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International Research Journal of Finance and Economics

ISSN 1450-2887 Issue 29 (2009)


© EuroJournals Publishing, Inc. 2009
http://www.eurojournals.com/finance.htm

Company Fundamentals and Equity Returns in India

Vanita Tripathi
Senior Lecturer Department of commerce Delhi School of Economics
University of Delhi, Delhi-110007
Tel: 91-011-27667891; 9213269951
E-mail: vtripathi@commerce.du.ac.in

Abstract

This paper examines the relationship between four company fundamental variables
(viz. market capitalization, book equity to market equity ratio, price earnings ratio and debt
equity ratio) and equity returns in Indian stock market using monthly price data of a sample
of 455 companies over the period June 1997 to June 2007. We also investigate whether the
inclusion of any one or more of these fundamental variables can better explain cross
sectional variations in equity returns in India than the single factor CAPM and whether
there are any seasonality patterns in equity returns. We find that market capitalization and
price earnings ratio have statistically significant negative relationship with equity returns
while book equity to market equity ratio and debt equity ratio have statistically significant
positive relationship with equity returns in India. The investment strategies based on these
variables produced extra risk adjusted returns over the study period. We further find that
Fama French three factor model ( viz. market risk premium, size premium and value
premium) explains cross sectional variations in equity returns in India in a much better way
than the single factor CAPM. However we did not find any seasonality patterns ( April or
January Effect) in equity returns in India. These results have important implications for
market efficiency, asset pricing and market microstructure issues in Indian stock market.

Keywords: Size Effect, Value effect, P/E effect, Leverage effect, CAPM, Asset pricing,
Seasonality effect.
JEL Classification Codes: G12, G14

I. Introduction
In an emerging stock market like India, investment analysts and market participants are continuously in
search for investment strategies that can outperform the market. Efficient Market Hypothesis (EMH)
rules out the possibility by anybody to consistently earn extra normal return in an efficient stock
market. According to this hypothesis securities are correctly priced and return is solely determined by
the amount of risk one assumes (as per the standard Capital asset Pricing Model – CAPM). However a
plethora of empirical studies doubts such a phenomenon and documents the availability of extra normal
returns by using investment strategies based on firm specific variables such as size (Banz (1981)),
leverage (Bhandari (1988)), price earnings ratio (Basu (1977)), book equity to market equity ratio
(Stattman (1980), Rosenberg, Reid and Lanstein (1985)) etc. These empirical evidences have been
commonly cited as anomalies to CAPM based on company fundamentals and popularly known as the
size effect (small capitalization stocks outperform large capitalization-stocks), leverage effect (high
debt-equity stocks outperform low debt-equity stocks), Price Earnings Effect (low p/E stocks
International Research Journal of Finance and Economics - Issue 29 (2009) 189

outperform high P/E stocks) and value effect (high book equity to market equity stocks outperform low
book to market equity stocks).
Two schools of thought have emerged in search for possible explanation of persistent departure
from the standard CAPM. One argument is that CAPM is mis specified; there is/are some missing risk
factor(s) which beta fails to capture. Hence there is a move towards multifactor asset pricing
framework as specified by Fama and French (1996). The other school blames the investors'
irrationality for the existence of the phenomenon. Whatever be the cause, the presence of these CAPM
anomalies provide gainful investment opportunities to the investing community. The robustness of size
and value effects in US stock market motivated Fama and French (1992, 1993, 1996) to suggest the
inclusion of a size and value factor in asset pricing model. A number of research studies have explored
the economic feasibility of investment strategies based on fundamental variables, but most of these
studies relate to US and other mature markets. Similar evidence for emerging markets including India
is limited and more recent in origin. Moreover no attempts have been made in Indian context to seek
the opinion of practitioners (e.g. equity analysts, mutual fund managers and investors at large) and
simultaneously perform secondary data analysis to substantiate (or disprove) their perceptions about
Indian stock market in general and performance of company fundamentals based investment strategies
in particular. The present study attempts to fill up this gap.
As a result of financial sector reforms initiated since early 1990s the Indian stock market has
witnessed metamorphic changes as regards to the size, structure and turnover. With more than 4700
listed companies, 2 crore shareowners and a market capitalization of Rs.30,257,720 million (in 2005-
06) developments in Indian stock markets are now comparable to those in other mature markets. Hence
there is a felt need for a study which can examine the relationship between various company
fundamentals and equity returns in Indian stock market in this changed regime and test for the
economic feasibility of fundamentals based investment strategies in the advent of technological up
gradation. The results of the study are of pertinent use by investment analysts, mutual fund managers
as well as marginal investors in devising fundamentals based investment strategies to earn extra-
normal returns in Indian stock market.

II. Research Objectives


The primary objectives of the study are :
• to examine the relationship between four company fundamentals (size, leverage, P/E ratio and
Book to market equity ratio) and equity returns in India.
• to test whether the investment strategies based on these company fundamentals yield any extra
risk adjusted returns in Indian stock market.
• to check whether the inclusion of any or more of these fundamental variables can better explain
cross sectional variations in average equity returns in India. In other words whether a multifactor
model can better explain cross-sectional variations in equity returns in India or not.
• to analyse the investment strategies used and/or recommended by equity analysts, fund managers
and active investors in Indian stock market.
The study also attempts to examine the following research issues :
• Whether arbitrage opportunities are available in Indian stock market.
• Whether the frequency of portfolio re-balancing has any effect on the documented
relationship between firm fundamentals and stock returns.
• Whether company fundamentals can explain variation in average stock return in a better
way than market factor in Indian context.
• Whether there is any seasonality effect in Indian stock market.
• What are the perceptions of equity analysts, fund managers and active investors about
Indian stock market in general.
190 International Research Journal of Finance and Economics - Issue 29 (2009)

• Whether there has been any change in the investment strategies of Indian investors over the
past five years.

III. Research Hypotheses


Following hypotheses have been tested in the study –

I. Regarding company fundamentals and equity returns in India.


(iii) There is a statistically significant relationship between company size (measured by market
capitalization; MC) and equity returns in India.
(iv) There is a statistically significant relationship between Price-Earnings ratio (P/E ratio) and
equity returns in India.
(v) There is a statistically significant relationship between Book equity to market equity ratio
(BE/ME ratio) and equity returns in India.
(vi) There is a statistically significant relationship between financial leverage (measured by Debt
equity (D/E) ratio) and equity returns in India.
(vii) Stocks of small companies outperform the stocks of large companies in Indian stock market.
(viii) Low P/E stocks outperform the stocks of high P/E ratio companies.
(ix) High BE/ME stocks outperform low BE/ME stocks.
(x) Stocks of companies with high D/E ratio outperform the stocks of low D/E ratio companies.
(xi) The investment strategy based on company size yields extra normal returns in Indian stock
market.
(xii) The investment strategy based on P/E ratio of companies yields extra normal returns in Indian
stock market.
(xiii) The investment strategy based on BE/ME ratio of companies yields extra normal returns in
Indian stock market.
(xiv) The investment strategy based on D/E ratio of companies yields extra normal returns in Indian
equity market.
(xv) More frequent rebalancing of portfolios yields still higher extra normal returns.

II. Regarding cross sectional variations in equity returns in Indian stock market.
(i). Company size can better explain cross sectional variations in equity returns in Indian stock
market than market factor.
(ii). P/E ratio can better explain cross sectional variations in equity returns in Indian stock market
than market factor.
(iii). BE/ME ratio can better explain cross sectional variations in equity returns in Indian stock
market than market factor.
(iv). D/E ratio better explain cross sectional variations in equity returns in Indian stock market than
market factor.
(v). A two factor model (excess market return and size premium) can better explain cross sectional
variations in equity returns in Indian stock market than the single factor CAPM.
(vi). A two factor model (based on excess market return and P/E risk premium) can better explain
cross sectional variations in equity returns in Indian stock market than the single factor CAPM.
(vii). A two factor model (based on excess market return and BE/ME risk premium, also known
popularly as value premium) can better explain cross sectional variations in equity returns in
Indian stock market than the single factor CAPM.
(viii). A two factor model (based on excess market return and leverage risk premium) can better
explain cross sectional variations in equity returns in Indian stock market than the single factor
CAPM.
International Research Journal of Finance and Economics - Issue 29 (2009) 191

(ix). A two factor model (based on size premium and P/E risk premium) can better explain cross
sectional variations in equity returns in Indian stock market than the single factor CAPM.
(x). A two factor model (based on size premium and BE/ME or value premium) can better explain
cross sectional variations in equity returns in Indian stock market than the single factor CAPM.
(xi). A two factor model (based on size premium and leverage risk premium) can better explain
cross sectional variations in equity returns in Indian stock market than the single factor CAPM.
(xii). A two factor model (based on P/E risk premium and BE/ME or value premium) can better
explain cross sectional variations in equity returns in Indian stock market than the single factor
CAPM.
(xiii). A two factor model (based on P/E risk premium and leverage risk premium) can better explain
cross sectional variations in equity returns in Indian stock market than the single factor CAPM.
(xiv). A two factor model (based on value premium and leverage risk premium) can better explain
cross sectional variations in equity returns in Indian stock market than the single factor CAPM.
(xv). A three factor model (based on excess market return, size premium and P/E risk premium) can
better explain cross sectional variations in equity returns in India than single factor CAPM
(based on excess market return only) or two factor models cited above (from (vi) to (xv)).
(xvi). A three factor model (based on excess market return, size premium and value premium) can
better explain cross sectional variations in equity returns in India than single factor CAPM
(based on excess market return only) or two factor models cited above (from (vi) to (xv)).
This is the famous Fama-French multifactor asset pricing model.
(xvii). A three factor model (based on excess market return, size premium and value premium
and leverage risk premium) can better explain cross sectional variations in equity
returns in India than single factor CAPM (based on excess market return only) or two
factor models cited above (from (vi) to (xv)).
(xviii). A three factor model (based on excess market return, P/E risk premium and value
premium) can better explain cross sectional variations in equity returns in India than
single factor CAPM (based on excess market return only) or two factor models cited
above (from (vi) to (xv)).
(xix). A three factor model (based on excess market return, P/E risk premium and leverage
risk premium) can better explain cross sectional variations in equity returns in India
than single factor CAPM (based on excess market return only) or two factor models
cited above (from (vi) to (xv)).
(xx). A three factor model (based on excess market return value premium and leverage risk
premium) can better explain cross sectional variations in equity returns in India than
single factor CAPM (based on excess market return only) or two factor models cited
above (from (vi) to (xv)).
(xxi). A three factor model (based on size premium, P/E risk premium and value premium)
can better explain cross sectional variations in equity returns in India than single factor
CAPM (based on excess market return only) or two factor models cited above (from (v)
to (xv)).
(xxii). A three factor model (based on size premium, P/E risk premium and leverage risk
premium) can better explain cross sectional variations in equity returns in India than
single factor CAPM (based on excess market return only) or two factor models cited
above (from (v) to (xv)).
(xxiii). A three factor model (based on size premium, value premium and leverage risk
premium) can better explain cross sectional variations in equity returns in India than
single factor CAPM (based on excess market return only) or two factor models cited
above (from (v) to (xv)).
(xxiv). A three factor model (based on P/E risk premium, value premium and leverage risk
premium) can better explain cross sectional variations in equity returns in India than
192 International Research Journal of Finance and Economics - Issue 29 (2009)

single factor CAPM (based on excess market return only) or two factor models cited
above (from (v) to (xv)).
(xxv). A four factor model (based on excess market return, size premium, P/E risk premium
and value premium) can better explain cross sectional variations in equity returns in
Indian stock market than any of the single factor two or three factors model.
(xxvi). A four factor model (based on excess market return, size premium, value premium and
leverage risk premium) can better explain cross sectional variations in equity returns in
Indian stock market than any of the single factor, two or three factors model.
(xxvii). A four factor model (based on excess market return, size premium, P/E risk premium
and leverage risk premium) can better explain cross sectional variations in equity
returns in Indian stock market than any of the single factor, two or three factors model.
(xxviii). A four factor model (based on excess market return, P/E risk premium, value premium
and leverage risk premium) can better explain cross sectional variations in equity
returns in Indian stock market than any of the single factor, two or three factors model.
(xxix). A four factor model (based on size premium, P/E risk premium, value premium and
leverage risk premium) can better explain cross sectional variations in equity returns in
Indian stock market than any of the single factor two or three factors model.
(xxx). A five factor model (based on excess market return, size premium, P/E risk premium
value premium and leverage risk premium) can better explain cross sectional variations
in equity returns in Indian stock market than any of the single factor, two factor, three
factor or four factor model.

III. Regarding Seasonality Patterns in Common Stock Returns


i. Equity returns in India are significantly higher in the month of January than in non-January
months.
ii. Equity returns in India are significantly higher in the month of April than in non-April months.

IV. Data and their Sources


The data comprises of the monthly closing adjusted share prices of 455 listed companies/stocks in
India (as included in S&P CNX 500 index) over the most recent 10 years period June 1997 to June
2007 (See Annexure I for List of Sample Companies). The monthly price data have then been
converted into monthly return data using the following equation :
P −P
R it = it i (t −1)
Pi ( t −1)
(1)
for i = 1 to 455 for t = 1 to 120where
Rit = Return on stock i in the month t
Pit = Closing adjusted share price of stock i in month t
Pi(t-1) = Closing adjusted share price of stock i in month t.
This gives us a monthly return series of 120 observations for every stock (or company)).
Monthly return on market portfolio (proxied by S&P CNX Nifty) has been calculated using equation
(1) except that in place of closing adjusted share prices we have used closing Index Values.
It is important to mention here that the entire data set (regarding four company fundamentals as
well as closing adjusted share prices) has not been available for all sample companies throughout the
sample period of 10 years. Hence effective number of companies used in the analysis ranges from 295
to 455.
Rate of returns on 91-days Treasury Bills has been used as a proxy for risk free return and S&P
CNX NIFTY, a broad based market index has been used as a proxy for the market portfolio. The study
also uses various accounting and financial information regarding the sample companies such as market
International Research Journal of Finance and Economics - Issue 29 (2009) 193

capitalization, P/E ratio, BE/ME ratio and D/E ratio. The data have been primarily collected from
PROWESS (a financial database of Centre for Monitoring Indian Economy) and web sources such as
rbi.org, sebindia.com and nseindia.com.

V. Operational Definitions of Various Company Fundamentals Used in the Study


As mentioned earlier we have used four company fundamentals in the study. The selection of these
fundamentals is based on the fact that robust CAPM anomalies have already been detected in
developed countries using these variables.
Table 1 provides operational definitions of various company fundamentals used in the study.

