The Lumbini Journal of Business and Economics, Vol.

1, April, 2011

STOCK BETA, FIRM SIZE AND BOOK-TO-MARKET EFFECTS ON CROSS-SECTION OF COMMON STOCK RETURNS IN NEPAL
Surya Bahadur Rana, M. Phil

Abstract
This study examines the cross-sectional variations in common stock returns with respect to stock beta, firm size and book-to-market equity of 61 sample firms with a total of 455 observations listed in Nepal stock exchange till mid-April 2010. The study covers firm specific data during the fiscal year 1996/97 through 2008/09. This study basically employs cross-sectional linear regression model along with empirical CAPM and three-factor model to assess the explanatory power of the firm specific variables. The results show that firm size does not explain the common stock returns in the context of stock market in Nepal. On the other hand, study reveals that book-to-market equity and stock beta effects on common stock returns are consistent across all the analyses and all the specifications of the model. The results indicate very strong role of stock beta and book-to-market equity to explain common stock returns in Nepal. The results also indicate that although the stock returns are significantly explained by stock beta or market risk factor, the underlying assumption of CAMP does not completely hold in Nepalese stock market as intercept term in empirical CAPM has been observed to be marginally significant. On the other hand, results support Fama and French (1995) three-factor model because intercept term in empirical FF three-factor model has been observed to be not significant, and the evidences establish market risk factor, firm size factor and book-to-market factor as the most significant determinants of stock returns in Nepal.

1. CONCEPTUAL BACKGROUND AND THEORETICAL FRAMEWORK

Asset pricing theory is concerned with determining how investors choose to allocate scarce resources among assets. As the underlying theory suggests, the investors allocate resources into assets based on the object and theory of choice. Mean and variance associated with an assets returns are the objects of choice. They indicate the risk-return combination of an investment. On the other hand, theory of choice guides on selecting the most preferable utility maximizing risk-return combination of an investment. The basic foundation for asset pricing theory was laid down by Markowitz (1952) through a seminal work entitled Portfolio

Surya B. Rana is Lecturer at Tribhuvan University, Lumbini Banijya Campus, Butwal. This paper constitutes a part of his M. Phil. research work.

Selection. Markowitz portfolio theory asserts that a single asset may be very risky when held in isolation, but not much risky when held in combination with other assets in a portfolio. This conclusion is based on the idea that the riskiness of a portfolio is not only determined by variance of assets return, but also by covariance or correlation of returns between assets held in the portfolio. The underlying construct of the Markowitz (1952) portfolio theory motivated Sharpe (1964), Linter (1965), Mossin (1966) and Black (1972) to extend and develop the assets pricing theory-the capital assets pricing model (CAPM). The underlying assumption of CAPM is that all investors are price takers and have homogeneous expectation about asset returns that have a joint normal distribution. In theory, when all individuals have homogeneous expectations, the market portfolio must be efficient. Without homogeneous expectations, the market portfolio is not necessarily efficient and the equilibrium model of capital market does not necessarily hold. Thus, the efficiency of the market portfolio and the capital asset pricing model are inseparable, joint hypothesis. It is not possible to test the validity of one without other. Given the market efficiency, CAPM postulates that only a component of total risk, which is related to the market, is relevant for pricing of capital assets. The CAPM establishes a link between market risk (measured by beta) and return for all assets. Therefore, the relationship between expected return and market risk is the essence of the CAPM. It argues that market portfolio is a well diversified portfolio and only the risk associated with the market portfolio is the systematic risk as measured by beta. Therefore, if an asset is included in a well diversified portfolio, the asset must be priced to compensate for systematic risk. The unsystematic risk is uncorrelated with the market and, therefore, is omitted. Hence, the theoretical foundation of CAPM reveals that stock beta, a measure of systematic risk, can capture much of the variations in common stock returns. The CAPM, however, has not gone unchallenged. The validity of the CAPM is questioned because it posits a positive linear relation between expected returns and betas, while other firm specific variables such as firm size and book-to-market equity should not have any ability to explain average cross-sectional returns. The key ingredient in the model is the use of beta as a measure of risk. Although, early

Stock Beta, Firm Size and Book-to-Market Effects on Cross-Section of Common Stock Returns in Nepal  Surya Bahadur Rana

studies, for example, Friend and Blume (1970), Black, Jensen, and Scholes (1972), and Fama and MacBeth (1973), demonstrated beta to have reasonable predictive power about returns on a portfolio of common stocks, other empirical evidences, for example, Banz (1981), Stambaugh (1982), Chan, Hamao and Lakonishok (1991), Fama and French (1992), Davis (1994), and Kothari, Shanken and Sloan (1995), among others, have raised doubt against validity and applicability of this model. Many of these studies have concluded that the factors other than beta are successful in explaining that portion of common stock returns not captured by beta. Several anomalies, other than CAPM beta, have become evident when studies have attempted to explain actual stock returns. For example, size effect of Banz (1981) is one of them, which has demonstrated that common stocks of firms with small market capitalization provide higher returns than common stocks of firms with high capitalization, holding other things constant. Another irregularity is that common stocks with high book-to-market equity ratio do better than common stocks with low ratios. For example, Chan, Hamao and Lakonishok (1991) have documented that book-to-market equity is important in explaining common stock returns. On the other part of studies, although empirical testing of CAPM by Black, Jensen and Scholes (1972) has reported a linear empirical market line with positive risk-return trade-off, the intercept term has been found significantly different from zero that rejects empirical validity of the CAPM. The study has suggested that the CAPM is either misspecified and requires the addition of factors other than beta to explain stock returns or that the problem in measuring beta are systematically related to variables such as firm size. Fama and French (1992) published a landmark study on the cross-sectional relationship between risk and return, as a test of CAPM. The results indicated noticeable relations between monthly stock returns and both size and beta when portfolios were arranged by size, but no sure relation when the portfolios were arranged by beta. Similarly, the study also exhibited no significant relation between average returns and beta when combined with size. The study documented that book-to-market equity has the strongest relation with expected returns. Furthermore, book-to-market equity and market value of equity were observed to capture the explanatory power of the beta for stock returns. In followStock Beta, Firm Size and Book-to-Market Effects on Cross-Section of Common Stock Returns in Nepal  Surya Bahadur Rana

