This paper examines competing explanations, based on risk and investor sentiment, for the cross-sectional returns in the Tunisian stock market. First, we examine the explanatory power of Fama and French (1993); and Carhart (1997) risk factors in the cross-section of stock returns. We find evidence for pervasive market and size factors; the value and momentum factors are verified respectively for high book-to-market equity ratio portfolios and winners' portfolios. Then, we investigate the relation between institutional investor sentiment and size portfolio returns. The empirical results indicate a significant effect of sentiment measures on returns and significant effect of returns on change in sentiment. Finally, we document that the addition of sentiment investor to the pricing model dramatically decreases the magnitude of the market factor. Moreover, the size effect is no longer significant.

Rationality-based asset-pricing models assert that the cross-section of expected stock returns can be explained by betas or factor loadings on a set of common factors. Early evidence in the 1970s largely supports the Sharpe-Lintner-Black Capital Asset-Pricing Model (CAPM) and the Efficient Market Hypothesis (EMH) (Fama, 1991). Fama and French (1992), however, find that the main prediction of the CAPM, a linear cross-sectional relationship between mean excess returns and exposures to the market factors, is violated for the US stock market. In particular, exposures to two other factors, a size based factor and a Book-to-Market based (BM) factor, often called a `value' factor, explain a significant part of the cross-section of equity returns.

Based on these findings, Fama and French (1993) propose a three-factor model that expected stock return is linearly related to the factor loadings on returns of three portfolios constructed to replicate underlying risk factors—market factor, size factor and BM factor. These portfolios are excess return on market portfolio, Small Minus Big (SMB) size portfolio, and High Minus Low (HML) BM portfolio.

The three-factor model of Fama and French has been used to explain most market anomalies (Fama and French, 1996), except the momentum anomaly initiated by Jegadeesh and Titman (1993). Carhart (1997) further includes a momentum factor constructed by the monthly return difference between the returns on the high and low prior return portfolios to capture the cross-sectional return patterns.

Applied Finance Journal, Cross-Sectional Returns, Capital Asset-Pricing Model, CAPM, Efficient Market Hypothesis, EMH, Psychological Findings, Behavioral Finance Theory, Vector Autoregression, VAR, Abnormal Rreturns, Eemerging Markets, Portfolio Returns, Empirical Results.