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FINANCIAL CONSTRAINTS: A MYTH OR REALITY? AN EMPIRICAL EVIDENCE FROM PAKISTAN STOCK EXCHANGE
Corresponding Author(s) : Musarrat Karamat
Humanities & Social Sciences Reviews,
Vol. 9 No. 2 (2021): March
Abstract
Purpose of the study: This study investigates the stock pricing of financially constrained (FC) firms in Pakistan for the period of 20 years (2000 to 2019). The researcher uses accounting information (financial ratios of the firms) to categorize Pakistani firms as the most and least financially constrained firms. Further, it examines how the Asset Pricing models perform with the risk-adjusted portfolio of the stock returns sorted based on financial constraints.
Methodology: Using the financial constraint proxies/ leverage ratios (Total Debt to Market Value(TDMV), Total Debt to Common Equity (TDC), Interest Coverage Ratio (ICR) and the asset pricing models of Sharpe (1964), Lintner (1965), and the three-factor and the five-factor model of Fama and French (1993, 1996), the returns of all the non-financial firms listed in PSX were sorted as the most and the least financially constraint firms and then their risk-adjusted portfolios were analyzed through Excel, Eviews and STATA.
Main Findings: Positive results (e.g. higher returns) are observed when the capital structure of the FC firms is heavy with debt as compared to unconstrained firms on Pakistan Stock Exchange (PSX). The time series outcome showed that risk-adjusted returns of most FC firms give an extra premium to investors in the PSX when the leverage ratios are used as proxies of financial constraints.
Applications of the study: This study can be used to make an augmented model of asset pricing specifically for emerging and frontier markets by taking the FC factor as one of the main contributing risk factors to predict returns in the equity market.
Novelty/Originality of the study: The devised methodology also results in a more refined and accurate quality of analyses and findings and more comprehensive and sound knowledge of asset pricing as compare to previously conducted studies in PSX.
Keywords
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- Ahmad, S., & Hashmi, M. (2019). Financial Constraints, Firms’ Investments and Performance of Manufacturing Sector of Pakistan: A Cross Industry Analysis. Pakistan Development Review (PDR), PIDE Islamabad. Retrieved from https://www.pide.org.pk/psde/pdf/AGM33/papers/Shagufta%20Ahmad.pdf
- Balafas, N. (2013). Essays on corporate finance, monetary policy and asset pricing on London Stock Exchange. Ph.D thesis draft, The university of Liverpool repository. Retrieved from https://livrepository.live rpool.ac.uk/id/eprint/9573
- Balafas, N., and Kostakis, A. (2015). Financial constraints and asset pricing: Comprehensive evidence from London Stock Exchange. The European Journal of Finance, 23(1), 80–110. https://doi.org/10.1 080/1351847X.2015.1115773
- Balafas, N., and Kostakis, A. (2017). Financial constraints and asset pricing: Comprehensive evidence from London Stock Exchange. The European Journal of Finance, 23(1), 680-110. https://doi.org/10.10 80/1351847X.2015.1115773 DOI: https://doi.org/10.1080/1351847X.2015.1115773
- Balafas, N., Florackis, C., & Kostakis, A. (2018). Monetary policy shocks and financially constrained stock returns The effects of the financial crisis. International Review of Financial Analysis, 58, 69–90. https://doi.org/10.1016/j.irfa.2018.05.001 DOI: https://doi.org/10.1016/j.irfa.2018.05.001
- Burton, N. (2018). Burton G. Malkiel's: A random walk down Wall Street.