up studies, Fama and French (1993; 1995) offered economic justifications for their findings by showing that book-to-market equity and market value of equity proxy for stock returns sensitivity to risk factors and postulated that these variables are also related to earnings. With the inspiration from findings of succeeding studies by Fama and French (1993; 1995), they proposed a three-factor model that comprises of market risk factor, size factor and book-to-market equity factor as opposed to the single factor -the market risk- proposed by the CAPM. The threefactor model showed that the stocks of small firms and those with a high book-tomarket equity ratio could provide above average returns. This could simply be a coincidence. But there are also evidences that these factors are related to firm profitability and therefore may be picking up risk factors that are left out of the simple CAPM. Since then, there is an ongoing wonder as to which explain the stock returns better- the CAPM or the three-factor model. The proposed three-factor model has also generated a number of subsequent studies with the objective of re-establishing the validity of beta as a measure of risk and the CAPM as a sound asset pricing model. Basically, the studies have focused more on the methodological improvements to reduce potential measurement error in beta. For example, among others, Kim (1995) used a methodology to correct for measurement bias effects. With this correction, the study revealed that beta has statistically significant explanatory power, but other variables such as firm size and book-to-market equity were also significant. Subsequent studies have thus been able to re-establish the latent value of beta as a significant explanatory variable for average cross-sectional returns but have not abolished or made clear why other firm specific variables continue to explain cross-sectional returns. Therefore, the underlying construct is that if the true beta is known, then the firm specific variables will not be present in a cross-sectional regression. However, if the CAPM is valid and if the beta is measured with errors, then it is quite possible to obtain any one of the two empirical results- either beta is not significant and one or more of the firm specific variables are; or beta and one or more of the firm-specific variables are significant. With respect to the ongoing debate on the role of stock beta, firm size and book-tomarket equity in explaining cross-section of common stock returns, this study is an attempt to examine these phenomena in the context of Nepalese stock market.
Stock Beta, Firm Size and Book-to-Market Effects on Cross-Section of Common Stock Returns in Nepal  Surya Bahadur Rana

Hence, the basic purpose of this study is to explore the effect size of these firm specific variables in the context of stock returns in Nepal. This paper is divided into a total of five sections. The first section dealt with a general background of the study. The second section provides a brief review of literature along with statement of the problem. The third section provides a description of data and methodology used. Results are presented and described in the fourth section and the final sections presents a concluding remarks of the study along with the limitations of the study.

2. STATEMENT OF THE PROBLEM

The capital asset pricing model (CAPM) of Sharpe (1964), Linter (1965), Mossin (1966), and Black (1972) scripts the origin of asset pricing theory. The primary implication of the CAPM is that the model is mean-variance efficiency. This implies that there exists a positive linear relation between expected returns and market betas, and variables other than beta should not have power in explaining the cross-sectional variations in common stock returns. The main attraction of the CAPM is that it offers influential and naturally agreeable predictions about how to measure risk and the relation between expected return and risk. However, the empirical documentation of the model is poor enough to nullify the way it is used in application. The early empirical tests in US stock markets focused on the models predictions about intercept and slope in the relation between expected return and market beta. Many tests rejected the basic assumption of the CAPM. For example, Friend and Blume (1970), Black, Jensen, and Scholes (1972), and Stambaugh (1982) documented positive relation between beta and average stock returns, but it was too flat. The CAPM also predicts that the intercept term is equal to risk-free rate and the coefficient on beta is the expected market return in excess of risk-free rate. On the contrary, the studies such as by Miller and Scholes (1972), Blume and Friend (1973), Fama and MacBeth (1973), among others, found intercept term greater than the average risk-free rate, and the coefficient on beta less than the average excess market returns. However, the issues associated with empirical validity of CAPM are yet to be tested in the context of stock market in Nepal.

Stock Beta, Firm Size and Book-to-Market Effects on Cross-Section of Common Stock Returns in Nepal  Surya Bahadur Rana

Hence, the present study attempts to test, using more recent data, whether the central prediction of CAPM holds true in Nepalese stock market. Contrary to the predictions of the CAPM model, empirical studies have found that variables relating to firm characteristics have significant explanatory power for average stock returns, while beta has little power. The most prominent variables associated with firm characteristics are firm size and book-to-market equity, cash flow yield and earnings-to-price ratio. Among the several contradictions, earlier one was Basus (1977) evidence that when common stocks were sorted on earningsto-price ratios, future returns on high earnings-to-price stocks were observed higher than that predicted by the CAPM. Similarly, La Porta (1996) demonstrated low earning growth stocks to have significantly lower standard deviations and betas than higher earnings growth stocks. On the other hand, in relation to firm size effect, Banz (1981), Reinganum (1981), and Keim (1983) observed that small firms have higher returns and larger firms have lower returns than those predicted by the CAPM. Jagadeesh (1992) also documented no explanatory power of beta in predicting cross-sectional differences in average returns because when the test portfolios were constructed the correlations between beta and firm size were found small. Finally, Stattman (1980), and Rosenberg, Reid, and Lanstein (1985) demonstrated high average returns for stocks with high book-to-market equity ratios that were not captured by their betas. In later period, Chan, Hamao, and Lakonishok (1991) revealed that book-to-market equity could explain stock returns in Japan. There is a theme in the contradictions of the CAPM summarized in these studies. Ratios involving stock prices have information about expected returns missed by market betas. However, most empirical tests that have found those contradictions to the CAPM, involve an error-in-variables problem, since true betas are unobservable and, thus, estimated betas are used as proxy for the unobservable betas. Handa, Kothari, and Wasley (1989), and Kim (1995) showed that the errors-in-variables problem could induce an underestimation of price of beta risk and an over estimation of other cross-sectional regression coefficients associated with firm characteristics variables such as firm size and book-to-market equity that might be observed with error. As a mater of fact, a greater correlation between the estimated betas and firm specific variables causes more downward bias in the price of beta
Stock Beta, Firm Size and Book-to-Market Effects on Cross-Section of Common Stock Returns in Nepal  Surya Bahadur Rana