Table 1: Operational Definitions of Various Company Fundamentals used in the Study

S.No. Fundamental-Variable Measured by


1. Size Market capitalization (MC) as on June end every year
2. Price Earnings ratio Price Earnings ratio (P/E ratio) as on June end every year
Book equity to market equity ratio (BE/ME) ratio as on June end
3. Book Equity to Market Equity Rate every year. This is calculated as inverse of Price to Book value ratio
(PB ratio) provided by PROWESS database as on that date.
4. Financial leverage Debt equity ratio (D/E ratio) as on March end every year

VI. research Methodology


Internationally accepted methodology as used by Davis Fama and French (2000) and Chan, Hamao and
Lakonishok (1991) has been used to test various research hypotheses regarding relationship between
company fundamentals and equity returns.

(i). Construction of Portfolios


In June-end of year T all the sample companies are ranked on the basis of size (measured by market
capitalization : MC). The ranked sample companies are then divided into 5 equally weighted portfolios
namely P1MC, P2MC, P3MC, P4MC and P5MC. P1MC is the smallest sized portfolio consisting of
20% of companies with lowest size while P5MC consists of top 20% companies with largest size. The
process is repeated using P/E ratio, BE/ME ratio and D/E ratio as the sorting variable. Since the study
uses four company fundamental variables (MC, P/E, BE/ME and D/E) there are four sets of 5
portfolios each or in total 20 portfolios. Portfolios sorted on the basis of P/E ratio have been specified
as P1PE (lowest), P2PE, P3PE, P4P3 and P5PE (highest). Portfolios sorted on the basis of BE/ME ratio
are named as P1BEME (lowest), P2BEME, P3BEME, P4BEME and P5BEME (highest), while those
sorted on the basis of D/E ratio are specified as P1DE (lowest), P2DE, P3DE, P4DE and P5DE
(highest).
Portfolios are rebalanced on annual basis. Then monthly equally weighted returns on all
portfolios including market portfolio (proxied by S&P CNX NIFTY) have been calculated from July
1997 till June 2007 giving a total of 120 monthly observations. The relationship between company
fundamentals and stock returns has been tested using time series regression as implied in the famous
market model equation i.e.
R pt − R ft = a p + b p (R mt − R ft ) + e t (for t = 1 to 120) (2)
(for p = 1 to 20)
where
R pt − R ft =Excess return on portfolio i.e. return on portfolio P minus risk for return in month t.
R mt − R ft =Excess return on market portfolio in month t.
194 International Research Journal of Finance and Economics - Issue 29 (2009)

a =Intercept term
b = Slope coefficient (or beta coefficient) of the market factor.
et = error term
It musts be mentioned here that if ap = 0 then equation (2) reduces to Black Jensen Scholas
(1972) version of single factor CAPM. The null hypothesis is that there are no extra normal returns
earned on portfolios sorted on the basis of various company fundamentals which is equivalent to
testing ap = 0 for all sorted portfolios. The alternate hypothesis is ap ≠ 0. The hypothesis is tested at 5%
level of significance.
In order to test whether the investment strategy based our company fundamentals yields any
extra normal returns in Indian equity market, equation (2) is estimated for the following portfolios.
i. Portfolio consisting of long position in P1MC and a short position in P5MC which is SMB
(i.e. small minus big) i.e. size based investment strategy.
ii. Portfolio consisting of long position in P1PE and short position in P5PE and which is LMH
(low minus high) i.e. the P/E ratio based investment strategy.
iii. Portfolio consisting of long position in P5BEME and short position in P1BEME which is
HML (high minus low) i.e. BE/ME ratio based investment strategy.
iv. Portfolio consisting of long position in P5DE and short position in P1DE which is LEVG
(high leverage minus low leverage) i.e. leverage or D/E ratio based investment strategy.
In order to test whether inclusion of any one or more of the four company fundamentals (viz.
Market capitalization : MC, Price Earnings ratio : P/E, Book equity to market equity ratio : BE/ME and
Financial Leverage : D/E ratio) can better explain cross sectional variations in average equity returns in
Indian stock market we have used the methodology followed by [Davis, Fama and French (DFF) :
2000] with the following modifications.
i. DFF (2000) constructed and used only nine portfolios based on size and book to market
equity. We have constructed, and used 20 portfolios based on size, P/E ratio, book to
market equity ratio and D/E ratio.
ii. DFF (2000) used the following 3 factors and tested Fama-French three factor asset pricing
model equation :
Factors used by DFF (2000)
(a.) Market Risk Premium = (RM – RF)
(b.) Size Premium = SMB = Return differential between small & large firms portfolios.
(c.) Value Premium = HML (High Minus Low) = Return differential between high BE/ME
stocks portfolio and low BE/ME stocks portfolio.
Instead we have used the following five factors :
Factors used in the present study
(a.) Market Risk Premium = R M − R F
(b.) Size Premium = SMB (Small Minus Big) = Monthly Return differential between PIMC
(Smallest Stocks Portfolio) and P5MC (Largest Stocks Portoflio).
(c.) P/E risk premium = LMH (Low Minus High) = Monthly return differential between PIPE
(lowest P/E stocks portfolio) and P5PE (highest P/E stocks portfolio).
(d.) Value risk premium = HML (High Minus Low) = Monthly return different between P5DE
(Highest BE/ME stocks portfolio) and P1BEME (Lowest BE/ME stocks portfolio)
(e.) Leverage risk premium = LEVG = Monthly Return differential between P5DE (Highest
D/E stocks portfolio) and PIDE (Lowest D/E stocks portfolio).
Then we have estimated the following first pass time series regression equations for each
portfolio over the 120 months between July 1997 – June 2007. The standard notations used in
equations (3 to 33) are given below :
R pt = Portfolio return in month t
R ft = Risk free return in month t
International Research Journal of Finance and Economics - Issue 29 (2009) 195

R mt = Return on market portfolio in month t


SMBt = Size risk premium in month t
LMHt = P/E risk premium in month t
HMLt = Value premium in month t
LEVGt= Leverage risk premium in month t
a = Intercept
b = slope coefficient of market risk premium i.e. beta
s = Slope coefficient or factor loading of size risk premium
p = Slope coefficient or factor loading of P/E risk premium
h = Slope coefficient or factor loading of value risk premium
l = Slope coefficient or factor loading of leverage risk premium
et = error term
Statistically significant values of slope coefficient of various factors would indicate that those
factors are important in explaining cross sectional variations in portfolio returns otherwise not.
Moreover whether independent variable in a particular model significantly explain cross sectional
variations in equity portfolio returns or not can be detected by looking at its adjusted R2 value. The
higher the value of adjusted R2 the greater is the explanatory power of the independent variable(s)
included in the model.

I. Single Factor Model


Here one independent factor is used to estimate portfolio excess returns i.e. the dependent variable. We
have used all four company fundamentals separately for this purpose and compared the results with the
results of the single factor market model.
(i). Market alone
R pt − R ft = a + b(R mt − R ft ) + e t for t = 1 … 120
p = 1 … 20
(3)
(ii). Size alone
R pt − R ft = a + s(SMB t ) + e t (4)
(iii). P/E risk premium alone
R pt − R ft = a + p(LMH t ) + e t
(5)
(iv). Value premium alone
R pt − R ft = a + h (HML t ) + e t
(6)
(v). Leverage risk premium alone
R pt − R ft = a + l(LEVG t ) + e t (7)

II. Two Factor Model


Here we have used two independent variables to estimate portfolio excess returns i.e. the dependent
variable.
(i) Market and Size
R Pt − R ft = a + b(R mt − R ft ) + s(SMB t ) + e t (8)
(ii) Market and P/E risk premium
196 International Research Journal of Finance and Economics - Issue 29 (2009)

R Pt − R ft = a + b(R mt − R ft ) + p(LMH t ) + e t (9)


(iii) Market and Value Premium
R pt − R ft = a + b(R mt − R ft ) + h[HMLt] + e t (10)
(iv) Market and Leverage (D/E ratio) risk premium
R pt − R ft = a + b(R m − R ft ) + l(LEVG t ) + e t (11)
(v) Size and P/E risk premium
R pt − R ft = a + s[SMB t ] + p[LMH t ] + e t (12)
(vi) Size and value premium
R pt − R ft = a + s[SMB t ] + h[HML t ] + e t (13)
(vii) Size and Leverage risk premium
R pt − R ft = a + s[SMB t ] + l[LEVG t ] + e t (14)
(viii) P/E risk premium and value premium
R pt − R ft = a + p[LMH t ] + h[HML t ] + e t (15)
(ix) P/E risk premium and leverage premium
R pt − R ft = a + p[LMH t ] + l[LEVG t ] + e t (16)
(x) Value premium and leverage risk premium
R pt − R ft = a + h[HML t ] + l[LEVG t ] + e t (17)

III. Three Factor Model


Here we have included three independent factors to explain portfolio excess returns (i.e. the dependent
factor).
(i) Market, Size and P/E risk premium
R pt − R ft = a + b[R mt − R ft ] + s[SMB t ] + p[LMH t ] + e t (18)
(ii) Market, Size and value premium
R pt − R ft = a + b[R mt − R ft ] + s[SMB t ] + h[HML t ] + e t (19)
This is the famous Fama-French three factor asset pricing model equation
(iii) Market, Size and Leverage
R pt − R ft = a + b[R mt − R ft ] + s[SMB t ] + l [LEVG t ] + e t (20)
(iv) Market, P/E and value premium
R pt − R ft = a + b(R mt − R ft ) + p(LMH t ) + h (HML t ) + e t (21)
(v) Market, P/E and Leverage premium
R pt − R ft = a + b(R mt − R ft ) + p(LMH t ) + l (LEVG t ) + e t (22)
(vi) Market, Value and Leverage Premium
R pt − R ft = a + b(R mt − R ft ) + h (HML t ) + l (LEVG t ) + e t (23)
(vii) Size, P/E and value premium
R pt − R ft = a + s(BMB t ) + p(LMH t ) + h (HML t ) + e t (24)
(viii) Size, P/E and Leverage premium
R pt − R ft = a + s(SMB t ) + p(LMH t ) + l (LEVG t ) + e t (25)
International Research Journal of Finance and Economics - Issue 29 (2009) 197

(ix) Size, Value and Leverage premium


R pt − R ft = a + s(SMB t ) + h (HML t ) + l (LEVG t ) + e t (26)
(x) P/E, Value and Leverage Premium
R pt − R ft = a + p(LMH t ) + h (HML t ) + l (LEVG t ) + e t (27)

IV. Four Factor Model


Here we have included four independent variables to explain the dependent variable i.e. portfolio
excess returns.
(i) Market, Size, P/E and Value Premium
R pt − R ft = a + b(R mt − R ft ) + s(SMTt ) + p(LMH t ) + h (HML t ) + e t (28)
(ii) Market, Size, Value and Leverage Premium
R pt − R ft = a + b(R mt − R ft ) + s(SMB t ) + h (HML t ) + l (LEVG t ) + e t (29)
(iii) Market, Size, P/E and Leverage
R pt − R ft = a + b(R mt − R ft ) + s(SMB t ) + p(LMH t ) + l (LEVG t ) + e t (30)
(iv) Market, P/E, Value and Leverage Premium
R pt − R ft = a + b(R mt − R ft ) + p(LMH t ) + h (HML t ) + l (LEVG t ) + e t (31)
(v) Size, P/E, Value and Leverage
R pt − R ft = a + s(SMB t ) + p(LMH t ) + h (HML t ) + l (LEVG t ) + e t (32)

V. Five Factor Model


Here we have included all five factors under study as independent variables to estimate the portfolio
excess returns (i.e. dependent variable).
The estimated regression equation is
R pt − R ft = a + b(R mt − R ft ) + s(SMB t ) + p(LMH t ) + h (HML t ) + l (LEVG t ) + e t (33)
Seasonality effect is tested using dummy variable regression method.
Under it the following regression equation is used
RPt = a + bDt + et for t= 1,2........................120 (34)
Where
RPt = Excess monthly return of portfolio P in month t.
Dt = Dummy variable
Dt = 1 in seasonality month
= 0 in non-seasonality months
a = Regression intercept which measures the average returns for non-seasonality months
b = Slope coefficient measuring the difference between average return in seasonality month and
average return in other months.
et= Random error term
198 International Research Journal of Finance and Economics - Issue 29 (2009)

The null hypothesis of no significant difference between the average return in seasonality
month and average return in non-seasonality months is equivalent to testing that b = 0. The alternative
hypothesis is b > 0, i.e. the average return differential between seasonality and non-seasonality months
is positive (i.e. seasonality months provide higher average return than the non-seasonality months). The
hypothesis is tested at 5% level of significance.Related propositions of the study have been examined
using disruptive statistics, frequency distribution, Pearson coefficient of correlation and dummy
variable regression. We have used Statistical Package for Social Sciences (SPSS) and Excel for the
purpose of data analysis.

VII. Empirical Results


Table 2 presents cross correlation matrix of these fundamental variables for the sample companies. As
is evident there is positive but low relationship between size and P/E ratio.
There is negative but low relationship between size and D/E ratio; and size and BE/ME ratio.
However a statistically significant positive relationship exists between D/E ratio and BE/ME
ratio; and a statistically significant negative relationship exists between D/E ratio and P/E ratio and
BE/ME ratio and P/E ratio. Thus it may be said that in Indian context BE/ME ratio, P/E ratio and D/E
ratio tend to capture almost similar firm characteristics.

Table 2: Cross Correlation-Matrix of Various Fundamental Variables[Pearson's coefficient of correlation]

D/E P/E BE/ME Average Return


MC -0.209 .414 -.307 -.716**
D/E - -0.608** +.897** .821**
P/E - - -.764** -0.816**
BE/ME +0.765**
Note: Correlations are calculated across portfolios over the study period.

VIIa. Relationship Between Company Fundamentals and Equity Returns in Indian Stock
Market
To begin with the relationship between four company fundamentals viz. market capitalization, P/E
ratio, BE/ME ratio and debt equity ratio and average security returns are analysed using correlation
coefficients. The results are presented in Table 3. It can be observed that there exists a
i. statistically significant negative relationship between company size and average stock returns
over the study period.
ii. Statistically significant negative relationship between P/E ratio and average stock returns over
the study period.
iii. Statistically significant positive relationship between BE/ME ratio and average stock returns
over the study period.
iv. Statistically significant positive relationship between Debt Equity ratio and average stock
returns over the study period.
These results are further substantiated by constructing various portfolios on the basis of these
four company fundamentals and then analyzing the pattern of mean monthly returns and mean monthly
excess returns.
Table 3 provides summary statistics of monthly excess returns of all 20 portfolios sorted on the
basis of four company fundamentals, while Table 4 provides results of the market factor model.

