Testing factor models in an emerging market: evidence from India

Abstract

PurposeThis paper aims to investigate the explanatory power of the Fama-French five-factor model and compares it to the other asset pricing models. In addition, the paper examines the contributions of two additional factors: profitability and investment factor. The authors test the alternative four-factor models.Design/methodology/approachThe authors use stock returns data of BSE-500 listed firms for the Indian market, an emerging market, from 1999 to 2020, thus covering the post-Asian crisis and pre- and post-financial crisis (2007–2008) periods. The authors employ 75 and 96 portfolios based on different factors. To check the performance of asset pricing models, the authors also used the GRS F-statistics and factor spanning tests.FindingsThe authors find that the five-factor model and alternative four-factor model outperform the three-factor model. Contrary to the findings for the US, but similar to the Chinese stock market, the value factor is significant for the Indian stock market. Simultaneously, the authors also find that the investment factor has no explanatory power in the presence of the profitability factor in their sample.Originality/valueTo the best of the authors' knowledge, this is the most comprehensive study using data more than two decades. These results are based on 75 (25 × 3) portfolios based on size, value, profitability and investment. The authors also tested these results based on 96 (32 × 3) portfolios to check robustness, and these results still hold. Furthermore, the authors find that factors based on 2 × 3 sorting have higher explanatory power than those based on 2 × 2 and 2 × 2 × 2 × 2 sorting.