value than potential investors. Investors interpret the firms An equilibrium may refuse for model to of the issue and of to actions model The rationally. that

invest decision is developed under these assumptions. The shows firms issue stock, aspects tendency therefore model corporate may pass up valuable investment opportunities. explanations behavior, several the including

suggests financing

rely on internal sources of funds, and to prefer debt to equity if internal financing is required (Myers, Stewart and Majluf, 1984). Vaihekoshi has undertaken the study in 1996. Equity and government bond indexes as risk factors have been used in this research risk paper. This approach risk allows for the time risk varying premium, adjusted returns,

sensitivities, and residual variances. Betas, risk adjusted returns, and residual variance are allowed to vary linearly with the conditioning information variables: A short-term interest rate level, a measure of interest rate volatility a measure of interest rate term structure, a measure of currency returns market on volatility. size, Tests are and done using weekly ranked seven industry leverage

portfolios. The sample period is 1987 to 1995. The results show some evidence that the bond factor is relevant to the pricing of the stocks. The results also support the idea that the conditioning variables can be used to predict the time variation in betas.

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Ahmet and Nusret in 1999 tests the overreaction hypothesis in seven industrialized countries using the methodology suggested by Conrad and Kaul. Then they try to determine whether price or size is significant in explaining holding period on two returns and to loser and and winner portfolios. finding Finally, sot the these past they evaluate the performance of arbitrage portfolios based price points size be compare the in performance of loser winner arbitrage portfolios. Moreover, must are considered on a interpreting variable like findings; first, as Loughran and Ritter 1996 observed when portfolios formed single returns, price or size the impact of any of these variable swill probably be overstated. Secondly, the returns to some portfolios might be accounted at least in part by higher risk. Fama and French in June 1998 studied the return performance of all no financial firms traded on the NYSE, AMEX and NASDAQ over the period from 1962 to 1990. They found that the of market the value was and not the a book to market ration It were is important predictors of average returns, and that the beta stock significant predictor. important to stress that it is not possible to disprove the concept of an efficient market through empirical tests. The interpretation of these findings is that they are finding a more accurate representation of the risk premium. It is not unreasonable to suppose that small firms are more risky than large firms. Investors, regulators, brokers, dealers and the press have all expressed concern over the level of stock market volatility. But the perception that prices move a lot and
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have been moving a lot more in recent years is in part merely a reflection of the historically high levels of popular indexes (William, 1990). David and shiller 1990, express that the excess volatility is an accepted phenomenon and cannot be adequately explained by fluctuations in real interest rates. In this essay the author has shown that it is more likely that capital gains or losses can be attributed to the actions of individual values little of investors, which the The rather ordinary author than would movements would postulate in ex-post very the that investor have

knowledge.

theory is only an extreme of certain limited markets. While it does hold to a certain extent in all markets, it is not the full explanation. The excess volatility, which has been examined, has been adequately explained by the theory of popular models, seems to be totally logical in its assumptions and is well supported by several texts as the author has demonstrated. Schiller book provides in statistical the stock evidence market that excess

volatility

exists

and

therefore

volatility cannot be totally explained by the EMH. Excess volatility is the name given to that level of volatility over and above that, which is predicted by efficient market theorists. investors This excess volatility can be He attributed claims to psychological behavior. that

substantial price changes can be explained by a collective change of mind by the investing public which can only be explained by its thoughts and beliefs on future events, i.e. its psychology.

12

The

low

correlation and investor

between

returns from

in

emerging implies

equity the in

markets global

industrial would

equity benefit

markets

that

diversification

emerging markets. This article explores the sensitivity of the emerging-market returns to measures of global economic risk. When these traditional measures of risk are used, the emerging from markets have little or no sensitivity. the This finding is consistent with these markets being segmented world capital markets. However, correlation between the emerging-market returns and the risk factors appears to be changing over time (Harvey, 1995) Hussain 1997, examined the day of the week effect in

Pakistani equity market using the data on 36 companies, 8 section indices and the market index January 1, 1989 to December 30, 1993 various prepositions regarding stock return behavior was examined. The results did not indicate any significant difference in stock returns across days. The analysis conducted in various sub periods revealed the presence of day of the week effect in the form of lowest returns indicates days. He also examined the relationship between returns and stock market volatility for Pakistani equity market using daily data. The study also found a strong evidence of persistence in variance in returns, implying that shocks to volatility continue for a long period of time. When volatility was controlled, it was found that serial dependence in stock returns was reduced but not eliminates which indicated that the returns in the market might be partially predictable.
13

on

the

first

trading

day.

However,

the

paper

identical

distribution of stock returns across

Stock return volatility represents the variability of stock price changes during a period of time. Investors, analysts, brokers, dealers and regulators care about stock return volatility not just because it is perceived as a measure of risk, but because they worry about excessive volatility in which observed fluctuations in stock prices do not appear to be accompanied by any important news about the firm or market as a whole (Karolyi, 2001). According to Ahmad and Rosser erratic and complex dynamics of the stock market suggests that Pakistani economy may be subject hand, to instabilities but and oscillations. market prices On the other rising volatile also reflect

optimism regarding future economic development. In a firm level study Farid and Ashraf 1995, analyzed the effects of trading volume on the volatility of stock prices has been studied by using average daily turnover of ten randomly selected companies for the first six months of 1994. Volatility of stock prices was found to be quite high ranging from a minimum of 26 percent per annum to 51 percent per annum. There was a strong positive correlation among the volume of trading, expected rate of return and volatility of stock prices during the first half of 1994 indicating the trend at the DSE to invest in stocks only for short term gains. It was observed in the study the majority of investors entered the market when it was rising and abandoned when it was falling, thus following their own portfolio insurance schemes. The author also suggested a more detailed study on the basis of daily fluctuation of stock prices to get more accurate results.
14

Bundoo in June 2002 was done the same study in Mauritius. He computed betas by using Capital Asset Pricing Model (CAPM) and Market Model to analyze the relationship between risk and return and also he checked the variation between the risks, which was so little. He concluded that if beta of the security is more than 1.0 than it is more risky security as compare to the market. The variation in its stock price is also greater than the market. Adjusted R squared showed percent change in security price due to the change in market returns.

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