risk estimate and more exaggeration of the explanatory power of the firm specific variables. Hence, this study also attempts to identify whether higher correlation exists between betas and firm specific variables and examine the joint role of beta, firm size and book-to-market equity in explaining common stock returns in the context of Nepal. Fama and French (1992) updated and synthesized the evidence on the empirical failures of the CAPM. Based on the cross-section regression, the study confirmed that size, earnings to price, debt-equity and book-to-market ratios could add to the explanation of expected stock returns provided by market beta. Fama and French (1996) reached the same conclusion using the time-series regression approach applied to portfolios of stocks sorted on price ratios. The study also found that different price ratios did have much the same information about expected returns. As a result, Fama and French (FF) (1993; 1995; 1996) advocated a three factor model in which a market portfolio return was attached by a portfolio long in high bookto-market stocks and short in low book-to-market stocks (HML-high minus low book-to-market equity) and a portfolio that is long in small firms and short in large firms (SMB-small minus big size). Since then several studies have used the FF three-factor model as an empirical asset pricing model. However, there is controversy over why the firm specific attributes that are used to form the FF three factors should predict stock returns. Some argue that such variables may be used to find securities that are systematically mispriced by the market (for example, Lakonishok, Shleifer, & Vishny, 1994; Daniel & Titman, 1997). Others argue that these measures are proxies for exposure to underlying economic risk factors that are rationally priced in the market (for example, Fama and French, 1993; 1995; 1996). A third view is that the observed predictive relations are largely the result of data snooping and various biases in the data (for example, Kothari, Shanken, & Sloan, 1995; Chan, Jagadeesh, & Lakonishok, 1995). In similar case, Berk (1995) emphasized that, because returns are related mechanically to price by a present value relation, ratios that have price in the denominator are related to returns by construction. As a matter of fact, if the numerator of such a ratio can capture cross-sectional variation in the expected cash flows, the ratio is likely to provide a proxy for the cross-section of expected returns. Ratios like the book-tomarket are therefore likely to be related to the cross-section of stock returns
Stock Beta, Firm Size and Book-to-Market Effects on Cross-Section of Common Stock Returns in Nepal  Surya Bahadur Rana

whether they are related to rationally priced economic risks or to mispricing effects. Given these prominences of the FF three-factor model, it is interesting to test its empirical performance as an asset pricing model. Therefore, this study also attempts to examine whether stock returns are largely associated with three factors as suggested by FF in the context of small capital market in Nepal. The study basically deals with following specific issues: a. b. Does CAPM explain stock returns in Nepal? Whether CAPM beta alone can predict stock returns, or inclusion of firm size and book-to-market equity subsume the beta effect on stock returns? c. Are the stock returns related to three factors suggested by FF three-factor model?

3. RESEARCH METHODOLOGY
Research design
This study has employed descriptive, correlational and causal comparative research designs to deal with the fundamental issues associated with factors affecting common stock returns in the context of stock market in Nepal. The descriptive research design has been adopted for fact-finding and searching adequate information about factors affecting common stock returns. This design has also been employed to describe the nature of cross-sectional common stock returns of 61 enterprises consisting of 455 observations during fiscal year 1996/97 through 2008/09 by using descriptive statistics with respect to firm specific variables such as stock beta, firm size and book-to-market equity ratio. This study is also based on correlational research design. This design has been adopted to ascertain and understand the directions, magnitudes and forms of observed relationship between common stock returns and firm specific variables. Moreover, this study has also employed causal comparative research design to determine the effect size of stock beta, firm size and book-to-market equity on cross-sectional common stock returns. The basic purpose of employing causal comparative research design is to examine whether it is possible to predict common stock returns on the basis of information about firm specific variables.

Stock Beta, Firm Size and Book-to-Market Effects on Cross-Section of Common Stock Returns in Nepal  Surya Bahadur Rana

Nature and sources of data

This study is based on secondary sources of data. The data for firm specific variables including stock market data have been obtained from financial statements of the sample firms recorded in the database of Nepal Stock Exchange (NEPSE) Limited and Securities Board of Nepal (SEBON) provided in their respective websites. NEPSE and SEBON have maintained the record of firm specific data only from the fiscal year 2002/03 to 2008/09 in their respective database as on mid-April 2010 in websites. Therefore, the firm specific data prior to 2002/03 have been derived from various issues of Financial Statements of Listed Companies published by Nepal Stock Exchange Limited. Similarly, firm specific data of more recent period (that is for the year 2008/09) are unavailable for most of the listed firms as these firms have not timely submitted their annual reports. Overall, the period covered in study with respect to firm specific variables ranges from fiscal year 1996/97 to 2008/09. The number of observations varies among enterprises with minimum 2 to maximum 13 observations. Such variations in number of observations have been noticed mainly due to the unavailability of continuous years data for several firms.

Population and sample

Population of this study includes all listed firms in Nepal Stock Exchange (NEPSE) Limited to the end of mid-April 2010. Table 1 shows the population and sample of the study along with their respective number of observations that represents different sectors as defined by NEPSE. A total of 179 enterprises were listed in NEPSE as of mid-April 2010 and 61 of them were included in the sample list. In selecting the most reliable and representative samples, first the population of the NEPSE was stratified into different sectors as defined by the NEPSE and then enterprises from each stratum were selected on the basis of availability of market and firm specific financial information of at least two continuous years from the fiscal year 1996/97 to 2008/09. There were total 128 enterprises from banking and finance sector listed in NEPSE to the date. Of these, 84 enterprises did not have complete firm specific financial information available for the period after 2004/05. Therefore, these enterprises were excluded from sample and only 44 of them with

Stock Beta, Firm Size and Book-to-Market Effects on Cross-Section of Common Stock Returns in Nepal  Surya Bahadur Rana

more recent years observations were included. The number of enterprises from insurance sector consisted of total 19 insurance companies to the date and 4 of them with complete financial information to the most recent years were considered in the sample. Table 1 Population and sample enterprises from different sectors
S. No. 1. 2. 3. 4. 5. 6. 7. Sector Banks and Companies Manufacturing Processing Trading Hydropower Hotels Other Total
Source: www.nepalstock.com

Population Finance 128 19 and 18 4 4 4 2 179

Sample 44 4 3 2 4 3 1 61

Observations 342 41 24 14 11 20 3 455

Insurance Companies

The data problem is more acute for manufacturing and processing sector enterprises listed in NEPSE. Out of total 18 enterprises from this sector, most have no regular trading and thus market information about them are not available. Therefore, only 3 enterprises from manufacturing sector with complete market information were taken into the sample. Similarly, there were 4 enterprises from trading sector listed in NEPE till mid-April, 2010. Out of them only two enterprises, namely Bishal Bazar Company Limited and Salt Trading Corporation had market information recorded in the NEPSE. Therefore, these enterprises were also included in the sample. Among the enterprises in hydropower sector, all 4 enterprises had complete market information of more recent years, so all of them were included in sample. The sample also consists of 3 out of 4 enterprises from hotels and 1 out of 2 enterprises from other sector defined by NEPSE. The selection of these enterprises was also based on the availability of complete firm specific and market information. The Nepalese stock market is dominated by deep and broad market of banks and finance companies and the updated financial statements of many of these sectors

Stock Beta, Firm Size and Book-to-Market Effects on Cross-Section of Common Stock Returns in Nepal  Surya Bahadur Rana

firms are available in the NEPSE and SEBON database. However, financial information relating to manufacturing and processing, trading, hotels, and other sectors enterprises are relatively of older date and the number of firm years are relatively fewer. Therefore, sample list is basically dominated by banks and finance sectors enterprises both in terms of number of firms and number of observations.