(i). Regarding Company Size and Equity Returns


The results regarding size sorted portfolios are presented in Panel A of Table 3 and Panel A of Table 4.
It is clearly visible that mean monthly excess returns of smallest size portfolio (PIMC) is much higher
than that of largest sized portfolio (P5MC). The mean excess return of PIMC was found to be 3.34%
International Research Journal of Finance and Economics - Issue 29 (2009) 199

per month as against 1.02% per month or P5MC. This clearly provides a size premium (the return
differential between PIMC and P5MC) of 2.32% per month (t-value 5.800) or about 24% per annum
which is quite robust. However the standard deviation of PIMC is also higher than that of P5MC
pointing towards the intuitive fact that small firms are more risky than their large counterparts.

Table 3: Summary Statistics of monthly excess returns of Portfolios sorted on the basis of various company
fundamentals (Total Period July 1997- June 2007)
Panel A: Size Based (Firm Size increases as one moves from P1MC to P1MC)

Portfolio Mean SE (Mean) t(Mean) S.D.


P1MC .0334 .0085 3.929* .0986
P2MC .0245 .0088 2.784* .0967
P3MC .0237 .0088 2.693* .0964
P4MC .0127 .0084 1.512 .0924
P5MC .0102 .0077 1.325 .0848
SMB (P1MC-P5MC) .0232 .0040 5.800* .0442

Table 4: Results of the Market Model Rpt – Rft = a + b (RMt – Rft) + et


Panel A: Portfolios sorted on the basis of Size (MC)

Portfolio a b t(a) t(b) Adj R – Square


P1MC .0306 .932 2.573* 11.068* .505
P2MC .0163 .973 2.643* 11.303* .516
P3MC .0053 1.010 1.600 12.341* .560
P4MC .0082 1.016 1.317 12.904* .618
P5MC .0063 .943 1.329 14.310* .631

Panel A of Table 4 presents the results of the market model equation used to check for the
relationship between company size and equity returns in Indian stock market. It is clear that intercept
value (i.e. a) decline monotonically as one moves from PIMC to P5MC. The smallest sized portfolio
has provided an extra normal return of 3.06 percent per month as revealed by its "a" value which is
statistically significant (t-value 2.573 as against its critical value of 1.96). Thus we can reject null,
hypothesis (i.e. ap = 0) as intercept value for this portfolio is positive and statistically significant. The
same is true for P2MC. However as one moves from P1MC to P5MC there has been a sharp decline in
intercept value and for P3MC, P4MC and P5MC we do not find any statistically significant extra
normal returns. These findings indicate that the stocks of small firms outperformed those of large firms
over the study period. These results are in line with the results presented earlier by Mohanty (2001)
Sehgal & Muneesh (2002), Sehgal and Tripathi (2005) for Indian stock market. A look at the R2 value
reveals the fact that market factor is important in capturing a large amount of variation in equity returns
especially for the large stocks portfolios. It is important to note were that the R2 value (coefficient of
determination) is low for small stocks portfolio (e.g. 50.5% for PIMC as against 63.1% for P5MC)
suggesting that the portfolio of small stocks have larger unexplained variations in their returns.
The slope coefficient "b" (i.e. commonly known as beta coefficient) of all the portfolios have
been statistically significant but there has been no substantial difference between the beta coefficient of
small and large stocks portfolios. This might indicate that market risk of small firms is not substantially
higher than that of large firms.

(ii). Regarding Price Earnings Ratio (P/E ratio) and Equity Returns
These results are presented in Panel B of Table 3 and Panel B of Table 4. It can be clearly seen from
the summary statistics of monthly excess returns of all P/E ratio sorted portfolios that low P/E stocks
provided a statistically significant mean monthly excess return of 3.01% (t value 3.040) over the study
period as against 1.33% per month by high P/E stocks portfolio during the study period. The mean
monthly excess return declines as one moves from PIPE to P5PE. However as was the case with size
200 International Research Journal of Finance and Economics - Issue 29 (2009)

based portfolios, portfolio returns of low P/E stocks have also shown higher standard deviation (or
variability) than those of high P/E stocks. The LMH (low minus high) risk premium based on P/E ratio
has been found to be a statistically significant 1.68% per month (t value 3.111) or about 20% per
annum over the study period. If one looks at the intercept values of the market model results presented
in Panel B of Table 5, one finds that the "a" values decline monotonically as one moves from PIPE to
P5PE, showing that low P/E stocks portfolio provided the investors with statistically significant extra
risk adjusted returns over the study period. The lowest P/E stocks portfolio i.e. PIPE provided an extra
risk adjusted return of 2.17 percent per month (t value 2.879) as against 0.45 percent per month (t value
1.015) on highest P/E stocks portfolio i.e. P5PE.

Table 5: Evaluation of Investment Strategy Based on Various Company Fundamentals

Strategy based on a differential t (a differential)


MC .0243 2.273*
PE Ratio .0171 3.157*
BE/ME Ratio .0156 2.474*
DE Ratio .0125 2.502*

(iii)Regarding Book Equity to Market Equity Ratio (BE/ME Ratio) and Equity Returns
The summary statistics and market model results of portfolios sorted on the basis of BE/ME ratio are
presented in Panel C of Table 3 and Panel C of Table 4 respectively. As expected mean monthly excess
return of high BE/ME stocks portfolio (P5BEME) is much larger and statistically significant (3.06%
per month with t value 3.091) than that of low BE/ME stocks portfolio (P1BEME: 1.49% per month
with t value 1.886). Moreover the standard deviation of high BE/ME stocks portfolio is also higher
than that of low BE/ME stocks portfolio. The intercept value "a" as shown in Panel C of Table 4 also
increases monotonically from 0.67 per cent per month (t value 1.434) for P1BEME to 2.23 percent per
month (t value 2.957) for P5BEME suggesting that high BE/ME stocks portfolio generated higher risk
adjusted extra return during the study period. The value premium (i.e. the return differential between
P5BEME and P1BEME) is as high as 1.57 percent per month (t value 2.492) which is also statistically
significant. Hence we can conclude that during the study period a strong value effect existed in the
Indian stock market.However the intensity of this effect is slightly lower as found by Muneesh Kumar
and Sehgal (2004) and Sehgal and Tripathi (2005).

Table 3: Summary Statistics of monthly excess returns of Portfolios sorted on the basis of various company
fundamentals (Total Period July 1997- June 2007)
Panel C: BEME Ratio Based (BEME ratio increases as one moves from P1BEME to P5BEME)

Portfolio Mean SE (Mean) t(Mean) S.D.


P1BEME .0149 .0079 1.886 .0868
P2BEME .0195 .0088 2.216* .0908
P3BEME .0171 .0084 2.036* .0924
P4BEME .0243 .0085 2.858* .0930
P5BEME .0306 .0099 3.091* .1084
LMH (P1BEME-P5BEME) .0157 .0063 2.492* .0685
Note: *Significant at 5% level
International Research Journal of Finance and Economics - Issue 29 (2009) 201
Table 4: Results of the Market Model Rpt – Rft = a + b (RMt – Rft) + et
Panel C: Portfolios sorted on the basis of BE/ME Ratio

Portfolio a b t(a) t(b) Adj R – Square


P1BEME .0067 .9850 1.434 15.153* .658
P2BEME .0110 1.018 1.207 14.639* .642
P3BEME .0091 .958 1.595 12.076* .549
P4BEME .0166 .920 2.74* 10.929* .499
P5BEME .0223 .993 2.957* 9.439* .425

(iv).Regarding Debt-Equity Ratio (D/E ratio) and Equity Returns


Bhandari (1988) found leverage effect in equity returns implying that stocks of firms having high
financial leverage provide higher risk adjusted returns than those of firms having low financial
leverage. The results of our analysis regarding financial leverage (as measured by Debt Equity ratio)
and equity returns in India are presented in Panel D of Table 3 and Panel D of Table 4.

Table 3: Summary Statistics of monthly excess returns of Portfolios sorted on the basis of various company
fundamentals (Total Period July 1997- June 2007)
Panel D: Financial Leverage or D/E ratio based (D/E ratio increases as one moves from P1DE to P5DE)

Portfolio Mean SE (Mean) t(Mean) S.D.


P1DE .0140 .0080 1.750 .0877
P2DE .0151 .0080 1.887 .0873
P3DE .0212 .0082 2.585* .0898
P4DE .0240 .0086 2.791* .0943
P5DE .0271 .0096 2.823* .1056
LEVG (P5DE-P5DE) .0131 .0049 2.673* .0543

Table 4: Results of the Market Model Rpt – Rft = a + b (RMt – Rft) + et


Panel D: Portfolio sorted on the basis of D/E Ratio

Portfolio a b t(a) t(b) Adj R – Square


P1DE .0061 .947 1.186 13.257* .595
P2DE .0123 .942 1.398 13.231* .594
P3DE .0132 .960 2.478* 12.929* .583
P4DE .0156 1.003 2.770* 12.786* .577
P5DE .0186 1.023 2.845* 10.481* .478
Note: *Significant at 5% level

The summary statistics of monthly excess returns of various portfolios sorted on the basis of
D/E ratio show that mean monthly excess return of high D/E stocks portfolio (P5DE) has been 2.71
percent (t value 2.823) as against 1.40 percent (t value 1.750) on low D/E stocks portfolio (PIDE). As
expected the standard deviation of high D/E stocks portfolio is also higher than that of low D/E stocks
portfolio. The return differential between high and low D/E stocks portfolio, popularly known as
leverage risk premium (LEVG) has been found to be 1.31 percent per month (t value 2.673).
Panel D of Table 4 shows that the intercept terms 'a' of P3DE, P4DE and P5DE are higher and
statistically significant than those of PIDE and P2DE. The extra normal return of P5DE is 1.86 percent
per month (t value 2.845) as against 0.61 percent per month (t value 1.186) for PIDE. This suggests
that during the study period stocks of high financial leverage firms outperformed those of low financial
leverage firms implying the presence of a "leverage effect" in the Indian stock market.
A peculiar feature of all the above results has been that the slope coefficients (or beta
coefficients) of all portfolios have been statistically significant but R2 values have been lower for
PIMC, PIPE, P5BEME and P5DE portfolios and high for P5MC, P5PE, PIBEME and PIDE portfolios
suggesting that portfolios of small capitalization stocks, low P/E stocks, high BE/ME stocks and high
202 International Research Journal of Finance and Economics - Issue 29 (2009)

D/E stocks have larger unexplained variations in their returns than those of large capitalization stocks,
high P/E stocks, low BE/ME stocks and low D/E stocks although market factor has been important in
capturing cross sectional variations in average stock returns of all portfolios.

VIIb. Economic Evaluation of Company Fundamentals based Investment Strategy


The statistically significant relationship between company fundamentals and equity returns in India
gives rise to arbitrage opportunities which can be used to earn super normal returns (on risk adjusted
basis) in Indian stock market. Table 5 presents results regarding the extra returns (on a risk adjusted
basis) which can be generated by investment strategies based on four company fundamentals viz.
Market capitalization, P/E ratio, BE/ME ratio and D/E ratio. It can be observed that size based
investment strategy generated a statistically significant extra normal return of 2.43% per month (t value
2.273), P/E ratio based investment strategy provided 1.71% per month (t value 3.157), BE/ME based
strategy gave 1.56% per month (t value 2.474) and D/E ratio based strategy provided the investors with
an extra normal return of 1.25% per month (t value 2.502) over the study period.
The fact that all these investment strategies generated statistically significant extra normal
returns (on a risk adjusted basis) points towards the fact that arbitrage opportunities were present in
Indian stock market during the study period.

VIIc. Frequency of Portfolio Rebalancing and Relationship between Company Size and Portfolio
Returns
In order to assess the effect of frequency of portfolio rebalancing on the relationship between company
size and portfolio returns we rebalanced the portfolios (based on market capitalization) after every six
months i.e. June end and December end every year and calculated their monthly excess returns using
the same procedure as discussed in Section 3.2. The results are shown in Panel A and B of Table 6.
Here the size premium becomes 2.19% (t value 5.763) as against 2.32% (with annual rebalancing). The
results are not found to be drastically different from those of annually rebalanced portfolios and hence
we reject the hypothesis that more frequent rebalancing provides higher risk adjusted returns on small
stocks portfolios in Indian stock market.

Table 6: Results with half-yearly Rebalanced Portfolio (July 1997 – June 2007)
Panel A: Summary Statistics of Monthly Excess Returns of Size Sorted Portfolios

Portfolio Mean t(Mean) S.D.


P1MC .0331 3.988* .0901
P2MC .0241 2.802* .0961
P3MC .0170 1.954 .0969
P4MC .0151 1.819 .0897
P5MC .0112 1534 .0821
SMB (P1MC – P5MC) .0219 5.763* .0441
Note: *Significant at 5% level

Panel B: Results of Market Model

Portfolio a b t(a) t(b) Adj R-Square


P1MC .0232 .942 2.673* 10.057* .615
P2MC .0147 .978 2.731* 11.001* .627
P3MC .0101 1.010 1.519 13.198* .673
P4MC .0120 1.070 1.267 14.327* .737
P5MC .0072 0.989 1.437 15.069* .813
Note: *Significance at 5% level.
International Research Journal of Finance and Economics - Issue 29 (2009) 203

The empirical results regarding the role of company fundamentals in explaining cross sectional
variations in equity returns in Indian stock returns are presented from Table 7 to 11.
Panel C show results of single factor model with size as independent variable, Panel D shows
results of single factor model based on P/E risk premium while Panel E and F shows single factor
model results based on value premium and leverage risk premium.
It is clearly visible from Panel A to F of Table 7 that market factor (excess return on market
portfolio) captures the most part of cross-sectional variations in equity returns in India, but not all. No
other factor (be it size premium, P/E risk premium, value premium or leverage premium) can capture
any significant portion of cross sectional variations in average equity returns, in isolation, as all other
single factor models have very low R2 value as compared to the single factor market model. Hence we
conclude that the company fundamentals, per se, are not capable of explaining cross sectional
variations in equity returns in India. They must be clubbed with market factor (or some other
independent variable) to check whether the two factor model can better explain cross sectional
variations in equity returns in India or not.

Table 7: Single Factor Model Regression Results


Panel A: Summary Statistics of monthly excess returns of Portfolios sorted on the basis of various company
fundamentals(Total Period July 1997- June 2007)

Portfolio Mean SE (Mean) t(Mean) S.D.