- Caggese, A. (2007). Financing constraints, irreversibility, and investment dynamics. Journal of Monetary Economics, 54(7), 2102-2130. https://doi.org/10.1016/j.jmoneco.2006.10.001 DOI: https://doi.org/10.1016/j.jmoneco.2006.10.001
- Cochrane, J.H. (2013). Finance: Function matters, not size. NBER Working Paper No. 18944. https://doi.org/10.3386/w18944 DOI: https://doi.org/10.3386/w18944
- Collot, S., and Hemauer, T. (2021). A literature review of new methods in empirical asset pricing: mitted-variable and errors-in-variables bias. Swiss Society for Financial Market Research, 35(1), 77-100. https://doi.org/10.1007/s11408-020-00358-0 DOI: https://doi.org/10.1007/s11408-020-00358-0
- Fama, E. and French, K. (1993). Common risk factors in the returns of stocks and bonds. Journal of Financial Economics, 33, 3-56. https://doi.org/10.1016/0304-405X(93)90023-5 DOI: https://doi.org/10.1016/0304-405X(93)90023-5
- Fama, E.F., and French K.R. (1996). Multifactor explanations of asset pricing anomalies. Journal of Finance, 51, 55−84. https://doi.org/10.1111/j.1540-6261.1996.tb05202.x DOI: https://doi.org/10.1111/j.1540-6261.1996.tb05202.x
- FAMA, E.F., and FRENCH, K. R. (1995). Size and book-to-market factors in earnings and returns. The Journal of Finance, 50(1), 131–155. https://doi.org/10.1111/j.1540-6261.1995.tb05169.x DOI: https://doi.org/10.1111/j.1540-6261.1995.tb05169.x
- Fazzari, S.M., Hubbard, R.G., & Petersen, B.C. (1988). Financing constraints and corporate investment. Brookings Papers on Economic Activity, 2, 141–195. https://doi.org/10.2307/2534426 DOI: https://doi.org/10.2307/2534426
- Ghunmi, A., Nawwash, D., & El-Hafeth, A. (2008), Stock return, risk and asset pricing, Durham theses, Durham University.
- Gomes, J. F., Yaron, A., & Zhang, L. (2006). Asset pricing implications of firms’ financing constraints. The Review of Financial Studies, 19(4), 1321-1356. https://doi.org/10.1093/rfs/hhj040 DOI: https://doi.org/10.1093/rfs/hhj040
- Jensen, M.C. (1978). Some anomalous evidence regarding market efficiency. Journal of Financial Economics, 6, 95−102. https://doi.org/10.1016/0304-405X(78)90025-9 DOI: https://doi.org/10.1016/0304-405X(78)90025-9
- Jensen, M.C. (1986). Agency costs of free cash flow, corporate finance and takeovers. American Economic Review, 76, 323-39.
- Jensen, M.C., and Meckling, W. (1976). Theory of the firm: Managerial behaviour, agency costs, and capital structure. Journal of Financial Economics, 4, 305-60. https://doi.org/10.1016/0304-405X(76)90026-X DOI: https://doi.org/10.1016/0304-405X(76)90026-X
- Kaplan, S.N., and Zingales, L. (1997). Do investment-cash flow sensitivities provide useful measures of financing constraints? The Quarterly Journal of Economics, 112(1), 169–215. https://doi.org/10.1162/0 03355397555163 DOI: https://doi.org/10.1162/003355397555163
- Lamont, O., Polk, C., & Saaá-Requejo, J. (2001). Financial constraints and stock returns. Review of Financial Studies, 14(2), 529–554. https://doi.org/10.1093/rfs/14.2.529 DOI: https://doi.org/10.1093/rfs/14.2.529
- Lee and Seunghyup (2020). Essays in financial economics. Doctoral dissertation, Harvard University, Graduate School of Arts & Sciences.
- Lintner, J. (1965). The valuation of risk assets and the selection of risky investments in stock portfolios and capital budgets. Review of Economics and Statistics, 47, 13−37. https://doi.org/10.2307/1924119 DOI: https://doi.org/10.2307/1924119
- Litzenberger, R., and Ramaswamy, K. (1979). The effects of personal taxes and dividends on capital asset prices: Theory and empirical evidence. Journal of Financial Economics, 7(2) 163-195. https://doi.org/10.1 016/0304-405X(79)90012-6 DOI: https://doi.org/10.1016/0304-405X(79)90012-6
- Livdan, D., Sapriza, H., & Zhang, L. (2009). Financially constrained stock returns. Journal of Finance, 64(4), 1827–1862. https://doi.org/10.1111/j.1540-6261.2009.01481.x DOI: https://doi.org/10.1111/j.1540-6261.2009.01481.x
- Sharpe, W.F. (1964). Capital asset prices: A theory of market equilibrium under conditions of risk. Journal of Finance, 19, 425−442. https://doi.org/10.1111/j.1540-6261.1964.tb02865.x
- Sharpe, W.F. (1964). Capital asset prices: A theory of market equilibrium under conditions of risk. The Journal of the American Finance Association, 19(3), 425-442. https://doi.org/10.1111/j.1540-6261.1964.tb02865.x DOI: https://doi.org/10.1111/j.1540-6261.1964.tb02865.x
- Shaikh, S., Channar, P., Shaikh, M., &, Ullah, M., (2021). Financial constraints and listed sugar mills on Pakistan Stock Exchange. International Journal of Management, 12(3), 70-76. https://doi.org/10.29270/JB S.12.2(2018).0118 DOI: https://doi.org/10.29270/JBS.12.2(2018).0118
- Steinbach, M. (2001). Markowitz revisited: Mean-variance models in financial portfolio analysis. SIAM Review, 43(1), 31-85. https://doi.org/10.1137/S0036144500376650 DOI: https://doi.org/10.1137/S0036144500376650
- Thompson, R. (1978). The information content of discounts and premiums on closed-end fund shares. Journal of Financial Economics, 6, 151−186. https://doi.org/10.1016/0304-405X(78)90028-4 DOI: https://doi.org/10.1016/0304-405X(78)90028-4
- Ullah, M., Shaikh, M., Channar, P., & Shaikh, S., (2021). Financial forecasting: an individual perspective. International Journal of Management, 12(3), 60-69.