Methods of data analysis

The main purpose of data analysis in this study is to explore the predictive power of firm specific variables in explaining common stock returns for selected enterprises in the context of stock market in Nepal. The method of data analysis used in this study consists of econometric models that include cross-sectional regression models, empirical version of CAPM model and FF three-factor model. The study has also used descriptive statistics, correlation analysis, two-way short of portfolios along with statistical test of significance such as t-test, F-test, Adjusted R2, test of autocorrelation and multicolinearity. In order to explain the effect size of firm specific explanatory variables on crosssection of common stock returns, the empirical regression model (Davis, 1994) of the form specified in equation (1) has been used.
Rit = +b1t it + b2t LMEit + b3t BE/MEit + et . . . (1)

In equation (1) Rit refers to the returns on common stock of firm i for period t, it is the stock beta of firm i for period t, LMEit is the natural logarithm of market value of equity, BE/MEit denotes the ratio of book-to-market equity, and eit refers to the unexplained residual error terms. is the intercept term, and b1t, b2t, and b3t, are the respective parameters of the explanatory variables to be estimated. The cross-sectional variations in stock returns associated with stock beta, firm size, book-to-market equity ratio, and earnings-to-price ratio have been examined by using several specifications of equation (1). The equation (1) specified above assumes the following reasonable a priori hypothesis: Rit Rit Rit > 0; < 0; and >0 . . . (2) it LMEit BE/MEit

Stock Beta, Firm Size and Book-to-Market Effects on Cross-Section of Common Stock Returns in Nepal  Surya Bahadur Rana

The priori sign expectation in equation (2) implies that the stock returns are positively related with stock beta, book-to-market equity and earnings-to-price ratios and negatively related with firm size. The next section of regression analysis tests the comparative performance of the CAPM and FF three-factor model in the context of Nepalese stock market. For the purpose of testing empirical validity of the CAPM, the empirical model of Sharpe (1964), Linter (1965) and Black (1972) version has been used to explain the crosssection of common stock returns with respect to the market risk premium. The empirical model is specified in equation (3).
Rit RFt = i + bi [RMt RFt] + eit . . . (3)

In equation (3), Rit is the returns on common stock of firm i for period t, RFt is the risk-free rate of return during period t, RMt is the rate of return on market portfolio, and eit denotes the unexplained residual error terms. The equation (3) specified above assumes the following reasonable a priori hypothesis:
(Rit RFt) >0 (RMt RFt)
. . . (4)

The priori sign expectation in equation (4) implies that excess stock returns are positively related with excess market returns. In an attempt to analyze the predictive power of market risk factor, size factor and book-to-market equity factor, and to compare with the CAPM, Fama and French (1995) three-factor model of the following form has been used.
Rit RFt = i + bi[RMt RFt] + si(SMBt) + hi(HMLt) + eit . . . (5)

In equation (5), [Rit - RFt] is the excess of stock returns of firm i over risk-free rate for period t, and [RMt - RFt] is the excess of market return over risk-free rate for period t. For each year, the stocks were sorted into two size groups- small and big, and three book-to-market equity group- high, medium, and low. SMBt refers to the size factor determined as average of small firm size minus average of big firm size portfolio returns during each year. Similarly, HMLt is the book-to-market equity
Stock Beta, Firm Size and Book-to-Market Effects on Cross-Section of Common Stock Returns in Nepal  Surya Bahadur Rana

factor defined as average of high BE/ME minus average of low BE/ME portfolio returns during each year. eit is the unexplained residual terms, i is the intercept term, and bi, si, and hi are the coefficients of market risk factor, size factor, and book-to-market equity factor respectively. The equation (5) specified above assumes the following reasonable a priori hypothesis:
(Rit RFt) (Rit RFt) (Rit RFt) > 0; < 0; and >0 (RMt RFt) (SMBt) (HMLt)
. . . (6)

The priori sign expectation in equation (6) implies that excess stock returns are positively related with excess market returns and book-to-market premium denoted by high minus low book-to-market, and negatively related with size premium denoted by small minus big size stocks.

4. STUDY RESULTS
Descriptive statistics
Descriptive statistics have been used to describe the characteristics of stock returns and firm specific variables during the study period. The descriptive statistics used in this study consists of mean, standard deviation, and minimum and maximum values associated with variables under consideration. Table 2 summarizes the descriptive statistics of firm specific variables used in this study during the period 1996/97 through 2008/09 associated with 61 sample firms listed in NEPSE. Market capitalization of equity of the sample firms ranges from minimum Rs 6.75 million to maximum Rs 72,227.675 with an average of Rs 2,062.7639 million and standard deviation of Rs 6,036.59 million. The wider range of market capitalization of equity implies that the firm included in the sample varies in terms of their size. Table 2 also reveals that net worth position of the firms varies significantly. It ranges from minimum negative Rs 71.4 million to maximum positive Rs 3,521.64 million with a mean value and standard deviation of Rs 359.1576 million and Rs 551.2338 million respectively. The firms also differ in terms of their earnings per share and market price per share. Earning per share has average value of Rs 35.14, while market price per share has an average value of Rs 587.4418 and standard
Stock Beta, Firm Size and Book-to-Market Effects on Cross-Section of Common Stock Returns in Nepal  Surya Bahadur Rana

deviation of Rs 867.5687. Relatively larger difference in market price implies that sample firms consist of low to high growth stocks. Table 2 Descriptive Statistics of Firm Specific Variables associated with 61 Sample Firms during the Period 1996/97 through 2008/09
This table shows descriptive statistics- mean, standard deviation, minimum and maximum values- of firm specific variables associated with 61 sample firms listed in the population of NEPSE till midApril 2010 with 455 observations for the period 1996/97 through 2008/09. ME refers to market value of equity defined as number of outstanding shares multiplied by corresponding market price per share, BE is the net worth, EPS is the earnings per share, MPS is the market price per share of common stock, BE/ME is the ratio of book value of equity to market value of equity, LME is the natural logarithm of market value of equity used as a proxy for firm size, is common stock beta used as a proxy of systematic risk, Ri is the annual return on common stock, RM - RF refers to the excess of market return above risk-free rate, Ri RF refers to the excess of stock returns above risk-free rate, and N refers to the number of observations. Variables ME (Rs in Million) BE (Rs in Million) EPS (In Rs) MPS (In Rs) BE/ME LME Ri RM RF Ri RF N 455 455 455 455 455 455 455 455 455 455 Mean 2062.7639 359.1576 35.1336 587.4418 0.6820 2.4484 0.9121 0.3129 0.2015 0.2763 Std. Dev. 6036.5900 551.2338 37.0411 867.5687 0.5623 0.8529 2.2643 0.7085 0.3313 0.7095 Minimum 6.7500 -71.4000 -79.0500 35.0000 -0.3245 0.8293 -19.3500 -0.7327 -0.3941 -0.7798 Maximum 72227.6750 3521.6400 285.7200 7750.0000 4.7189 4.8587 12.4900 4.6198 0.7439 4.5776