P1MC .0334 .0085 3.929 .0986
P2MC .0245 .0088 2.784 .0967
P3MC .0237 .0088 2.693 .0964
P4MC .0127 .0084 1.512 .0924
P5MC .0102 .0077 1.325 .0848
SMB (P1MC-P5MC) .0232 .0040 5.800 .0442
P1PE .0301 .0099 3.040 .1089
P2PE .0241 .0081 2.975 .0883
P3PE .0206 .0082 2.512 .0902
P4PE .0160 .0083 1.927 .0907
P5PE .0133 .0081 1.6419 .0891
LMH (P1PE-P5PE) .0168 .0054 3.111 .0588
P1BEME .0149 .0079 1.886 .0868
P2BEME .0195 .0088 2.216 .0908
P3BEME .0171 .0084 2.036 .0924
P4BEME .0243 .0085 2.858 .0930
P5BEME .0306 .0099 3.091 .1084
HML (P1BEME-P5BEME) .0157 .0063 2.492 .0685
P1DE .0140 .0080 1.750 .0877
P2DE .0151 .0080 1.887 .0873
P3DE .0212 .0082 2.585 .0898
P4DE .0240 .0086 2.791 .0943
P5DE .0271 .0096 2.823 .1056
LEVG (P5DE-P5DE) .0131 .0049 2.673 .0543
PMKT .0084 .0065 1.292 .0716
Note: *All t-values above 196 are statistically significant.
204 International Research Journal of Finance and Economics - Issue 29 (2009)
Panel B: Results of the Market Model
Rpt – Rft = a + b (RMt – Rft) + et

Portfolio a b t(a) t(b) Adj R – Square


P1MC .0306 .932 2.573 11.068 .505
P2MC .0163 .973 2.643 11.303 .516
P3MC .0053 1.010 1.600 12.341 .560
P4MC .0082 1.016 1.317 12.904 .618
P5MC .0063 .943 1.329 14.310 .631
P1PE .0217 1.008 2.879 9.613 .434
P2PE .0167 .890 2.957 11.335 .517
P3PE .0127 .948 2.314 12.439 .563
P4PE .0101 .986 1.925 13.494 .603
P5PE .0045 1.042 1.015 16.675 .700
P1BEME .0067 .9850 1.434 15.153 .658
P2BEME .0110 1.018 1.207 14.639 .642
P3BEME .0091 .958 1.595 12.076 .549
P4BEME .0166 .920 2.74 10.929 .499
P5BEME .0223 .993 2.957 9.439 .425
P1DE .0061 .947 1.186 13.257 .595
P2DE .0123 .942 1.398 13.231 .594
P3DE .132 .960 2.478 12.929 .583
P4DE .0156 1.003 2.770 12.786 .577
P5DE .0186 1.023 2.845 10.481 .478
Note: *all t values above 1.96 statistically significant.

Panel C: Size as Independent Factor


R pt − R ft = a + b(SMB t ) + e t

Portfolio a s t(a) t(s) Adj. R2


P1MC .0151 .90 2.904 5.099 .174
P2MC .0184 .662 2.133 3.453 .082
P3MC .0189 .524 2.160 2.687 .050
P4MC .0172 .369 2.029 1.95 .023
P5MC .0151 -.100 1.904 -.569 -.006
P1PE .0242 .643 2.459 2.934 .060
P2PE .0199 .459 2.474 2.563 .045
P3PE .0165 .446 2.003 2.434 .040
P4PE .0147 .401 1.763 2.163 .030
P5PE .0096 .403 1.17 2.22 .032
P1BEME .0105 .480 1.336 2.738 .052
P2BEME .0158 .404 1.899 2.179 .031
P3BEME .0135 .394 1.589 2.087 .027
P4BEME .0200 .458 2.362 2.426 .039
P5BEME .0249 .458 2.362 2.426 .039
P1DE .0094 .497 1.187 2.813 .055
P2DE .0156 .492 1.187 2.813 .055
P3DE .0177 .385 2.144 2.097 .028
P4DE .0196 .475 2.281 2.482 .042
P5DE .5224 .504 2.326 2.344 .036
Note: *all t values above 1.96 statistically significant.
International Research Journal of Finance and Economics - Issue 29 (2009) 205
Panel D: P/E Risk Premium as Independent Factor
R pt − R ft = a + p(LMH t ) + e t

Portfolio a p t(a) t(p) Adj. R2


P1MC .0131 .609 1.590 4.502 .139
P2MC .0150 .561 1.734 3.948 .109
P3MC .0151 .513 1.729 3.579 .090
P4MC .0130 .454 1.545 3.276 .076
P5MC .0062 .474 .811 3.781 .108
P1PE .0121 1.068 1.429 7.671 .327
P2PE .0143 .585 1.84 4.596 .145
P3PE .0122 .496 1.505 3.716 .097
P4PE .0117 .395 1.400 2.880 .058
P5PE .0121 .0683 1.429 .490 -.006
P1BEME .0149 .013 1.801 .010 -.008
P2BEME .0138 .339 1.637 2.444 .040
P3BEME .0075 .568 .919 4.216 .129
P4BEME .0123 .714 1.549 5.496 .197
P5BEME .0139 .990 1.602 6.914 .282
P1DE .0093 .278 1.135 2.059 .027
P2DE .0134 .399 1.675 3.027 .064
P3DE .0126 .512 1.564 3.865 .015
P4DE .0143 .575 1.705 4.179 .122
P5DE .0128 .848 1.445 5.823 .217
Note: *all t values above 1.96 statistically significant.

Panel E: Value Premium as Independent Factor


R pt − R ft = a + h (HML t ) + e t

Portfolio a h t(a) t(h) Adj. R2


P1BEME .0157 -0.50 1.928 -.433 -.007
P2BEME .0148 .303 1.777 2.552 .044
P3BEME .0088 .523 1.111 4.573 .143
P4BEME .0135 .683 1.793 6.326 .247
P5BEME .0157 .950 1.928 8.144 .354
P1MC .0148 .543 1.836 4.709 .151
P2MC .0171 .469 1.996 3.825 .103
P3MC .0162 .476 1.905 3.904 .107
P4MC .0138 .434 1.684 3.609 .096
P5MC .0065 .485 .893 4.629 .147
P1PE .0167 .856 1.93 6.942 .218
P2PE .0147 .599 2.00 5.708 .210
P3PE .0132 .470 1.670 4.146 .120
P4PE .0127 .357 1.553 3.037 .065
P5PE .0113 .127 1.352 1.070 .001
P1DE .0102 .243 1.259 2.097 .028
P2DE .0147 .344 1.865 3.040 .065
P3DE .0138 .477 1.748 4.242 .125
P4DE .0149 .573 1.859 4.981 .167
P5DE .0150 .772 1.744 6.280 .244
Note: *all t values above 1.96 statistically significant.
206 International Research Journal of Finance and Economics - Issue 29 (2009)
Panel F: Leverage as Independent Factr
R pt − R ft = a = l(LEVG t ) + e t

Portfolio a l t(a) t(l) Adj. R2


P1MC .0157 .584 1.892 3.910 .107
P2MC .0175 .534 2.010 3.412 .082
P3MC .0159 .597 1.858 3.878 .106
P4MC .0129 .592 1.58 4.025 .113
P5MC .0066 .580 .886 4.338 .130
P1PE .0174 .970 1.934 5.994 .227
P2PE .0156 .650 2.043 4.731 .152
P3PE .0143 .480 1.758 3.274 .075
P4PE .0119 .490 1.46 3.328 .078
P5PE .0093 .300 1.132 2.017 .025
P1BEME .0127 .174 1.595 1.188 .003
P2BEME .0146 .378 1.748 2.521 .043
P3BEME .0101 .534 1.222 3.590 .091
P4BEME .0139 .786 1.793 5.612 .204
P5BEME .0173 1.017 1.967 6.420 .253
P1DE .0128 .0875 1.557 .589 -.006
P2DE .0145 .429 1.830 3.03 .063
P3DE .0135 .590 1.707 4.145 .120
P4DE .0148 .695 1.827 4.741 .153
P5DE .0128 1.088 1.557 7.321 .307
Note: *all t values above 1.96 statistically significant.

The results regarding various two factor regression models have been presented in Panel A to
Panel J of Table 8. It has been observed that here has been considerable improvement in adjusted R2
value when both excess market return and size premium are used as independent variables (See Panel
Aof Table 8). This can also be confirmed by the fact that the slope coefficient of size premium i.e. s is
statistically significant for all 20 portfolios while all (except six) intercept values i.e. 'a' values are very
low and not statistically significant. Hence we conclude that size and market factors together can better
explain cross sectional variations in equity returns in India than the market factor alone.
International Research Journal of Finance and Economics - Issue 29 (2009) 207
Table 8: Results of Two Factor Regressions for various portfolios
Panel A: Market and Size
R Pt − R ft = a + b(R mt − R ft ) + s(SMB t ) + e t

Portfolio a b s t(a) t(b) t(s) Adj.R2


P1MC .0070 .942 .926 1.439 14.264 8.652 .691
P2MC .0090 .980 .690 1.76 12.738 5.535 .672
P3MC .0101 1.0160 .553 1.824 13.382 4.49 .694
P4MC .0084 1.021 .398 1.654 14.619 3.520 .732
P5MC .0069 .942 -.073 1.438 14.264 -.688 .815
P1PE .0154 1.015 .671 2.148 10.349 4.224 .721
P2PE .0122 .895 .484 2.248 12.119 4.045 .710
P3PE .0083 .953 .473 1.575 13.294 4.074 .690
P4PE .0061 .991 .429 1.207 14.317 3.825 .670
P5PE .0005 1.046 .433 .128 18.141 4.634 .721
P1BEME .0020 .991 .508 .462 16.931 5.36 .731
P2BEME .0070 1.023 .433 1.462 15.654 4.092 .732
P3BEME .0052 .963 .422 .929 12.670 3.423 .752
P4BEME .0121 .926 .485 2.059 11.580 3.741 .631
P5BEME .0163 1.000 .648 2.249 10.101 4.036 .693
P1DE .0012 .953 .525 .255 14.609 4.963 .726
P2DE .0075 .948 .519 1.560 14.555 4.914 .739
P3DE .0093 .964 .413 1.808 13.629 3.598 .732
P4DE .0109 1.008 .504 2.031 13.746 4.237 .728
P5DE .0136 1.029 .533 1.989 11.038 3.528 .731
Note: *all t values above 1.96 statistically significant.

Panel B: Market and P/E Risk Premium


R Pt − R ft = a + b(R mt − R ft ) + p(LMH t ) + e t

Portfolio a b s t(a) t(b) T(s) Adj.R2


P1MC .0043 .955 .657 .842 13.961 7.893 .680
P2MC .0059 .994 .612 1.075 13.613 6.88 .658
P3MC .0056 1.03 .565 1.069 14.66 6.607 .682
P4MC .0035 1.034 .506 .748 16.5 6.63 .724
P5MC -.0026 .961 .523 -.671 18.114 8.09 .766
P1PE .0024 1.046 1.1211 .534 16.836 14.818 .802
P2PE .0058 .911 .631 1.252 14.534 8.263 .698
P3PE .0033 .967 .545 .692 14.978 6.936 .688
P4PE .0024 1.00 .446 .507 15.359 5.614 .685
P5PE .0024 1.046 .121 .535 15.836 1.601 .703
P1BEME .0058 .987 .0512 1.194 15.129 .645 .662
P2BEME .0043 1.031 .391 .915 16.298 5.074 .709
P3BEME -.0014 .980 .618 -.308 15.175 7.856 .707
P4BEME .0035 .946 .762 .764 15.303 10.109 .773
P5BEME .0045 1.028 1.042 .857 14.657 12.193 .749
P1DE .0004 .958 .326 .099 14.217 3.947 .646
P2DE .0046 .957 .447 .979 15.192 5.823 .682
P3DE .0036 .979 .561 .786 15.982 7.525 .716
P4DE .0048 1.024 .627 1.035 16.301 8.197 .729
P5DE .0031 1.054 .902 .592 14.983 10.520 .729
Note: *all t values above 1.96 statistically significant.
208 International Research Journal of Finance and Economics - Issue 29 (2009)
Panel C: Market and Value Premium
R pt − R ft = a + b(R mt − R ft ) + h[HMLt] + e t

Portfolio a b h t(a) t(b) T(h) Adj.R2


P1MC .0072 .928 .535 1.392 13.24 7.304 .657
P2MC .0091 .969 .460 1.626 12.711 5.7774 .620
P3MC .0079 1.007 .467 1.523 14.163 6.290 .668
P4MC .0055 1.013 .425 1.187 16.064 6.44 .716
P5MC -.0011 .939 .477 -.314 18.427 8.956 .779
P1PE .0084 1.00 .846 1.546 13.542 10.966 .719
P2PE .0074 .885 .592 1.706 15.01 9.60 .728
P3PE .0054 .945 .462 1.143 14.567 6.806 .689
P4PE .0046 .983 .348 .946 14.761 4.997 .670
P5PE .0027 1.041 .119 .593 16.825 1.834 .705
P1BEME .0076 .986 -.058 1.589 15.143 -.864 .657
P2BEME .0064 1.016 .295 1.344 15.674 4.347 .689
P3BEME .0010 .954 .515 .215 14.588 7.526 .693
P4BEME .0060 .915 .675 1.362 15.275 10.777 .746
P5BEME .0076 .986 .941 1.588 15.143 13.829 .780
P1DE .0024 .945 .235 .477 13.7763 3.218 .626
P2DE .0070 .939 .336 1.463 14.44 4.732 .661
P3DE .0058 .956 .469 1.287 15.429 7.234 .709
P4DE .0067 .998 .565 1.508 16.395 8.873 .745
P5DE .0066 1.018 .763 1.261 14.293 10.247 .722
Note: *all t values above 1.96 statistically significant.