- Whited, T.M., and Wu, G. (2006). Financial constraint risk. The Review of Finance Studies, 19, 531-559. https://doi.org/10.1093/rfs/hhj012 DOI: https://doi.org/10.1093/rfs/hhj012
References
Ahmad, S., & Hashmi, M. (2019). Financial Constraints, Firms’ Investments and Performance of Manufacturing Sector of Pakistan: A Cross Industry Analysis. Pakistan Development Review (PDR), PIDE Islamabad. Retrieved from https://www.pide.org.pk/psde/pdf/AGM33/papers/Shagufta%20Ahmad.pdf
Balafas, N. (2013). Essays on corporate finance, monetary policy and asset pricing on London Stock Exchange. Ph.D thesis draft, The university of Liverpool repository. Retrieved from https://livrepository.live rpool.ac.uk/id/eprint/9573
Balafas, N., and Kostakis, A. (2015). Financial constraints and asset pricing: Comprehensive evidence from London Stock Exchange. The European Journal of Finance, 23(1), 80–110. https://doi.org/10.1 080/1351847X.2015.1115773
Balafas, N., and Kostakis, A. (2017). Financial constraints and asset pricing: Comprehensive evidence from London Stock Exchange. The European Journal of Finance, 23(1), 680-110. https://doi.org/10.10 80/1351847X.2015.1115773 DOI: https://doi.org/10.1080/1351847X.2015.1115773
Balafas, N., Florackis, C., & Kostakis, A. (2018). Monetary policy shocks and financially constrained stock returns The effects of the financial crisis. International Review of Financial Analysis, 58, 69–90. https://doi.org/10.1016/j.irfa.2018.05.001 DOI: https://doi.org/10.1016/j.irfa.2018.05.001
Burton, N. (2018). Burton G. Malkiel's: A random walk down Wall Street.
Caggese, A. (2007). Financing constraints, irreversibility, and investment dynamics. Journal of Monetary Economics, 54(7), 2102-2130. https://doi.org/10.1016/j.jmoneco.2006.10.001 DOI: https://doi.org/10.1016/j.jmoneco.2006.10.001
Cochrane, J.H. (2013). Finance: Function matters, not size. NBER Working Paper No. 18944. https://doi.org/10.3386/w18944 DOI: https://doi.org/10.3386/w18944
Collot, S., and Hemauer, T. (2021). A literature review of new methods in empirical asset pricing: mitted-variable and errors-in-variables bias. Swiss Society for Financial Market Research, 35(1), 77-100. https://doi.org/10.1007/s11408-020-00358-0 DOI: https://doi.org/10.1007/s11408-020-00358-0
Fama, E. and French, K. (1993). Common risk factors in the returns of stocks and bonds. Journal of Financial Economics, 33, 3-56. https://doi.org/10.1016/0304-405X(93)90023-5 DOI: https://doi.org/10.1016/0304-405X(93)90023-5
Fama, E.F., and French K.R. (1996). Multifactor explanations of asset pricing anomalies. Journal of Finance, 51, 55−84. https://doi.org/10.1111/j.1540-6261.1996.tb05202.x DOI: https://doi.org/10.1111/j.1540-6261.1996.tb05202.x
FAMA, E.F., and FRENCH, K. R. (1995). Size and book-to-market factors in earnings and returns. The Journal of Finance, 50(1), 131–155. https://doi.org/10.1111/j.1540-6261.1995.tb05169.x DOI: https://doi.org/10.1111/j.1540-6261.1995.tb05169.x
Fazzari, S.M., Hubbard, R.G., & Petersen, B.C. (1988). Financing constraints and corporate investment. Brookings Papers on Economic Activity, 2, 141–195. https://doi.org/10.2307/2534426 DOI: https://doi.org/10.2307/2534426
Ghunmi, A., Nawwash, D., & El-Hafeth, A. (2008), Stock return, risk and asset pricing, Durham theses, Durham University.