Similarly, book-to-market equity ratio has mean value of 0.6820 and standard deviation of 0.5623 with minimum to maximum range of negative 0.3245 to positive 4.7189. Table 2 also indicates that firms differ significantly in terms of their systematic risk level proxied by stock beta. The stock beta has minimum value of negative 19.35 to maximum positive 12.49 with a mean of 0.9121. The average stock return of the sample firms during the period has been recorded at 0.3129 with a minimum negative return of 0.7327 to maximum positive return of 4.6198. The range of minimum to maximum excess stock return is wider than that of excess market return. This implies that average stock returns of the sample firms are more volatile than the market returns.

Stock Beta, Firm Size and Book-to-Market Effects on Cross-Section of Common Stock Returns in Nepal  Surya Bahadur Rana

Correlation analysis
The firm specific variables used in this study, particularly, book-to-market equity ratio, firms size, stock beta, and stock returns are all scaled version of market price per share or market value of equity. Therefore, it is reasonable to expect some kind of statistically significant relationship among these pairs of variables. This section therefore is devoted to explaining the direction and magnitude of relationship among different pairs of these firm specific variables including stock returns. The correlation analysis has been performed for this purpose. Table 3 presents the value of bivariate Pearson correlation coefficient between different pairs of firm specific variables of 61 sample firms with 455 observations during the period 1996/97 through 2008/09. Table 3 Bivariate Pearson Correlation Coefficients of Firm Specific Variables Observed for 61 Sample Firms during the Period 1996/97 through 2008/09
This table reveals the bivariate Pearson correlation coefficients between different pairs of firm specific variables. Ri, , BE/ME and LME are as defined in the Table 2. The correlation coefficients are based on the data on Ri, , BE/ME and LME from 61 sample firms listed in NEPSE till mid-April 2010 with 455 observations for the period 1996/97 through 2008/09. * sign indicates that correlation is significant at 1 percent level. Ri Ri BE/ME LME 1.000 0.526* -0.299* 0.210* 1.000 -0.214* 0.201* 1.000 -0.638* 1.000 BE/ME LME

As Table 3 reports, common stock returns are positively related to stock beta and firm size and the relationships are significant at 1 percent level. On the other hand, stocks returns are significantly negatively related to book-to-market equity ratio. From among given set of firm specific variables, the stock beta reveals stronger positive relation with stock returns than other. Similarly, there exists high negative correlation between firm size and book-to-market equity. Gujarati (1995) states that high correlations (in excess of 0.8) are a sufficient but not necessary condition for the existence of multicolinearity because it can exist even though the correlations are comparatively low (less than 0.5). However, low correlations being observed among different pairs of explanatory variables in Table 3 gives sufficient evidence

Stock Beta, Firm Size and Book-to-Market Effects on Cross-Section of Common Stock Returns in Nepal  Surya Bahadur Rana

to believe that the problem of multicolinearity may not exist in the analysis. This has also been confirmed by employing variance inflationary factor (VIF) to test the problem of multicolinearity.

Properties of portfolios formed on two-way sorts

This section examines the properties of stock returns with respect to firm specific variables. Five equal percentiles portfolios were formed based on bivariate sorts of firm size and BE/ME, firm size and stock beta, and BE/ME and stock beta. The characteristics of average returns associated with each of these bivariate sorts of portfolios are described below. Average returns, firm size, and book-to-market equity Table 4 reports two dimensional variations in average returns that results when five firm size portfolios are each subdivided into five portfolios based on BE/ME for individual stocks. Within a firm size portfolio (across a row in Table 4), average returns decrease strongly with BE/ME. On average, the returns on the lowest and highest BE/ME portfolios in a size group differ by 36.03 percent (that is, 52.7 percent minus 16.67 percent). Similarly, from top to down in a column of average return shows that there is a positive relation between average return and firm size. On average, the spread of returns across the lowest and highest size portfolios in a BE/ME group is 19.72 percent (that is, 39.58 percent minus 19.86 percent). The results indicate that controlling for firm size, book-to-market equity captures strong variation in average returns. Similarly, controlling for book-to-market equity, firm size also can capture significant variation in average returns although the average returns from portfolio 4 to 5 have been declined. However, the direction of movement in average returns with respect to these two variables are opposite of those documented in Fama and French (1992). As reported in Table 3, the correlation between the cross-section of firm size and BE/ME for individual stocks is -0.638. The negative correlation is also apparent in the average values of firm size and BE/ME for the portfolios sorted in Table 4. Thus, firm with low market equity are likely to have poor prospects, resulting in a low average return and high book-to-market equity. Conversely, larger stocks are more likely to have good prospects with higher average returns and lower book-to-market equity.
Stock Beta, Firm Size and Book-to-Market Effects on Cross-Section of Common Stock Returns in Nepal  Surya Bahadur Rana

Table 4 Average Returns on Portfolios Formed on Firm Size and Book-to-Market Equity of 61 Sample Firms during the Period 1996/97 through 2008/09
This table shows the average returns of the five portfolios formed on firm size and book-to-market equity. Stocks sorted by firm size are shown in the order of low to high in the portfolio 1 to 5 from top to down and stocks sorted by BE/ME are shown in the order of low to high in the portfolio 1 to 5 across left to right. Firm size is measured by natural logarithm of market value of equity and BE/ME is the ratio of book value of equity to market value of equity. BE/ME Firm Size All Low - 1 2 3 4 High - 5 All 0.3136 0.1986 0.2405 0.2849 0.4484 0.3958 Low - 1 0.5270 0.4296 0.4718 0.5241 0.5792 0.6301 2 0.4131 0.2850 0.3087 0.3558 0.5837 0.5322 3 0.2431 0.1222 0.1626 0.2071 0.4153 0.3083 4 0.2183 0.0822 0.1618 0.2017 0.3646 0.2814 High - 5 0.1667 0.0741 0.0977 0.1357 0.2991 0.2268