Panel D: Market & Leverage Premium


R pt − R ft = a + b(R m − R ft ) + l(LEVG t ) + e t

Portfolio A b h t(a) t(b) t(l) Adj.R2


P1MC .0097 .897 .464 1.697 11.414 4.477 .574
P2MC .0112 .942 .406 1.870 11.475 3.766 .564
P3MC .0094 .974 .467 1.7 12.84 4.664 .626
P4MC .0064 .981 .461 1.320 14.782 5.257 .688
P5MC .0005 .908 .458 .134 15.583 5.96 .715
P1PE .0111 .943 .844 1.734 10.744 7.283 .608
P2PE .0099 .849 .536 1.951 12.163 6.823 .622
P3PE .0082 .921 .357 1.541 12.641 3.710 .606
P4PE .0056 .958 .361 1.102 13.833 3.952 .647
P5PE .0025 1.029 .162 .57 16.592 1.980 .707
P1BEME .0061 .982 .0429 1.282 14.976 .496 .655
P2BEME .0079 .999 .245 1.597 14.679 2.7726 .660
P3BEME .0039 .927 .410 .7725 12.395 4.156 .604
P4BEME .0082 .869 .670 1.581 12.261 7.163 .649
P5BEME .011 .924 .893 1.781 10.75 7.885 .622
P1DE .0066 .950 -.039 1.244 13.185 -.414 .592
P2DE .0084 .919 .306 1.679 13.391 3.380 .627
P3DE .0074 .924 .467 1.495 13.702 5.24 .659
P4DE .0085 .959 .567 1.7 14.0 6.26 .681
P5DE .0065 .95 .961 1.244 13.184 10.10 .719
Note: *all t values above 1.96 statistically significant.
International Research Journal of Finance and Economics - Issue 29 (2009) 209
Panel E: Size and P/E Risk Premium
R pt − R ft = a + s[SMB t ] + p[LMH t ] + e t

Portfolio a b p t(a) t(b) t(p) Adj.R2


P1MC .0077 .779 .504 1.00 4.607 3.965 .065
P2MC .0112 .546 .488 1.324 2.927 3.481 .163
P3MC .0122 .414 .457 1.407 2.171 3.185 .118
P4MC .0111 .269 .417 1.315 1.446 2.978 .084
P5MC .0077 -.211 .504 1.002 -1.307 3.965 .121
P1PE .0094 .4 1.014 1.107 2.156 7.274 .347
P2PE .0119 .329 .540 1.546 1.936 4.226 .164
P3PE .0099 .338 .451 1.217 1.894 3.355 .117
P4PE .0095 .316 .353 1.135 1.719 2.547 .073
P5PE .0093 .4 .014 1.107 2.156 .102 .024
P1BEME .011 .496 -.0656 1.410 2.772 -.488 .046
P2BEME .011 .334 .294 1.361 1.796 2.104 .058
P3BEME .0057 .267 .532 .690 1.472 3.903 .132
P4BEME .0102 .297 .673 1.285 1.707 5.144 .210
P5BEME .0112 .395 .937 1.292 2.068 6.523 .302
P1DE .0062 .445 .218 .769 2.495 1.622 .068
P2DE .0106 .410 .343 1.331 2.343 2.613 .098
P3DE .0107 .271 .475 1.324 1.524 3.55 .115
P4DE .0119 .349 .528 1.416 1.892 3.816 .140
P5DE .0106 .311 .806 1.197 1.589 5.479 .227
Note: L*all t values above 1.96 statistically significant.

Panel F: Size & Value Premium


R pt − R ft = a + s[SMB t ] + h[HML t ] + e t

Portfolio a b h t(a) t(b) t(h) Adj.R2


P1MC .0079 .831 .495 1.067 5.093 4.705 .299
P2MC .0121 .602 .434 1.448 3.287 3.670 .172
P3MC .0124 .461 .449 1.465 2.484 3.750 .144
P4MC .0712 .312 .416 1.359 1.717 3.550 .110
P5MC .0079 .169 .495 1.067 -1.038 4.705 .147
P1PE .0123 .528 .826 1.442 2.830 6.863 .324
P2PE .0115 .578 .578 1.577 2.360 5.582 .239
P3PE .0100 .384 .447 1.268 2.215 3.998 .148
P4PE .0098 .354 .336 1.191 1.962 2.886 .087
P5PE .0081 .389 .105 .964 2.129 .891 .030
P1BEME .0116 .491 -.078 1.446 2.783 -.693 .048
P2BEME .0117 .365 .282 1.408 1.999 2.395 .068
P3BEME .0062 .324 .504 .771 1.839 4.435 .160
P4BEME .0105 .366 .662 1.391 2.217 6.206 .271
P5BEME .0116 .491 .921 1.446 2.783 8.090 .389
P1DE .0063 .467 .216 .788 2.662 1.903 .075
P2DE .0110 .447 .318 1.407 1.857 4.102 .143
P3DE .0111 .321 .458 1.401 1.857 4.102 .143
P4DE .0116 .398 .550 1.451 2.262 4.843 .195
P5DE .0117 .400 .748 1.356 2.122 6.157 .266
Note: *all t values above 1.96 statistically significant.
210 International Research Journal of Finance and Economics - Issue 29 (2009)
Panel G: Size & Leverage Premium
R pt − R ft = a + s[SMB t ] + l[LEVG t ] + e t

Portfolio a b h t(a) t(b) t(h) Adj.R2


P1DE .083 .497 .085 1.016 2.802 .591 .050
P2DE .0114 .0659 .531 1.356 3.601 3.561 .167
P3DE .0111 .520 .595 1.315 2.829 3.976 .156
P4DE .0095 .365 .590 1.165 2.053 4.069 .137
P5DE .0074 -.104 .580 .991 -.634 4.330 .126
P1PE .0116 .636 .967 1.316 3.338 6.229 .288
P2PE .0114 .454 .648 1.512 2.771 4.849 .198
P3PE .0103 .443 .478 1.265 2.519 3.334 .116
P4PE .0083 .398 .488 1.013 2.239 3.372 .108
P5PE .0057 .401 .298 .686 2.238 2.039 .057
P1BEME .0083 .479 .172 1.025 2.736 1.206 .055
P2BEME .0109 .402 .3777 1.304 2.216 2.551 .074
P3BEME .0065 .391 .532 .788 2.173 3.635 .119
P4BEME .0098 .453 .784 1.27 2.705 5.746 .244
P5BEME .0117 .613 1.014 1.359 3.278 6.663 .310
P1MC .00753 .896 .580 .991 5.446 4.330 .282
P2MC .0100 .489 .427 1.28 2.873 3.079 .117
P3MC .0100 .381 .588 1.263 2.218 4.201 .148
P4MC .0106 .470 .693 1.307 2.683 4.850 .197
P5MC .0083 .497 1.085 1.016 2.802 7.516 .345
Note: *all t values above 1.96 statistically significant.

Panel H: P/E and Value Premium


R pt − R ft = a + p[LMH t ] + h[HML t ] + e t

Portfolio a p h t(a) t(p) t(h) Adj.R2


P1MC .0134 .258 .35 1.641 1.014 1.629 .151
P2MC .0148 -.027 .620 1.983 -.119 3.106 .203
P3MC .0126 .115 .386 1.564 .460 1.794 .114
P4MC .0117 .153 .245 1.428 .589 1.102 .059
P5MC .0124 -.207 .278 1.462 -.786 1.232 -.002
P1PE .0095 .135 .144 1.149 .529 .656 .022
P2PE .0136 .211 .190 1.695 .845 .888 .063
P3PE .014 .0145 .372 1.621 .582 1.743 .120
P4PE .0119 .153 .245 1.428 .589 1.102 .059
P5PE .0124 .207 .278 1.462 -.7786 1.232 .002
P1BEME .0147 -.183 .184 1.777 .712 -.833 -.011
P2BEME .0140 .201 .140 1.658 .534 .892 .038
P3BEME .0079 .182 .390 .972 .722 1.799 .140
P4BEME .0128 .137 .583 1.666 .576 2.847 .243
P5BEME .0147 .183 .816 1.777 .712 3.692 .352
P1DE .0095 .135 .144 1.149 .529 .656 .022
P2DE .0136 .211 .190 1.695 .845 .888 .063
P3DE .0129 .145 .372 1.621 .582 1.743 .120
P4DE .0148 .0303 .51 1.805 .119 2.521 .160
P5DE .0133 .306 .549 1.532 1.131 2.364 .246
Note: *all t values above 1.96 statistically significant.
International Research Journal of Finance and Economics - Issue 29 (2009) 211
Panel I: P/E and Leverage Premium
R pt − R ft = a + p[LMH t ] + l[LEVG t ] + e t

Portfolio a p l t(a) t(p) t(l) Adj.R2


P1MC .0129 .447 .285 1.473 2.610 1.534 .149
P2MC .0141 .416 .255 1.631 2.306 1.304 .114
P3MC .0137 .279 .411 1.582 1.551 2.107 .116
P4MC .0114 .188 .466 1.376 1.090 2.492 .115
P5MC .0047 .232 .424 .629 1.487 2.507 .139
P1PE .0107 .843 .411 1.275 4.779 2.174 .348
P2PE .0128 .347 .417 1.680 2.187 2.426 .179
P3PE .0114 .361 .238 1.402 2.128 1.296 .102
P4PE .0104 .188 .364 1.258 1.087 1.945 .079
P5PE .0107 -.166 .411 1.275 -.953 2.174 .024
P1BEME .0139 -.159 .280 1.686 -.922 1.503 .002
P2BEME .0129 .199 .245 1.535 1.132 1.284 .045
P3BEME .0067 .426 .248 .813 2.495 1.341 .129
P4BEME .0105 .429 .499 1.364 2.676 2.870 .243
P5BEME .0119 .664 .572 1.413 3.763 2.993 .328
P1DE .0099 .369 -.160 1.198 2.147 -.857 .024
P2DE .0125 .249 .262 1.563 1.494 1.449 .073
P3DE .0112 .284 .400 1.409 1.713 2.225 .134
P4DE .0125 .290 .501 1.530 1.698 2.706 .166
P5DE .0099 .369 .840 1.198 2.147 4.514 .327
Note: *all t values above 1.96 statistically significant.

Panel J: Value and Leverage Premium


R pt − R ft = a + h[HML t ] + l[LEVG t ] + e t

Portfolio a b l t(a) t(b) t(l) Adj.R2


P1MC .013 .42 .23 1.69 2.73 1.16 .15
P2MC .015 .33 .25 1.84 2.05 1.21 .11
P3MC .014 .29 .35 1.71 1.78 1.73 .12
P4MC .012 .22 .41 1.45 1.40 2.07 .12
P5MC .005 .32 .31 .69 2.31 1.75 .15
P1PE .014 .62 .45 1.69 3.80 2.17 .31
P2PE .013 .46 .26 1.83 3.29 1.47 .22
P3PE .012 .39 .15 1.56 2.56 .79 .12
P4PE .011 .17 .34 1.35 1.13 1.73 .08
P5PE .09 -.056 .35 1.15 -.35 1.73 .018
P1BEME .0139 -.257 .391 1.708 -1.662 2.001 .018
P2BEME .0137 .186 .222 1.640 1.166 1.102 .046
P3BEME .0080 .434 .168 1.002 2.822 .867 .142
P4BEME .0017 .482 .380 1.56 3.37 2.11 .268
P5BEME .013 .74 .39 1.71 4.80 2.0 .37
P1DE .011 .35 -.21 1.37 2.28 -1.67 .63
P2DE .013 .21 .25 1.71 1.39 1.31 .07
P3DE .012 .29 .34 1.54 1.99 1.779 .14
P4DE .013 .37 .38 1.64 2.43 1.98 .18
P5DE .011 .35 .79 1.37 2.28 4.02 .33
Note: *all t values above 1.96 statistically significant.

As far as other company fundamentals are concerned we found an improvement in adjusted R2


value when they are used in addition to the market factor but such an improvement has not been as
large as the one produced by market and size factors.
212 International Research Journal of Finance and Economics - Issue 29 (2009)

The following two factor regression models did not produce any significant results in
explaining cross sectional variations in equity returns in India, as their adjusted R2 values have been
found to be very low.
Size and P/E risk premium
Size and value premium
Size and leverage premium
P/E and value premium
P/E and leverage premium
Value and leverage premium
The results of various three factor models are presented in Panel A to Panel J of Table 9. It is
clear visible that the following three factor models in which one of the factors is excess market return
have still higher adjusted R2 values as compared to any of the two factor models:
Market, Size and P/E risk premium (Panel Aof Table 9).
Market, Size and value premium (Panel B of Table 9).
Market, Size and leverage risk premium (Panel C of Table 9).
Market, P/E and value risk premium (Panel D of Table 9).
Market, P/E and leverage premium (Panel E of Table 9).
All other three factor models were not capable of explaining cross sectional variations in equity
returns in India as their adjusted R2 values have been found to be very low (see Panel F to Panel J of
Table 9).

Table 9: Three Factor Model Regression Results


Panel A: Market, Size and P/E Risk Premium
R pt − R ft = a + b[R mt − R ft ] + s[SMB t ] + p[LMH t ] + e t

Portfolio A b s p t(a) t(b) t(s) t(p) Adj.R2


P1BEME .002 .99 .51 -.02 .50 16.84 5.29 -.24 .72
P2BEME .002 .99 .56 .54 .38 15.09 5.17 6.55 .72
P3BEME .002 1.03 .43 .51 .52 15.60 3.96 6.19 .71
P4BEME .001 1.03 .29 .47 .33 17.03 2.87 6.21 .74
P5BEME -.001 .96 -.21 .5 -.31 18.45 -2.9 8.54 .77
P1PE -.0004 1.049 .42 1.06 -.098 18.15 4.39 14.89 .83
P2PE .003 .91 .34 .58 .76 15.25 3.49 7.88 .72
P3PE .0008 .97 .35 .49 .18 15.71 3.49 6.51 .72
P4PE .0001 1.00 .33 .40 .03 16.00 3.23 5.16 .71
P5PE -.0004 1.049 .41 .06 -.09 18.15 4.39 .91 .74
P1MC .001 1.03 .35 .34 .41 17.11 3.53 4.60 .73
P2MC -.003 .98 .28 .58 -.73 15.62 2.74 7.45 .72
P3MC .001 .95 .31 .72 .30 15.93 3.19 9.75 .72
P4MC .001 .95 .31 .72 .30 15.93 3.19 9.75 .75
P5MC .001 1.03 .4 .98 .32 15.50 3.77 11.99 .77
P1DE -.002 .96 .46 .26 -.5 15.38 4.49 3.41 .69
P2DE .001 .96 .43 .39 .37 16.40 4.41 5.37 .73
P3DE .001 .98 .29 .52 .35 16.53 2.95 7.11 .73
P4DE .002 1.02 .37 .58 .51 17.21 3.73 7.83 .75
P5DE .0008 1.05 .33 .86 .16 15.49 2.93 10.15 .75
Note: *all t values above 1.96 statistically significant.
International Research Journal of Finance and Economics - Issue 29 (2009) 213
Panel B: Market, Size & Value Premium
R pt − R ft = a + b[R mt − R ft ] + s[SMB t ] + h[HML t ] + e t

Portfolio a b s h t(a) t(b) t(s) t(h) Adj.R2


P1MC .000 .938 .859 .486 .001 18.545 10.436 9.148 .822
P2MC .0038 .976 .631 .424 .761 14.445 5.740 5.973 .701
P3MC .0038 1.012 .492 .439 .785 15.419 4.601 6.37 .717
P4MC .0026 1.017 .405 .342 .588 16.874 3.486 6.406 .740
P5MC .000 .938 .486 -.141 .001 18.545 9.148 -1.717 .783
P1PE .0037 1.007 .558 .815 .746 15.016 5.111 11.578 .768
P2PE .0040 .890 .405 .568 .985 16.317 4.564 9.931 .767
P3PE .0020 .949 .412 .438 .441 15.63 4.174 6.864 .723
P4PE .0014 .988 .384 .326 .306 15.619 3.727 4.909 .703
P5PE -.0008 1.046 .420 .0943 -.190 18.238 4.503 1.567 .747
P1BEME .0032 .992 .521 -.089 .747 17.025 5.496 -1.456 .725
P2BEME .0031 1.020 .395 .272 .679 16.709 3.980 4.238 .724
P3BEME -.0019 .95 .353 .459 -.409 15.320 3.465 7.529 .720
P4BEME .0027 .920 .394 .652 .649 16.472 4.336 11.131 .780
P5BEME .0032 .991 .521 .911 .747 17.025 5.495 14.901 .824
P1DE -.0017 .951 .496 .206 -.368 15.113 4.844 3.119 .686
P2DE .0030 .945 .476 .308 .681 15.893 4.917 4.935 .717
P3DE .0029 .960 .35 .448 .667 16.285 3.65 7.247 .737
P4DE .0032 1.00 .428 .540 .757 17.892 4.696 9.177 .784
P5DE .0030 1.022 .43 .7738 .599 15.223 3.938 10.466 .753
Note: *all t values above 1.96 statistically significant.

