In this issue, we have three interesting papers broadly pertaining to asset pricing, while the last one focuses on the settlement failures in the bond market. Literature on asset pricing has come a long way from the simple Sharpe-Lintner model to the Fama-French multifactor models. The first paper, “Unexpected Correlations in Fama-MacBeth Methodology Outcomes”, by Laurent Cavenaile, David Dubois and Jaroslav Hlávka, applies the two-stage Fama-MacBeth procedure to the three-factor model of Fama and French. Instead of a market model, the first stage time series regression uses a three-factor model. In the second stage, a cross-sectional regression is estimated using the partial slopes of the earlier regression. The results are further corroborated using the procedure described by Cochrane (2001). The analysis is based on 55 portfolios consisting of 25 two-way sorted portfolios and 30 industry portfolios. The results highlight the pitfalls in using the Fama-MacBeth procedure due to the presence of unexpected quasi-perfect correlations in the second stage cross-sectional regression.

The second paper, “Capital Asset Pricing Model: Evidence from the Stock Exchange of Mauritius”, by Subadar Agathee Ushad, examines the validity of the standard and higher moments-based extensions of Capital Asset Pricing Model (CAPM). Specifically, this paper evaluates the significance of co-skewness and co-kurtosis factors in explaining security returns. Past theoretical and empirical results suggest that a part of cross-sectional variation in returns due to size and value effects is accounted for by co-skewness. Further, it has been proved that skewness can partially explain the momentum anomaly documented by Jegadeesh and Titaman vis-à-vis Fama-French three-factor model. Results in this paper indicate weak support for the three-moment CAPM while rejecting the co-kurtosis term. The result adds to the body of literature motivating the inclusion of skewness as an important variable in valuation.

The third paper, “Illiquidity Premium and Stylized Equity Returns”, by Arshad Hassan and Muhammad Tariq Javed, focuses on the relevance of the (il)liquidity premium. There is a growing literature support for the inclusion of the liquidity-based factor in the asset pricing equation. The last decade has witnessed a large number of papers supporting the extension of Fama and French model to incorporate the fourth factor of liquidity. The findings of the paper add further support to the liquidity-based factor in the Pakistani context. The results are consistent and robust with regard to various characteristics-based sorting, such as size, book-to-market ratio, price-earnings ratio, and momentum.

The fourth paper, “Trade Settlement Failures in US Bond Markets”, by Susanne Trimbath, provides a nice primer on the trade settlement operations for the bond market and provides estimates and impact of settlement failures. A very high level of heterogeneity is documented in the trade settlement failures for the US bond market. Based on a conservative estimate, the author arrives at $271 mn as annual revenue loss to the states in the form of taxes and $7.3 bn per year as loss of use of funds to investors. Given the huge economic significance, the author explores various reasons for the continuing settlement failures. Evidences presented suggest moral hazard behavior of broker-dealers as the key problem. Besides providing some policy implications, the paper also highlights the scope for further research in this area.

-- Vishwanathan Iyer
Consulting Editor