Average returns, firm size, and stock beta Table 5 reveals two-way variations in average returns that results when five firm size portfolios are each subdivided into five portfolios based on stock beta for individual stocks. There is a positive relation between average returns and stock beta within a size group. On average, the returns on the lowest and highest stock beta portfolios in a size group differ by 40.38 percent (that is, 58.97 percent minus 18.59 percent). Similarly, there is also a general pattern of positive relation between average return and firm size within a beta group. On average, the difference of returns across the size portfolios in a beta group is 17.20 percent (that is, 37.74 percent minus 20.54 percent). The results indicate that controlling for firm size, stock beta can capture significant variation in stock returns as average returns move into the same direction with beta in a size group. Similarly, controlling for stock beta, firm size also can capture much of the variation in average returns. Specifically it has been observed that there is an increase in average returns from portfolio 1 to 4 in a beta group, and then decrease in size portfolio from the portfolio 4 to 5. The correlation between firm size and stock beta for individual stocks was observed to be 0.201 and significant at 1 percent level as indicated in Table 3 in the earlier section. This positive relation has been also revealed by the average values of firm size and
Stock Beta, Firm Size and Book-to-Market Effects on Cross-Section of Common Stock Returns in Nepal  Surya Bahadur Rana

stock beta in the portfolios sorted in Table 5. This implies that smaller size stocks are likely to have poor prospects with low average returns and low beta, and larger stocks are more likely to have good prospects of having higher average returns with higher beta. Table 5 Average Returns on Portfolios Formed on Firm Size and Stock Beta of 61 Sample Firms during the Period 1996/97 through 2008/09
This table shows the average returns of the five portfolios formed on firm size and stock beta. Stocks sorted by firm size are shown in the order of low to high in the portfolio 1 to 5 from top to down and stocks sorted by stock beta are shown in the order of low to high in the portfolio 1 to 5 across left to right. Stock Beta Firm Size All Low - 1 2 3 4 High - 5 All 0.3124 0.2054 0.2455 0.2872 0.4466 0.3774 Low - 1 0.1859 0.0758 0.1168 0.1599 0.3321 0.2447 2 0.1973 0.0775 0.1273 0.1686 0.3501 0.2628 3 0.2619 0.1401 0.1925 0.2197 0.4161 0.3411 4 0.3273 0.2190 0.2551 0.3031 0.4918 0.3677 High - 5 0.5897 0.5144 0.5356 0.5847 0.6431 0.6709

Average returns, book-to-market equity, and stock beta The characteristics of average returns with respect to two-way sort of portfolios based on book-to-market equity and then stock beta are reported in Table 6. The portfolios were first sorted into five equal BE/ME group and then each BE/ME portfolios were subdivided into five beta group portfolios. The results show that average returns increase with beta in a BE/ME group (across the row), and decrease with BE/ME within a beta group (across the column). On average, there is 40.79 percent difference in average returns of high and low beta portfolio in a BE/ME group, whereas the spread of low and high BE/ME portfolio in a beta group is only 35.45 percent. The results indicate that, controlling for book-to-market equity, beta can capture strong variations in average returns. Similarly, controlling for stock beta, book-tomarket equity also can capture significant variation in average returns but in opposite direction to that documented in Fama and French (1992). The observed

Stock Beta, Firm Size and Book-to-Market Effects on Cross-Section of Common Stock Returns in Nepal  Surya Bahadur Rana

correlation between BE/ME and stock beta was -0.214 and was significant at 1 percent level as reported in Table 3. This negative relation between BE/ME and stock beta has also been established in the BE/ME and beta sorted portfolios in Table 6. The results suggest that lower book-to-market stocks are likely to have higher average returns with higher beta, and higher book-to-market stocks are more likely to have lower average returns with lower beta. Table 6 Average Returns on Portfolios Formed on Book-to-Market Equity and Stock Beta of 61 Sample Firms during the Period 1996/97 through 2008/09
This table shows the average returns of the five portfolios formed on book-to-market equity and stock beta. Stocks sorted by book-to-market equity are shown in the order of low to high in the portfolio 1 to 5 from top to down and stocks sorted by stock beta are shown in the order of low to high in portfolio 1 to 5 across left to right. Stock Beta BE/M E All Low 1 2 3 4 High 5 All 0.3122 0.5217 0.4112 0.2427 0.2180 0.1672 Low - 1 0.1835 0.4160 0.2850 0.0950 0.0897 0.0319 2 0.1946 0.4343 0.3072 0.1126 0.0869 0.0320 3 0.2624 0.5196 0.3762 0.1767 0.1428 0.0966 4 0.3289 0.5425 0.4482 0.2340 0.2382 0.1816 High - 5 0.5914 0.6961 0.6395 0.5952 0.5322 0.4939

Cross-sectional regression analysis

In order to test the statistical significance and robustness of the results, this study also relies on cross-sectional regression model specified in equation (1). It basically deals with regression results from various specifications of the model to examine the estimated relationship of common stock returns with firm specific variables for cross-sectional data of 61 sample firms that include 455 observations during the period 1996/97 through 2008/09. The regression results are reported in Table 7. The simple regression result of stock returns on beta in model specification I shows a positive relationship of stock returns with stock beta. The slope coefficient of stock beta is significant at 1 percent level which implies that stock returns increase with stock beta. However, the result also indicates that the intercept term is
Stock Beta, Firm Size and Book-to-Market Effects on Cross-Section of Common Stock Returns in Nepal  Surya Bahadur Rana

significantly different from zero. The empirical validity of the CAPM lies on the notion that stock returns should have significant positive linear relation with stock beta and the intercept term should not be statistically significant. The statistical significance of the intercept term in this study raises a doubt on empirical validity of the CAPM in the context Nepalese stock market. This result is consistent with Black, Jensen, and Scholes (1972) where the study reported a linear empirical market line with positive trade-off between return and market risk denoted by beta. However the intercept term in the study was also found statistically different from zero that rejected empirical validity of the CAPM. Table 7 Estimated Relationship from Cross-Sectional Regression of Stock Returns on Beta, Firm Size, Book-to-Market Equity Ratio, and Earnings-to-Price Ratio for 61 Sample Firms with 455 Observations during the Period 1996/97 through 2008/09
Model 1: Rit = +b1t it + b2t LMEiit + b3t BE/MEit + eit This table shows regression results of stock returns on four firm specific variables based on pooled cross-sectional data of 61 firms listed in NEPSE with 455 observations from the year 1996/97 to 2008/09. The regression results consist of various specifications of the model 1 in the form of simple and multiple regressions. The reported values are intercepts and slope coefficients of respective explanatory variables with t-statistics in the parentheses. Dependent variable is the stock return denoted as Rit, and independent variables are stock beta (it), firm size (LMEit), and book-to-market equity ratio (BE/MEit). The reported results also include the values of F-statistics (F) and adjusted coefficient of determination (Adj. R2). The single asterisk (*) sign indicates that result is significant at 1 percent level. Model I II III IV V VI VII Intercept 0.163 (5.339*) -0.114 (-1.150) 0.570 (11.419*) -0.052 (-0.608) 0.343 (7.247*) 0.487 (3.073*) 0.394 (2.855*) 0.152 (12.116*) 0.158 (12.452*) 0.152 (12.137*) 0.027 (0.549) -0.017 (-0.399) 0.090 (2.683*) -0.246 (-4.893*) -0.351 (-4.781*) -0.262 (-4.076*) Dependent Variable: Stock Returns LME BE/ME F 0.165 173.440* (13.170*) 0.174 (4.567*) -0.377 (-6.670*) 20.862* 44.493* 91.504* 103.083* 22.363* 68.647* Adj. R2 0.275 0.042 0.087 0.285 0.310 0.086 0.309