Panel C: Market, Size and Leverage Premium


R pt − R ft = a + b[R mt − R ft ] + S[SMB t ] + l [LEVG t ] + e t

Portfolio a b s l t(a) t(b) t(s) t(l) Adj.R2


P1MC .011 .91 .92 .46 .29 15.54 9.880 5.96 .77
P2MC .005 .95 .68 .40 .91 13.13 5.89 4.23 .66
P3MC .004 .98 .55 .46 .85 14.14 4.91 5.07 .69
P4MC .002 .98 .39 .46 .59 15.72 3.90 5.54 .72
P5MC .001 .91 -.07 .46 .29 15.4 -.83 5.96 .71
P1PE .005 .95 .66 .84 .85 11.96 5.18 8.01 .68
P2PE .005 .85 .48 .53 1.15 13.26 4.61 6.27 .68
P3PE .003 .93 .47 .35 .77 13.63 4.29 3.95 .66
P4PE .001 .96 .43 .36 .34 14.79 4.06 4.18 .69
P5PE -.001 1.03 .43 16 -.34 18.10 4.68 2.12 .75
P1BEME .001 .98 .51 .04 .34 16.74 5.34 .51 .72
P2BEME .004 1.00 .43 .24 .84 15.76 4.19 2.88 .70
P3BEME .0001 .93 .42 .41 .02 13.09 3.64 4.34 .64
P4BEME .003 .87 .48 .66 .77 13.32 4.53 7.70 .70
P5BEME .005 .93 .64 .89 .91 11.95 5.09 8.65 .69
P1DE .001 .96 .53 -.04 .35 14.54 4.95 -.48 .66
P2DE .003 .92 .51 .30 .79 14.87 5.15 3.69 .70
P3DE .003 .93 .41 .46 .76 14.162 4.00 5.54 .70
P4DE .003 .965 .50 .56 .84 15.43 4.95 6.84 .73
P5DE .001 .95 .52 .95 .35 14.54 4.95 11.03 .77
Note: *all t values above 1.96 statistically significant.
214 International Research Journal of Finance and Economics - Issue 29 (2009)
Panel D: Market, P/E and Value Premium
R pt − R ft = a + b(R mt − R ft ) + p(LMH t ) + h (HML t ) + e t

Portfolio a b h p t(a) t(b) t(s) t(h) Adj.R2


P1MC .004 .95 .202 .457 .90 13.86 1.49 2.91 .68
P2MC .005 .99 .05 .056 1.08 13.48 .36 3.31 .65
P3MC .006 1.02 .20 .38 1.12 14.56 1.44 2.72 .68
P4MC .003 1.02 .20 .30 .81 16.42 1.64 2.12 .72
P5MC .002 .95 .35 .18 -.58 18.59 3.45 1.52 .78
P1PE .002 1.04 .11 1.01 .56 16.69 .88 7.05 .80
P2PE .006 .89 .47 .16 1.47 15.08 4.06 1.18 .73
P3PE .003 .96 .23 .31 .76 14.92 1.81 2.14 .69
P4PE .002 .99 .08 .36 .53 15.21 .64 2.40 .68
P5PE .002 1.04 .11 .013 .56 16.69 .88 .09 .70
P1BEME .005 1.00 -.35 .39 1.13 15.72 -2.75 2.69 .67
P2BEME .004 1.03 .03 .36 .92 16.15 .27 2.43 .70
P3BEME -.001 .97 .23 .38 -.25 15.12 1.84 2.62 .71
P4BEME .004 .93 .43 .33 .93 15.76 3.71 2.45 .76
P5BEME .005 1.00 .65 .39 1.13 15.72 5.19 2.69 .79
P1DE .0004 .96 -.011 .34 .09 14.11 -.08 2.16 .64
P2DE .004 .96 .03 .41 .98 15.06 .28 2.82 .68
P3DE .003 .97 .21 .35 .85 15.93 1.78 2.49 .72
P4DE .005 1.00 .38 .24 1.19 16.63 3.23 1.74 .75
P5DE .003 1.04 .38 .52 .71 15.13 2.80 3.32 .74
Note: *all t values above 1.96 statistically significant.

Panel E: Market, P/E and Leverage Premium


R pt − R ft = a + b(R mt − R ft ) + p(LMH t ) + l (LEVG t ) + e t
Portfolio a b p l t(a) t(b) t(p) t(l) Adj.R2
P1MC .04 .95 .64 .02 .82 13.68 5.98 .23 .67
P2MC .006 .99 .62 -.01 1.07 13.39 5.41 -.12 .65
P3MC .005 1.02 .48 .13 1.00 14.30 4.45 1.31 .68
P4MC .003 1.01 .39 .19 .65 16.15 4.09 1.80 .73
P5MC -.003 .94 .42 .17 -.79 17.76 5.19 1.88 .77
P1PE .002 1.03 1.04 .13 .46 16.45 10.80 1.24 .80
P2PE .005 .89 .53 .17 1.61 14.18 5.45 1.65 .70
P3PE .003 .97 .56 -.02 .70 14.75 5.53 .22 .69
P4PE .002 .99 .39 .09 .45 15.00 3.84 .65 .68
P5PE .002 1.03 .04 .13 .46 16.45 .47 1.24 .70
P1BEME .005 .98 .04 .01 1.18 14.85 .43 .12 .65
P2BEME .004 1.03 .04 .13 .46 16.45 .47 1.24 .70
P3BEME .001 .98 .63 -.02 -.29 14.94 6.20 -.16 .70
P4BEME .02 .92 .62 .25 .63 15.02 6.53 2.41 .74
P5BEME .003 .99 .86 .30 .72 14.39 8.11 2.58 .76
P1DE .001 .99 .57 .002 .97 14.92 4.51 .02 .68
P2DE .004 .95 .45 .002 .97 14.92 4.51 .02 .68
P3DE .003 .98 .48 .14 .71 15.61 5.05 1.33 .72
P4DE .004 1.00 .49 .23 .92 15.99 5.12 2.17 .74
P5DE .001 .99 .57 .57 .34 15.54 5.78 5.27 .78
Note: *all t values above 1.96 statistically significant.
International Research Journal of Finance and Economics - Issue 29 (2009) 215
Panel F: Market Value & Leverage Premium
R pt − R ft = a + b(R mt − R ft ) + h (HML t ) + l (LEVG t ) + e t

Portfolio a b h l t(a) t(b) t(h) t(l) Adj.R2


P1MC .003 .96 .43 .02 .29 13.49 3.21 3.69 .63
P2MC .002 .98 .52 -.01 .93 165.19 2.51 2.73 .66
P3MC .006 1.01 .62 .17 .81 17.29 2.13 5.23 .64
P4MC -.002 .97 .71 .19 -.52 17.19 1.97 5.92 .71
P5MC .004 .96 .39 .13 .23 13.21 1.86 2.12 .72
P1PE .001 1.04 1.02 .15 .81 11.13 3.27 3.95 .83
P2PE -.003 .97 .51 -.02 -1.13 10.59 2.93 2.01 .72
P3PE .006 .93 .32 -.05 .73 11.53 2.62 2.10 .70
P4PE .007 .97 .95 .25 .31 12.52 1.98 1.889 .65
P5PE .001 .98 .27 .31 +.31 15.39 2.02 1.93 .68
P1BEME .003 .98 .35 .25 .71 16.29 3.05 2.73 .62
P2BEME -.002 .99 1.02 .21 -.23 13.21 5.93 4.71 .66
P3BEME .003 1.03 1.03 .14 .43 12.29 5.63 5.15 .73
P4BEME .005 1.05 .48 .23 .59 11.21 4.89 3.71 .70
P5BEME .001 1.02 .71 .15 .29 8.93 5.13 2.19 .72
P1DE .003 .98 .63 .51 .73 19.23 5.15 2.32 .65
P2DE .004 .97 .51 .14 .63 10.23 5.09 2.74 .70
P3DE .001 .99 .71 .21 .52 11.29 3.13 2.12 .69
P4DE .005 .99 .57 .27 .84 12.31 4.15 1.9 .71
P5DE -.003 .97 .48 .32 -.99 12.93 3.72 3.01 .73
Note: *all t values above 1.96 statistically significant.

Panel G: Size, P/E and Value Premium


R pt − R ft = a + S(SMB t ) + h (HML t ) + l (LEVG t ) + e t

Portfolio a b h s t(a) t(b) t(h) t(s) Adj.R2


P1BEME .011 .048 -.11 .48 .140 .19 -.52 2.68 .064
P2BEME .011 .040 .25 .36 1.37 .15 1.13 1.92 .084
P3BEME .005 .096 .43 .31 .71 .37 2.01 1.72 .154
P4BEME .010 .03 .64 .36 1.35 .15 3.13 2.13 .26
P5BEME .012 .04 .88 .48 1.40 .19 4.08 2.68 .38
P1MC .007 .027 .47 .83 1.04 .11 2.37 4.95 .29
P2MC .011 .19 .29 .57 1.33 .72 1.32 3.07 .17
P3MC .012 .02 .43 .45 1.43 .09 1.89 2.41 .14
P4MC .011 .022 .41 .31 1.34 .009 1.85 1.67 .103
P5MC .007 .027 .47 -1.7 1.04 .11 2.37 -1.04 .14
P1PE .019 .67 .34 .43 1.12 2.56 1.53 2.34 .35
P2PE .012 -.14 .67 .39 1.64 -.59 3.44 2.42 .235
P3PE .010 .008 .44 .38 1.25 .034 2.07 2.15 .14
P4PE .009 .056 .29 .35 1.15 .21 1.33 1.87 .08
P5PE .009 -.33 .34 .43 1.12 -1.25 1.53 2.34 .03
P1DE .006 .005 .21 .47 .77 .02 .98 2.59 .67
P2DE .011 .089 .25 .43 1.34 .36 1.20 2.47 .102
P3DE .011 .057 .41 .31 1.35 .23 1.95 1.77 .136
P4DE .012 -.084 .61 .41 1.47 -.33 2.82 2.27 .19
P5DE .011 .20 .60 .37 1.24 .74 2.61 1.93 .26
Note: *all t values above 1.96 statistically significant.
216 International Research Journal of Finance and Economics - Issue 29 (2009)
Panel H: Size, P/E and Leverage Premium
R pt − R ft = a + s(SMB t ) + p(LMH t ) + l (LEVG t ) + e t

Portfolio a s p l t(a) t(b) t(p) t(l) Adj.R2


P1MC .005 .83 .26 .40 .78 4.97 1.67 2.36 .29
P2MC .009 .59 .29 .38 1.15 3.17 1.62 1.77 .18
P3MC .010 .47 .17 .47 1.18 2.54 .97 2.48 .15
P4MC .009 .34 .11 .51 1.07 1.85 .66 2.47 .15
P5MC .005 .25 -.17 .40 .78 -.99 1.67 2.36 .44
P1PE .007 .46 .73 .47 .87 2.53 4.19 2.55 .38
P2PE .009 .39 .26 .47 1.31 2.35 1.64 2.77 .21
P3PE .008 .38 .28 .291 1.06 1.63 2.10 1.59 .13
P4PE .007 .37 .11 .41 .93 2.04 .61 2.23 .10
P5PE .007 .46 -.26 .47 .87 2.53 -1.52 2.55 .07
P1BEME .009 .54 -.27 .36 1.22 3.05 -1.61 1.95 .068
P2BEME .01 .37 .12 .29 1.21 2.00 .67 1.56 .07
P3BEME .004 .31 .36 .29 .54 1.68 2.07 1.57 .14
P4BEME .007 .35 .37 .55 1.01 2.19 2.16 3.19 .27
P5BEME .008 .46 .56 .64 1.00 2.60 3.17 3.39 .36
P1DE .006 .43 .27 -.09 .81 2.39 1.60 -.54 .06
P2DE .009 .45 .15 .32 1.15 2.60 .91 1.82 .11
P3DE .008 .33 .21 .45 1.09 1.88 1.26 2.48 .15
P4DE .009 .42 .19 .56 1.15 2.36 1.16 3.05 .20
P5DE .006 .43 .27 .90 .81 2.39 1.59 4.88 .35
Note: *all t values above 1.96 statistically significant.