Gomes, J. F., Yaron, A., & Zhang, L. (2006). Asset pricing implications of firms’ financing constraints. The Review of Financial Studies, 19(4), 1321-1356. https://doi.org/10.1093/rfs/hhj040 DOI: https://doi.org/10.1093/rfs/hhj040
Jensen, M.C. (1978). Some anomalous evidence regarding market efficiency. Journal of Financial Economics, 6, 95−102. https://doi.org/10.1016/0304-405X(78)90025-9 DOI: https://doi.org/10.1016/0304-405X(78)90025-9
Jensen, M.C. (1986). Agency costs of free cash flow, corporate finance and takeovers. American Economic Review, 76, 323-39.
Jensen, M.C., and Meckling, W. (1976). Theory of the firm: Managerial behaviour, agency costs, and capital structure. Journal of Financial Economics, 4, 305-60. https://doi.org/10.1016/0304-405X(76)90026-X DOI: https://doi.org/10.1016/0304-405X(76)90026-X
Kaplan, S.N., and Zingales, L. (1997). Do investment-cash flow sensitivities provide useful measures of financing constraints? The Quarterly Journal of Economics, 112(1), 169–215. https://doi.org/10.1162/0 03355397555163 DOI: https://doi.org/10.1162/003355397555163
Lamont, O., Polk, C., & Saaá-Requejo, J. (2001). Financial constraints and stock returns. Review of Financial Studies, 14(2), 529–554. https://doi.org/10.1093/rfs/14.2.529 DOI: https://doi.org/10.1093/rfs/14.2.529
Lee and Seunghyup (2020). Essays in financial economics. Doctoral dissertation, Harvard University, Graduate School of Arts & Sciences.
Lintner, J. (1965). The valuation of risk assets and the selection of risky investments in stock portfolios and capital budgets. Review of Economics and Statistics, 47, 13−37. https://doi.org/10.2307/1924119 DOI: https://doi.org/10.2307/1924119
Litzenberger, R., and Ramaswamy, K. (1979). The effects of personal taxes and dividends on capital asset prices: Theory and empirical evidence. Journal of Financial Economics, 7(2) 163-195. https://doi.org/10.1 016/0304-405X(79)90012-6 DOI: https://doi.org/10.1016/0304-405X(79)90012-6
Livdan, D., Sapriza, H., & Zhang, L. (2009). Financially constrained stock returns. Journal of Finance, 64(4), 1827–1862. https://doi.org/10.1111/j.1540-6261.2009.01481.x DOI: https://doi.org/10.1111/j.1540-6261.2009.01481.x
Sharpe, W.F. (1964). Capital asset prices: A theory of market equilibrium under conditions of risk. Journal of Finance, 19, 425−442. https://doi.org/10.1111/j.1540-6261.1964.tb02865.x
Sharpe, W.F. (1964). Capital asset prices: A theory of market equilibrium under conditions of risk. The Journal of the American Finance Association, 19(3), 425-442. https://doi.org/10.1111/j.1540-6261.1964.tb02865.x DOI: https://doi.org/10.1111/j.1540-6261.1964.tb02865.x
Shaikh, S., Channar, P., Shaikh, M., &, Ullah, M., (2021). Financial constraints and listed sugar mills on Pakistan Stock Exchange. International Journal of Management, 12(3), 70-76. https://doi.org/10.29270/JB S.12.2(2018).0118 DOI: https://doi.org/10.29270/JBS.12.2(2018).0118
Steinbach, M. (2001). Markowitz revisited: Mean-variance models in financial portfolio analysis. SIAM Review, 43(1), 31-85. https://doi.org/10.1137/S0036144500376650 DOI: https://doi.org/10.1137/S0036144500376650
Thompson, R. (1978). The information content of discounts and premiums on closed-end fund shares. Journal of Financial Economics, 6, 151−186. https://doi.org/10.1016/0304-405X(78)90028-4 DOI: https://doi.org/10.1016/0304-405X(78)90028-4
Ullah, M., Shaikh, M., Channar, P., & Shaikh, S., (2021). Financial forecasting: an individual perspective. International Journal of Management, 12(3), 60-69.
Whited, T.M., and Wu, G. (2006). Financial constraint risk. The Review of Finance Studies, 19, 531-559. https://doi.org/10.1093/rfs/hhj012 DOI: https://doi.org/10.1093/rfs/hhj012