Stock Beta, Firm Size and Book-to-Market Effects on Cross-Section of Common Stock Returns in Nepal  Surya Bahadur Rana

Similarly, the regression result of stock returns on firm size in model specification II shows a positive relationship between stock returns and firm size and the regression coefficient of firm size is statistically significant at 1 percent level. In another simple regression result of specification III, common stock returns are observed to be negatively related with book-to-market equity and coefficient is again significant at 1 percent level. However, the result indicates that only 8.7 percent variations in common stock returns are captured by book-to-market equity. In all simple regressions, except specification I, despite of statistical significance of F-value, the firm specific variables such as firm size, and book-tomarket equity ratio individually explains small variations in common stock returns as indicated by adjusted R2 in the respective model specifications. In specification VII, three variables, namely stock beta, firm size, and book-tomarket equity, have been used as explanatory variables. The results show that stock returns have significant positive relation with stock beta and significant negative relation with book-to-market equity. However, a surprising result has been obtained in relation to firm size that its observed direction of relation has been reversed although the size coefficient is not statistically significant. This study hypothesized that common stock returns are positively related to stock beta and book-to-market equity and negatively related to firm size. Thus, the observed relationship of common stock returns with stock beta is according to priori sign expectation although the priori sign expectations do not hold with other firm specific variables. In cross-sectional regression, data are often collected on the basis of a probability sample of cross-sectional firms so that there is no prior reason to believe that the error term pertaining to one firm is correlated with the error tem of another firm. If by chance such a correlation is observed in cross-sectional firms, it is called spatial autocorrelation, that is, correlation in space rather than over time. However, it is important in cross-sectional analysis that the ordering of the data must have some logic, or economic interest, to make sense of any determination of whether spatial autocorrelation is present or not. In this study, cross-sectional data have the ordering over time so that there is a need to detect the problem of autocorrelation, and it has been confirmed by using Durbin-Watson (DW) d-statistic. Similarly, in a multiple regression analysis, the problem of multicolinearity is more prominent.
Stock Beta, Firm Size and Book-to-Market Effects on Cross-Section of Common Stock Returns in Nepal  Surya Bahadur Rana

Therefore, the diagnostic check of the model has been conducted using variance inflationary factor (VIF) of explanatory variables to detect the multicolinearity problem, if any, associated with multiple regressions of specification IV through VII. As argued by Durbin and Watson (1951), if computed DW is less than lower bound critical value (dL), there is enough evidence to believe that the problem of positive autocorrelation exists. If it lies between dU to 4-dU, there is no evidence of autocorrelation. However if computed DW falls in between of lower and upper bound critical value, the result is inconclusive as to whether the problem of autocorrelation exists or not. Analyses show that computed DW for all the model specifications falls in between dU to 4-dU so that there is no evidence of autocorrelation. With regard to multicolinearity, the analyses also show that variance inflationary factors (VIF) of explanatory variables across all the model specifications are significantly lower than 10. Therefore, there is also no evidence of multicolinearity in the regression model.

The CAPM and the three-factor model

The empirical tests of CAPM (for example Friend and Blume, 1970; Black, Jensen & Scholes, 1972; Fama & Macbeth, 1973, among others) have asserted that stocks can earn higher returns if they have a high beta. There is a general agreement that if the CAPM is a better model of the reward-risk trade-off for securities, beta should be a better measure of risk. However, the studies (for example, Rosenberg, Reid, & Lanstein, 1985; Fama & French, 1992; 1993; 1995; Lakonishok, Shleifer, & Vishny, 1994; Kothari, Shanken, & Sloan, 1995; Daniel, Titman, & Wei, 2001, among others) have also shown that the single risk factor is not quite enough for describing crosssectional variations in common stock returns. The current consensus is that firm size and book-to-market equity factors are pervasive risk factors besides the overall market risk factor. Therefore, this section attempts to explore the economic performance of the CAPM versus the three-factor model in explaining crosssection of common stock returns. In order to test the performance of CAPM versus three-factor model, this study relies on regression analysis of the empirical CAPM and three-factor model. The regression results have been reported in Table 8. The CAPM model reports the simple regression results, where excess stock returns have been regressed on
Stock Beta, Firm Size and Book-to-Market Effects on Cross-Section of Common Stock Returns in Nepal  Surya Bahadur Rana

excess market returns, and FF model reports the multiple regression results where excess stock returns have been regressed on market risk factor, size factor, and book-to-market equity factor. At first it is necessary to note that empirical validity of the CAPM will be established if slope coefficient of market risk factor is significantly positive and intercept term is not statistically different from zero. The results report the intercept value of 0.059 with t-statistic of 1.762. The intercept term is marginally significant at 10 percent level. It, thus, implies that intercept is statistically different from zero and rejects the second condition of empirical CAPM. On the other hand, the same results report regression slope coefficient of 1.077 with t-statistic of 12.376. The coefficient is statistically significant at 1 percent level. The results indicate that stock returns are significantly positively related to market risk factor. But the statistical significance of the market risk factor coefficient satisfies only first condition of empirical CAPM. Therefore, the regression results for the CAPM shown in Table 8 are not consistent with the expectations. Table 8 Estimated Relationship from Regression of Excess Stock Returns on Market Risk Factors, Firm Size Factors, and Book-to-Market Equity Factors for 61 Sample Firms with 455 Observations during the Period 1996/97 through 2008/09 CAPM Model: Rit RFt = i + bi [RMt RFt] + eit FF Three-Factor Model: Rit RFt = i + bi[RMt RFt] + si(SMBt) + hi(HMLt) + eit
This table presents comparative regression results of the CAPM and Fama-French three-factor model. The dependent variable is the excess of stock returns over risk-free rate and denoted by Rit RFt. The independent variables are market risk factors [RMt RFt], size factors (SMBt) measured as small minus big size portfolio, and book-to-market factors (HMLt) measured as high minus low book-tomarket equity portfolio. The sample includes 61 firms listed in NEPSE till mid-April 2010 with 455 observations from the year 1996/97 to 2008/09. b denotes to the coefficient of market risk factor, s refers to the coefficient of size factor, and h is the coefficient of book-to-market equity factor. The reported values are intercepts and slope coefficients, and figures in the parentheses are t-statistics. Also reported are the F-statistics, and adjusted coefficient of determination (Adj. R2). *, **, and *** indicate that results are significant at 1, 5, and 10 percent levels respectively. Model CAPM FF Intercept 0.059 (1.762***) -0.198 (-0.583) Dependent Variable: Excess Stock Returns b s h F 1.077 153.159* (12.376*) 1.085 0.672 -0.636 73.087* (12.119*) (2.587**) (-6.480*) Adj. R2 0.251 0.323