Panel I: Size, Value and Leverage Premium


R pt − R ft = a + s(SMB t ) + p(LMH t ) + h (HML t ) + e t

Portfolio a s h L t(a) t(b) t(s) t(l) Adj.R2


P1MC .006 .85 .34 .29 .85 5.24 2.40 1.67 .31
P2MC .010 .62 .27 .30 1.25 3.41 1.73 1.51 .18
P3MC .01 .48 .39 .24 1.22 2.65 1.96 1.50 .16
P4MC .008 .34 .18 .44 1.08 1.90 2.23 1.18 .14
P5MC .006 -.15 .34 .29 .85 -.92 2.40 1.67 .16
P1PE .009 .56 .56 .49 1.15 3.06 3.55 2.47 .35
P2PE .01 .39 .29 .42 1.36 2.49 3.05 1.68 .25
P3PE .009 .39 .35 .18 1.13 2.28 2.32 .97 .15
P4PE .007 .37 .13 .37 .95 2.12 .89 1.90 .10
P5PE .006 .41 -.09 .38 .72 2.28 1.93 -.62 .05
P1BEME .009 .52 .43 -.31 1.17 2.28 2.99 -2.05 .081
P2BEME .010 .38 .15 .38 1.24 1.27 2.09 .93 .07
P3BEME .005 .34 .40 .19 .64 1.91 2.61 1.01 .16
P4BEME .008 .39 .44 .41 1.11 2.43 3.14 2.33 .30
P5BEME .009 .52 .43 .69 1.17 2.99 4.59 2.28 .41
P1DE .007 .45 +.31 -.17 .89 2.58 2.02 -.91 .07
P2DE .009 .46 .16 .29 1.21 2.73 1.10 1.5 .12
P3DE .009 .35 .26 .36 1.15 2.01 1.77 1.96 .16
P4DE .009 .41 .43 .33 1.18 2.45 2.18 2.19 .22
P5DE .007 .45 .31 .83 .89 4.30 2.59 2.02 .36
Note:*all t values above 1.96 statistically significant.
International Research Journal of Finance and Economics - Issue 29 (2009) 217
Panel J: PE, Value and Leverage Premium
R pt − R ft = a + p(LMH t ) + h (HML t ) + l (LEVG t ) + e t

Portfolio a p h l t(a) t(p) t(h) t(l) Adj.R2


P1MC .012 .22 .27 .20 1.54 .87 1.17 1.04 .15
P2MC .014 .31 .12 .22 1.65 1.15 .51 1.04 .11
P3MC .014 .09 .23 .34 1.63 .34 .92 1.66 .11
P4MC .011 .019 .20 .41 1.42 .07 .87 2.04 .11
P5MC .005 -.07 .37 .31 .73 -.32 1.77 1.77 .15
P1PE .011 .73 .12 .37 1.29 2.78 .53 1.85 .34
P2PE .014 -.07 .51 .27 1.84 -.31 2.41 1.49 .21
P3PE .012 .09 .33 .14 1.48 .36 1.43 .73 .11
P4PE .01 .09 .11 .33 1.28 .37 .47 1.66 .07
P5PE .011 -.27 .12 .37 1.29 -1.03 .53 1.85 .018
P1BEME .013 .12 -.34 .38 1.61 .46 -1.45 1.91 .011
P2BEME .013 .10 .11 .21 1.55 .39 .48 1.04 .039
P3BEME .007 .15 .33 .15 .89 .61 1.42 .778 .14
P4BEME .011 .07 .43 .37 1.49 .31 2.0 2.04 .26
P5BEME .014 .12 .66 .38 1.61 .46 2.85 1.92 .37
P1DE .01 .17 .24 -.23 1.25 .67 1.01 -1.15 .02
P2DE .01 .17 .09 .23 1.58 .68 .42 1.21 .06
P3DE .01 .08 .24 .33 1.46 .35 1.06 1.73 .13
P4DE .014 -.03 .39 .38 1.64 -.14 1.72 1.97 .18
P5DE .01 .17 .24 .77 1.25 .67 1.01 3.89 .33
Note:*all t values above 1.96 statistically significant.

Moreover among the above mentioned three factor models, the model having market, size and
value premium as independent variables produced the best results as adjusted R2 values of this model
were higher for all 20 portfolios than any other three factor model or two factor model. This factor
model (based on market, size and value premium) is the famous Fama-French multifactor asset pricing
model. Moreover none of the intercept values (i.e. 'a' values) of this model are statistically significant
while all slope coefficients of market premium, size premium and value premium have been found to
be statistically significant. Hence we conclude that the three factor model (based on excess market
return, size premium and value premium) works very well in explaining cross sectional variations in
equity returns in Indian stock market.
The results of various four factor models are presented in Panel A to E of Table 10.
It can be clearly seen that the four factor model based on market, size, P/E and value premium
(Panel A of Table 10) provides the best results here although adjusted R2 values have improved only
marginally as compared to the three factor model based on market, size premium and value premium
(Panel B of Table 9). This might be due to the overlapping effect of value and P/E risk premium in
Indian context.
218 International Research Journal of Finance and Economics - Issue 29 (2009)
Table 10: Four Factor Model Regression Results
Panel A: Market, Size, P/E & Value
R pt − R ft = a + b(R mt − R ft ) + s(SMTt ) + p(LMH t ) + h (HML t ) + e t

Portfolio a b s p h t(a) t(b) t(s) t(p) t(h) Adj.R2


P1MC -.001 .94 .82 .22 .32 -.27 18.85 9.97 1.92 .322 .83
P2MC .002 .99 .57 .40 .13 .41 14.96 5.26 2.56 1.03 .71
P3MC .002 1.02 .45 .23 .26 .56 15.58 4.23 1.5 2.04 .72
P4MC .001 1.02 .31 .21 .25 .36 17.04 3.14 1.54 2.07 .74
P5MC -.001 .95 -.17 .22 .32 -.27 18.85 -2.08 1.92 3.22 .79
P1PE -.0003 1.04 .43 .89 .17 -.07 18.06 4.56 6.58 1.50 .83
P2PE .003 .89 .39 .04 .53 .92 16.22 4.38 .38 4.87 .76
P3PE .001 .96 .38 .21 .28 .23 15.78 3.82 1.47 2.37 .73
P4PE .0002 .99 .34 .26 .13 .05 15.87 3.34 1.80 1.07 .71
P5PE -.003 1.04 .43 -.11 .17 -.07 18.06 4.56 -.79 1.50 .75
P1BEME .0020 1.00 .485 .259 -.276 .476 17.32 5.075 1.91 -2.398 .73
P2BEME .001 1.03 .36 .26 .08 .42 16.96 3.58 1.80 .71 .73
P3BEME .003 .97 .31 .30 .27 -.70 15.65 3.04 2.06 2.25 .73
P4BEME .001 .93 .36 .23 .48 .39 16.72 3.94 1.778 4.38 .78
P5BEME .002 1.00 .48 .25 .72 .47 17.32 5.07 1.91 6.29 .83
P1DE -.002 .96 .46 .21 .05 -.56 15.26 4.49 1.40 .45 .69
P2DE .001 .95 .43 .29 .09 .38 16.25 4.48 2.01 .84 .73
P3DE .001 .97 .31 .26 .26 .39 16.57 3.25 1.90 2.23 .74
P4DE .002 1.00 .41 .13 .45 .61 17.90 4.41 .97 3.99 .78
P5DE .001 1.04 .37 .42 .43 .21 15.82 3.43 2.73 3.32 .77
Note: *all t values above 1.96 statistically significant.

Panel B : Market Size Value Leverage


R pt − R ft = a + b(R mt − R ft ) + s(SMB t ) + h (HML t ) + l (LEVG t ) + e t

Portfolio a b s h l t(a) t(b) t(s) t(h) t(l) Adj.R2


P1MC -.0003 .93 .86 .44 .08 -.10 18.26 10.47 6.14 .93 .82
P2MC .003 .97 .63 .38 .08 .68 14.21 5.75 3.96 .66 .70
P3MC .003 1.0 .50 .35 .17 .62 15.17 4.71 3.78 1.41 .72
P4MC .001 1.0 .35 .29 .21 .37 16.68 3.66 3.49 1.95 .75
P5MC -.0003 .93 -.13 .44 .08 -.10 18.26 -1.64 6.14 .93 .78
P1PE .002 .98 .57 .67 .26 .49 14.86 5.35 7.19 2.27 .78
P2PE .003 .88 .41 .52 .09 .87 16.05 4.62 6.71 .94 .77
P3PE .002 .95 .41 .45 -.03 .47 15.47 4.12 5.26 -.29 .72
P4PE .0007 .97 .39 .24 .150 .15 15.37 3.82 2.75 1.32 .70
P5PE -.001 1.03 .43 .01 .14 -.35 17.98 4.61 .21 1.42 .73
P1BEME .002 .976 .535 -.20 .21 .51 16.85 5.70 -2.42 2.05 .73
P2BEME .0003 1.019 .39 .26 .02 .65 16.47 3.96 2.99 .19 72
P3BEME -.001 .96 .35 .51 -.02 -.38 15.16 3.42 5.68 -.20 .71
P4BEME .001 .90 .40 .54 .21 .42 16.30 4.54 6.95 2.09 .78
P5BEME .002 .97 .53 .79 .21 .52 16.85 5.70 9.80 2.05 .83
P1DE .0001 .97 .47 .42 -.39 .03 16.26 4.82 4.92 3.71 .75
P2DE .002 .94 .48 .27 .07 .59 15.64 4.95 3.17 .71 .72
P3DE .002 .95 .36 .36 .15 .50 16.04 3.76 4.42 1.44 .72
P4DE .002 .99 .44 .43 .19 .54 17.770 4.87 5.57 1.93 .74
P5DE .0001 .97 .47 .41 .60 .03 16.26 4.82 4.92 5.63 .81
Note: *all t values above 1.96 statistically significant.
International Research Journal of Finance and Economics - Issue 29 (2009) 219
Panel C: Market, Size, P/E and Leverage Premium
R pt − R ft = a + b(R mt − R ft ) + s(SMB t ) + p(LMH t ) + l (LEVG t ) + e t

Portfolio a b s h l t(a) t(b) t(s) t(h) t(l) Adj.R2


P1MC -.001 .94 .81 .14 .46 -.44 18.07 9.48 1.59 5.63 .81
P2MC .001 .9 .57 .06 .49 .34 14.75 5.18 .58 4.67 .71
P3MC .001 1.06 .46 .20 .38 .38 15.24 4.20 1.77 3.69 .72
P4MC .0006 1.01 .31 .23 .33 .14 16.74 3.21 2.29 3.42 .75
P5MC -.001 .94 -.18 .14 .46 -.44 18.07 -2.16 1.59 5.63 .77
P1PE -.001 -.25 1.30 .44 .19 .95 17.81 4.67 1.97 10.38 .83
P2PE .002 .889 .37 .23 .45 .59 14.94 3.83 2.25 4.76 .73
P3PE .0007 .96 .36 .02 .48 .16 15.41 3.48 .24 4.86 .71
P4PE -.003 .99 .35 .14 .31 -.07 15.62 3.39 1.35 3.14 .71
P5PE -.001 1.03 .44 .19 -.05 -.26 17.81 4.67 1.97 -.54 .75
P1BEME .001 .98 .52 .08 -.06 .43 16.46 5.35 .86 -.74 .72
P2BEME .001 1.03 .35 .01 .33 .39 116.79 3.50 .14 3.45 73
P3BEME -.003 .97 .28 .02 .56 -.74 15.31 2.73 .21 5.59 .72
P4BEME .0002 .92 .35 .29 .54 .06 15.77 3.69 3.02 5.87 .77
P5BEME .0003 .99 .46 .37 .76 .06 15.41 4.35 3.34 7.52 .77
P1DE -.001 .99 .41 -.37 .48 -.31 16.45 4.17 5.09 -3.65 .72
P2DE .01 .95 .43 .06 .35 .32 16.03 4.45 .63 3.73 .72
P3DE .0009 .96 .31 .18 .41 .21 16.17 3.19 4.40 1.80 .74
P4DE .001 .99 .40 .28 .40 .29 17.04 4.20 4.40 2.88 .77
P5DE -.001 .9 .41 .63 .48 -.31 16.55 4.17 6.16 5.09 .81
Note: *all t values above 1.96 statistically significant.

Panel D: Market, P/E Value and Leverage Premium


R pt − R ft = a + b(R mt − R ft ) + p(LMH t ) + h (HML t ) + l (LEVG t ) + e t

Portfolio a b s h l t(a) t(b) t(s) t(h) t(l) Adj.R2


P1MC .004 .95 .46 .21 -.03 .91 13.71 2.90 1.50 -.29 .68
P2MC .006 .99 -.03 .56 .06 1.09 13.33 3.29 .42 -.25 .65
P3MC .005 1.01 .35 .16 .08 1.06 14.28 2.14 1.12 .68 .68
P4MC .003 1.01 .25 .14 .150 .71 16.12 1.91 1.10 1.33 .73
P5MC -.002 .94 .17 .36 .07 -.64 18.26 1.38 2.96 .83 .78
P1PE .002 1.03 .9 .11 .06 .48 16.37 6.83 .49 .99 .80
P2PE .006 .88 .15 .45 .04 1.43 14.82 1.10 3.68 .40 .73
P3PE .003 .96 .33 .27 -.10 .82 14.88 2.25 2.00 -.89 .69
P4PE .002 .99 .35 .05 .07 .47 14.93 2.27 .37 .67 .68
P5PE .002 1.03 -.008 .06 .11 .48 16.38 -.05 .49 .99 .70
P1BEME .004 .99 .37 -.39 .12 1.04 15.42 2.50 -.296 1.11 .675
P2BEME .004 1.03 .36 .05 -.05 .94 16.00 2.46 .40 -.45 .7
P3BEME -.0008 .97 .40 .27 -.09 -.18 15.06 2.70 2.00 -.83 .71
P4BEME .003 .92 .38 .31 .14 .83 15.46 2.24 3.06 1.32 .76
P5BEME .004 .99 .37 .60 .13 1.04 15.41 2.50 4.52 1.11 .79
P1DE .001 .99 .42 .17 -.48 .42 15.54 2.89 1.33 -4.21 .68
P2DE .004 .95 -.008 .41 .03 .98 14.85 2.78 .28 -.07 .68
P3DE .003 .96 .33 .18 .08 .79 15.63 2.34 .78 1.41 .72
P4DE .004 .99 .21 .34 .13 1.09 16.32 1.54 2.64 1.21 .75
P5DE .001 .99 .42 .51 .17 .42 15.54 2.89 4.54 1.33 .78
Note: *all t values above 1.96 statistically significant.
220 International Research Journal of Finance and Economics - Issue 29 (2009)
Panel E: Size, P/E, Value and Leverage Premium
R pt − R ft = a + s(SMB t ) + p(LMH t ) + h (HML t ) + l (LEVG t ) + e t

Portfolio a b s h l t(a) t(b) t(s) t(h) t(l) Adj.R2


P1MC .006 .85 -.03 .36 .29 .86 5.13 -.13 1.69 1.67 .30
P2MC .01 .60 .13 .18 .28 1.18 3.21 .50 .78 1.41 .17
P3MC .01 .49 -.05 .27 .39 1.23 2.62 -.20 1.15 1.96 .16
P4MC .009 .35 -.08 .24 .44 1.11 1.92 -.32 1.03 2.45 .15
P5MC .006 -.14 -.03 .36 .29 .86 -.87 -.13 1.69 1.67 .32
P1PE .007 .47 -.58 .17 .42 .90 2.58 2.24 .75 2.15 .37
P2PE .01 .43 -.20 .55 .31 1.45 2.61 -.86 2.67 1.79 .25
P3PE .009 .40 -.02 .36 .18 1.13 2.24 -.11 1.62 .97 .14
P4PE .007 .38 -.01 .15 .37 .95 2.07 -.06 .64 1.88 .09
P5PE .007 .47 -.41 .17 .42 .90 2.58 -1.57 .74 2.15 .06
P1BEME .009 .52 -.28 -.03 .43 1.17 2.94 -.15 -1.26 2.27 .07
P2BEME .001 .38 -.009 .15 .25 1.23 2.04 -.03 .64 1.25 .06
P3BEME .004 .33 .05 .36 .18 .60 1.81 .22 1.57 .96 .15
P4BEME .008 .04 -.04 .47 .41 1.12 2.40 -.19 2.23 2.32 .29
P5BEME .009 .53 -.03 .72 .43 1.17 2.94 -.14 3.16 2.27 .40
P1DE .007 .45 .04 .28 -.17 .86 2.48 .15 1.23 -.91 .06
P2DE .009 .46 .03 .14 .28 1.17 2.63 .13 .63 1.50 .11
P3DE .009 .34 -.27 .01 .36 1.51 1.97 -.06 1.22 1.94 .16
P4DE .01 .45 -.17 .44 .43 1.25 2.53 -.67 1.95 2.26 .22
P5DE .007 .45 .04 .28 .82 .86 2.48 .15 1.23 4.21 .36
Note: *all t values above 1.96 statistically significant.

