A Liquidity-Augmented Capital Asset Pricing Model: Analytical and Empirical Perspectives

Abstract

The objective of this study is to compare the single-factor model of asset pricing with liquidity liquidity-augmented model in the emerging market of Pakistan. Many researchers have proved that the traditional Capital Asset Pricing Model (CAPM) was not able to explain the variations in returns completely. Therefore liquidity, which is the main problem of emerging markets, was added to CAPM to increase its explaining power. For the said purpose, monthly data for the period of 2008-2017 was taken for PSX 100-index. Amongst the many proxies for liquidity, turnover was selected. Then the performance of single factor and CAPM adjusted liquidity risk was evaluated through Pooled OLS to determine which model is better for asset pricing. The results of two-factor models suggest that LCAPM performs better than single single-factor model. Market excess returns have a positive significant effect while the liquidity factor has also a significant effect but is negative which is consistent with the literature. The research can further be extended by comparing the results with Fama and French's three, four, and five-factor models.