Stock Beta, Firm Size and Book-to-Market Effects on Cross-Section of Common Stock Returns in Nepal  Surya Bahadur Rana

Table 8 also shows the regression results of FF three-factor model. The coefficient of market risk factor is 1.085 with a t-value of 12.119. The effect size of the market risk factor has been slightly improved with the coefficient significant at 1 percent level. Besides the coefficient of market risk factor, other coefficients are also statistically significant. The firm size factor coefficient is 0.672 with a t-value of 2.587 which is significant at 5 percent level. Similarly, coefficient of book-to-market equity factor is -0.636 with t-value of -6.480, which is significant at 1 percent level. The results exhibit an increase in explanatory power of three-factor model as compared to CAPM results because adjusted R2 has been increased to 0.323 with significant F-value and intercept term not statistically different from zero. The results also reveal that FF three-factor model is able to explain the book-to-market and firm size effects. It has documented a negative HML coefficient which means that high book-to-market stocks have lower expected returns than low book-tomarket stocks. However, the direction of book-to-market effect contradicts with Drew and Veeraraghavan (2003), and Gaunt (2004), among other, who observed positive HML coefficient. Hence, the results in this study suggest that low book-to market firms are more risky than their high book-to-market counterparts thereby attracting a risk premium. The results also show a positive SMB coefficient implying that larger stocks have higher expected returns than smaller stocks. But, again, the direction of firm size effect contradicts with Halliwell, Heaney, and Sawicki (1999), Drew and Veeraraghavan (2003) and Gaunt (2004), among others, who reported a negative SMB coefficient. On the whole, the applicability of the FF three-factor model in explaining Nepalese stock returns has to be up-weighted due to significant s and h coefficient along with the significant coefficient for market risk factor (b).

5. CONCLUSION
The study revealed an important picture in relation to the significance of market risk factor, and firm specific variables in predicting stock returns. Rationality-based asset-pricing models assert that the cross-section of stock returns can be explained by betas or factor loadings on a set of common factors (Chou, Chou & Wang, 2004). Early evidence in the 1970s largely supported the Sharpe-Linter-Black (SLB) capital asset pricing model and the efficient market hypothesis. The seminal work of Fama
Stock Beta, Firm Size and Book-to-Market Effects on Cross-Section of Common Stock Returns in Nepal  Surya Bahadur Rana

and French (1992), however, identified market value of equity and the ratio of book-to-market equity as the two major determinants of the cross-sectional expected returns, and sentenced the death of beta. The major conclusion of this study is that the firm size does not explain the common stock returns in the context of stock market in Nepal. The results show the inconsistent relationship of firm size with common stock returns, and hence its effects are not conclusive. On the other hand, book-to-market equity and stock beta effects on common stock returns are consistent across all the analyses and all the specifications of the model. The results indicate very strong role of stock beta and book-to-market equity to explain common stock returns in Nepal. Stock beta has consistently significant explanatory power in all the models indicating that stocks with higher beta have higher returns. Similarly, book-to-market equity also has consistent significant negative relation with stock returns in all cases. The results associated with positive and significant relationship between stock returns and beta do not support the findings of some earlier studies such as by Banz (1981), Stambaugh (1982), Fama and French (1992) and others. So far the results in this study are concerned, although the stock returns are significantly explained by stock beta or market risk factor, the underlying assumption of CAMP does not completely hold in Nepalese stock market as intercept term in empirical CAPM has been observed to be marginally significant. On the other hand, results support Fama and French (1995) three-factor model because intercept term in empirical FF three-factor model has been observed to be not significant, and the evidences establish market risk factor, firm size factor and book-to-market factor as the most significant determinants of stock returns in Nepal. However, the direction of relationship of size and book-to-market equity factors with excess stock return contradicts from priori hypothesis. The conclusions derived from this study, however, deserve some considerations from the methodological aspects and thus can not be generalized. First, this study used annual closing price of shares of common stock to provide an estimate of stock returns and annual closing NEPSE index to estimate market return. Annual closing prices and stock indexes are suffered from high deviations and thus inflate the annual returns. Therefore, future studies should be directed towards computing returns from daily or weekly or monthly observations of closing prices. Second, this study has assumed linear relationship between stock returns and explanatory variables. In emerging markets, it is expected that there exists nonStock Beta, Firm Size and Book-to-Market Effects on Cross-Section of Common Stock Returns in Nepal  Surya Bahadur Rana

linearity. Moreover, emerging markets are characterized by less frequent transactions termed as thin trading. In order to incorporate these issues, the future studies are suggested to apply non-linear models to test the predictive power of explanatory variables. Third, this study used few firm specific variables to assess the cross-sectional variations in stock returns. Inclusion of some other variables, for example cash flow to price (Chan, Hamao, & Lakonishok, 1991) leverage (Fama & French, 1992), annual sales growth (Davis, 1994), sales-to-price and debt-to-equity ratio (Barbee, Mukherji, & Raines, 1996), may provide an important insight into the cross-sectional relationship of common stock returns in Nepal. Therefore, future studies are recommended to include these variables as well. Lastly, this study used over 75 percent observations from banking and financial sectors. The results are thus not representative of all sectors of the economy. Hence, future studies are suggested to include significant number of observations from the sectors other than banks and financial institutions as well.

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Stock Beta, Firm Size and Book-to-Market Effects on Cross-Section of Common Stock Returns in Nepal  Surya Bahadur Rana

The Lumbini Journal of Business and Economics, Vol. 1, April, 2011