Finally, the results of the five factor model have been provided in Table 11. It is clearly visible
that the five factor model is not any substantial improvement in explaining cross sectional
improvement in explaining cross sectional variations in equity returns in India over three or four factor
models, as adjusted R2 values have improved only marginally with the inclusion of two additional
factors (P/E risk premium and leverage premium).

Table 11: Five Factor Model Result Market, Size Value, P/E and Leverage
R pt − R ft = a + b(R mt − R ft ) + s(SMB t ) + p(LMH t ) + h (HML t ) + l (LEVG t ) + e t

] a B s h p l t(a) t(b) t(s) t(h) t(p) t(l) Adj.R2


P1MC -.0012 .942 .833 .300 .215 .05779 -.329 18.523 9.962 2.833 1.7780 .637 .825
P2MC .0019 .989 .579 .124 .393 .0315 .379 14.707 5.237 .884 2.479 .262 .713
P3MC .0022 1.01 .472 .213 .209 .140 .452 15.285 4.342 1.5 1.344 1.185 .721
P4MC .0009 1.010 .329 .178 .186 .212 3.324 16.766 1.415 1.257 1.723 .748 .732
P5MC -.0012 .942 -.167 .300 .214 .0579 -.329 18.523 -1.998 2.834 1.790 .636 .787
P1PE -.0009 1.028 .45 .111 .857 .163 -.216 17.767 4.732 .920 6.283 1.571 .833
P2PE .0034 .885 .407 .499 .0306 .0884 .832 15.917 4.448 4.313 .234 .889 .765
P3PE .0012 0.962 .378 .309 .224 -.0601 .277 15.646 3.736 2.41 1.54 -.546 .724
P4PE -.0002 .988 .358 .088 .241 .120 -.046 15.561 3.43 .668 1.609 1.056 .709
P5PE .0001 1.028 .450 .111 -.143 .163 -.216 17.7767 4.732 .919 -1.049 1.571 .749
P1BEME .0013 .987 .502 -.345 .220 .184 .319 17.046 5.278 -2.865 1.614 1.773 .736
P2BEME .0019 1.031 .359 .0902 .260 -0.010 .428 16.731 3.542 .703 1.788 -.698 .727
P3BEME .0031 .975 .306 .301 .313 -.0612 -.650 15.525 2.959 2.302 2.118 -.544 .726
P4BEME .009 .914 .379 .416 .193 .183 .232 16.453 4.151 3.594 1.477 1.836 .7788
P5BEME .0013 .987 .502 .655 .220 .184 .319 17.047 5.278 5.429 1.614 1.773 .831
P1DE -.0010 .993 .426 .220 .3 -.434 -.234 16.649 4.343 1.772 2.134 -.4060 .725
P2DE .0015 .953 .439 .083 .282 .0407 .347 15.969 4.479 .667 2.007 .381 .723
P3DE .0013 .96 .326 .214 .235 .123 .292 16.26 3.35 1.736 1.692 1.159 .743
P4DE .0019 .994 .428 .379 .0899 .180 .453 17.630 4.616 3.232 .678 1.786 .788
P5DE -.0010 .993 .426 .22 .300 .566 -.234 16.649 4.343 1.773 2.135 5.302 .811
Note: *all t values above 1.96 statistically significant.

The empirical results regarding April Seasonality effect and January Seasonality effect are
presented in Table 12 and 13 respectively. It is clearly visible that none of the slope coefficients of the
International Research Journal of Finance and Economics - Issue 29 (2009) 221

dummy variable i.e. 'b values' are statistically significant. Moreover all intercept values or 'a' values are
very high and statistically significant. Hence we may conclude that none of the seasonality effects
(April or January) has been present in equity returns in India over the study period.

Table 12: Result regarding April Seasonality Effect

Portfolio a B t(a) t(b) Adj.R2


P1MC .0289 .00149 3.237 .048 -.008
P2MC .0279 .0263 3.038 .0825 -.003
P3MC .0288 .0065 3.134 .206 -.008
P4MC .0266 -.0033 3.018 -.109 -.008
P5MC .0186 .0155 2.297 .553 -.006
P1PE .0345 .0146 3.324 .405 -.007
P2PE .0276 .0256 3.295 .880 -.002
P3PE .0248 .0170 2.893 .571 -.006
P4PE .0239 .0011 2.762 .039 -.008
P5PE .0199 -.0118 2.346 -.400 -.007
P1BEME 0.021 -0.015 2.64 -0.539 -0.006
P2BEME 0.024 0.0093 2.82 0.311 -0.008
P3BEME .0219 .0097 2.493 .319 -.008
P4BEME .0280 .0229 3.167 .750 -.004
P5BEME .0346 .0203 3.347 .568 -.006
P1DE .0188 .0101 2.253 .348 -.007
P2DE .0250 .0988 3.00 .342 -.007
P3DE .0261 .00953 3.047 .321 -.008
P4DE .0286 .0134 3.175 .430 -.007
P5DE .0136 -.0063 2.625 -.351 -.007
Note: *all t values above 1.96 statistically significant.

Table 13: Result regarding January Seasonality Effect

Portfolio a B t(a) t(b) Adj.R2


P1MC .0306 -.0193 3.436 -.623 -.005
P2MC .0312 -.0128 3.385 -.401 -.007
P3MC .0314 -.0239 3.417 -.750 -.004
P4MC .0285 -.0261 3.243 -.857 -.002
P5MC .0217 -.0228 2.695 -.811 -.003
P1PE .0377 -.0231 3.63 -.642 -.005
P2PE .0324 -.0315 3.867 -1.083 .001
P3PE .0276 -.0160 3.212 -.536 -.006
P4PE .263 -.0274 3.047 -.915 -.001
P5PE .0195 -.0068 2.296 -.231 -.008
P1BEME .0217 -.0125 2.613 -.436 -.003
P2BEME .0272 -.0236 3.143 -.787 -.007
P3BEME .0242 -.0164 2.742 -.536 -.006
P4BEME 0.0321 -.0261 3.631 -.850 -.002
P5BEME .0385 -.0261 3.725 -.729 -.004
P1DE .0216 -.0165 2.520 -.570 -.006
P2DE .0273 -.0180 3.282 -.624 -.005
P3DE .0284 -.0179 3.317 -.603 -.005
P4DE .0316 -.0241 3.528 -.774 -.003
P5DE .0351 -.0282 3.494 -.809 -.003
Note: *all t values above 1.96 statistically significant.

VIII. Summary of the Research Results


On the basis of the empirical results presented in this study, following conclusions may be drawn.
222 International Research Journal of Finance and Economics - Issue 29 (2009)

i. There existed a statistically significant negative relationship between company size (Market
Capitalisation) and equity returns in India over the study period. The smallest stocks portfolio
(PIMC) outperformed largest stocks portfolio and provided the investors with an extra risk
adjusted return of 3.06 percent per month (t value 2.573) as against 0.63 percent per month (t
value 1.329) on P5MC i.e. largest stocks portfolio. The size premium (i.e. the return differential
between smallest and largest stocks portfolios) has been found to be 2.32 percent per month (t
value 5.800) over the study period which is quite robust.
ii. There existed a statistically significant negative relationship between P/E ratio and equity
returns in India over the study period. The lowest P/E ratio stocks portfolio (PIPE)
outperformed the highest P/E stocks portfolio (P5PE) and provided the investors with an extra
risk adjusted return of 2.17 percent per month (t value 2.879). The P/E risk premium (i.e. the
return differential between PIPE and P5PE) has been found to be statistically significant over
the study period (1.68 percent per month with t value 3.111).
iii. There existed a statistically significant positive relationship between BE/ME ratio and equity
returns in India over the study period. The highest BE/ME stocks portfolio outperformed the
lowest BE/ME stocks portfolio. The highest BE/ME stocks portfolio (P5BEME) produced an
extra risk adjusted return of 2.23 percent per month (t value 2.957) as against 0.67 percent per
month (t value 1.434) on P1BEME i.e. the lowest BE/ME stocks portfolio. The HML premium
or value premium (i.e. the return differential between P5BEME and P1BEME) has been found
to be 1.57 percent per month (t value 2.492) which is also statistically significant.
iv. There existed a statistically significant positive relationship between D/E ratio and equity
returns in India over the study period. The highest D/E stocks portfolio (P5DE) outperformed
the lowest D/E stocks portfolio (PIDE) and provided an extra risk adjusted return of 1.86
percent per month (t value 2.845) as against 0.61 percent per month (t value 1.186) on lowest
D/E stocks portfolio i.e. PIDE. The leverage risk premium has been found to be statistically
significant at 1.31 percent per month (t value 2.673) over the study period.
v. The investment strategies based on size, P/E ratio, BE/ME ratio and D/E ratio would have
provided the investors with statistically significant extra risk adjusted returns of 2.43% (t value
2.273), 1.71% (t value 3.157), 1.56% (t value 2.474) and 1.25% (t value 2.502), respectively
over the study period. It shows that opportunities are available for Indian investors to earn extra
returns on a risk adjusted basis by following investment strategies based on company
fundamentals.
vi. More frequent rebalancing of portfolios did not produce any drastically different results in
Indian context and hence we may conclude that frequency of portfolio rebalancing does not
affect the results in any significant way.
vii. Excess market return has been found to be an important factor in explaining cross sectional
variations in equity returns in India although it is not capable of explaining all such variations.
It implies that other company fundamentals should be added to the asset pricing model in order
to explain cross-sectional variations in equity returns in India in a better way.
viii. None of the company fundamentals, in isolation, could explain cross sectional variations in
equity returns in India in any significant way.
ix. The three factor model based on market, size premium and value premium (Popularly known as
Fama-French Multifactor asset Pricing Model) explained cross-sectional variations in equity
returns in India in a much better way than the single factor CAPM or any two factor model.
x. Four factors or five factors models did not improve the results regarding cross-sectional
variations in equity returns in India in any significant manner and hence we may conclude that
the three factor Fama-French model works well in Indian context.
xi. None of the seasonality effects (April or January) had been found to be present in equity returns
in India over the study period.
International Research Journal of Finance and Economics - Issue 29 (2009) 223

IX. Policy Implications of the Findings


The findings of the research paper have important policy implications and are of pertinent use for
equity analysts, fund managers and investing community at large.
i. Implications for Market Efficiency : We have found a statistically significant relationship
between four company fundamentals (viz. market capitalization, P/E ratio, BE/ME ratio and
D/E ratio) and equity returns in India over the study period of 1997-2007. This implies that a
strong size effect, P/E effect, value effect and leverage effect existed in Indian stock market
over the most recent ten years period. This further implies that Indian stock market is still not
semi strong efficient because publically available financial information can be used to earn
extra return (on risk adjusted basis) in Indian stock market. Although the intensity (or
robustness) of these effects have been lower than those detected by earlier studies during the
decade of 1990s. Hence although the efficiency level has been increasing in Indian stock
market, it has still not become fully semi-strong efficient.
ii. Implications for Investment Strategies : Presence of strong size effect, P/E effect, value
effect and leverage effect are indicative of the fact that arbitrage opportunities are available in
Indian stock market and gainful investment strategies can be formulated and used by equity
analysts, fund managers and investing community at large based on these company
fundamentals. Since the research results are of the most recent ten years period their utility gets
further enhanced in this context.
iii. Implications for Asset Pricing Framework
(a.) We have found that no single factor asset pricing model (be it based on market risk
premium or any of the company fundamentals) work well in explaining cross sectional
variations in equity returns in India. Hence more factors should be included in the asset
pricing framework. We have found that addition of two company fundamentals (viz. size
premium and value premium) in the asset pricing model can substantially explain cross-
sectional variations in equity returns in India. This lends further support to the Fama French
three factor asset pricing model in Indian stock market in a recent time period.
(b.) Contrary to Fama & French (1996) we have found that market risk premium is still ‘the’
most important independent factor in asset pricing framework although its relative
importance has substantially declined since the decade of 1980’s or 1990’s. This implies
that company fundamentals are gaining importance in explaining cross sectional variations
in equity returns in India.
iv. Implications for Market Microstructure : The findings also have important implications for
market microstructure aspects as we have found the presence of strong size effect, P/E effect,
value effect and leverage effect on National Stock Exchange (i.e. the prominent exchange
having much higher turnover than that of Bombay Stock Exchange). Earlier studies have found
the presence of size and value effect on Bombay Stock Exchange (See Sehgal and Tripathi
(2005a and 2005b). This implies that unlike Reinganum (1993) market microstructural aspects
do not affect the relationship between company fundamentals and equity returns in India in any
substantial manner.
224 International Research Journal of Finance and Economics - Issue 29 (2009)

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