# Investigating The Determinants Of Equity Risk In Pakistan

Last decade has witnessed significant progression in capital theory and its application to corporate finance, Portfolio analysis and investment policy. More recently a growing body of work has undertaken the analytically testing the positive inference of the theory. The study of risk has engaged a central position of corporate finance. The term risk has variety of meanings in business and everyday life. Risk was to describe any situation where there is uncertainty about what outcome will occur. The purpose of studied was to investigate the determinants of equity risk through analysis of firm’s fundamental characteristics, specially, firm size and financial leverage.

Major research studies have been conducted by the majority of researchers on the equity risk. When investment depreciated due to market dynamics was known as equity risk. The empirical study of the determinants of risk can be classified in to two broad categories according to their macro and micro orientation. Number of studies has analyzed the relationship between risk premium on stock market as a whole, the level of standard and poor’s stock index, and required rate of return on equity. Macro means aggregate such as, the money supply, the federal deficit, the long- term short-term interest rate spread and expected inflation. Robichek and Cohn (1975) tested the influence of real economic growth and inflation on systematic risk (beta) of individual firms’. It was found that macro variables did not light on determinant of the systematic risk, and only small firms’ influenced by real growth and inflation. In the micro category, Fisher and Hall (1969) have focused on risk-rate of return relationship through analysis of mean and higher moment of the rate of return distribution.

As the equity risk was already explained in earlier section, now according to different research studies, it was found that equity risk premium was directly or positively related with the risk. The study of Kyriacou, Jakob and Bryan (2006) described equity risk premium as a difference of stock return and risk-free return. Whilst equity was considered undoubtedly more riskier than government issuance of securities, and remaining portion characterized as a puzzle. The authors again demonstrated that equity risk premium was positively related with inflation. It was found that the performance of bond was negatively related with inflation. The comparatively poor performance of bond during inflation drove the equity premium high. The equity premium had tried to resolve the puzzle by explaining the size of the premium. At one conclusion of the spectrum were efforts that allowed for alternative preferences, thereby making it possible for investors to have the required high levels of risk aversion. These ranged from the incorporation of thin framing Barberis (2003) and custom formation (Constantinides, 1990) to the submission of generalized expected value in Bansal and Yaron (2004). On the other hand, the author recommended a friction-based explanation. The equity premium became lower if the young had not liquidity constraints from investing in equity. Instead, older investors considered equity as not a desirable asset that determined the premium.

## 1.2 Problem Statement

In the corporate finance, the equity risk was considered to be one of the most important issues. The main objective behind the study of the equity risk was that it was the most important issue for the present firms to bear the equity risk due to market dynamics. Furthermore, equity risk was prompted by several other factors such as the dividend records and future uncertain cash flows.

The purpose of the study was to investigate the determinants of equity risk in Pakistan. The scope of study was to analyze the distinctive financial factors which affected the equity risk and depreciate the value of investment in Pakistan. In this study, the effect of two variables such as firms’ size and financial leverage was analyzed.

## 1.3 Hypotheses

A central query in front of firms was how to cope with equity risk and to determine which steps to be taken in order to minimize equity risk. The main objective of the study was to determine and examine the factors presented by Zion and Shalit (1975) really played a vital role in the analyses of the equity risk and those factors as discussed by the author were firms’ financial leverage and firm size. The hypothesized relationship of these listed factors with equity risk is provided below:

H1: There is positive impact of leverage on equity risk.

H2: There is negative impact of firms’ size on equity risk.

## 1.4 Outline of the Study

The research structured as follows. Chapter one based on the introduction of the research study, which consists of the some introduction of the equity risk by different authors, the statement of problem, scope and objectives, hypothesis etc. Chapter two consists of literature review given by different authors, theories on equity risk and factors affecting the equity risk. Chapter three described methodology which is composed of justification of the selection of the variables utilized in analysis sample, the data, technique and hypothesis, also estimate model utilized in analysis. In chapter four, analyses of the results were there which were taken after the data processing. Chapter five contained the final results, conclusions and recommendations. References are included in chapter number six.

CHAPTER 2:

LITERATURE REVIEW

It was common question which arose in finance that how firms raised their equity, how to minimize equity risk and was there any factor or factors which influence the equity. In the last forty years a large number of ideas and related theories have proposed to answer these questions. The empirical study of the determinants of risk can be classified in to two broad categories according to their macro and micro orientation. Number of studies has analyzed the relationship between risk premium on stock market as a whole, the level of standard and poor’s stock index, and required rate of return on equity. Macro means aggregate such as, the money supply, the federal deficit, the long- term short-term interest rate spread and expected inflation. Robichek and Cohn (1975) tested the influence of real economic growth and inflation on systematic risk (beta) of individual firms’. It was found that macro variables did not light on determinant of the systematic risk, and only small firms’ influenced by real growth and inflation. In the micro category, Fisher and Hall (1969) have focused on risk-rate of return relationship through analysis of mean and higher moment of the rate of return distribution.

Beaver, Kettler, and Scholes (1970) examined the relationship between financial ratios (payout, liquidity, and earning variability etc) to systematic risk or beta and found significant relationship among them. Breen and Lerner (1973) used same type of explanatory variables and found same results and provided additional evidences.

Hamada (1972) found that conditional on the validity of Modigliani and Miller’s model, leverage accounts contributed a portion (21% to 24%) of systematic risk or beta. Rosenberg and McKibbon (1973) tested the joint power of accounting data and its historical stock return on systematic and specific risk of its common stocks. Melicher and Rush (1974) found same results as previous studies presented and selected explanatory variables on the basis of factor analyzed and not on intuition basis. Both of these presented a study which was different from previous study in following ways.

Melicher and Rush (1974) focused on relatively small number of economic variables but previous study emphasized on large number of accounting and financial variables.

Previous study used one measure of risk (beta) whose results were somewhat challenged. But they used three alternative risk measures, and found a consistency and interrelationship.

With the exception of Hamada (1972) all previous used accounting measure of leverage based on book value, whereas the appropriate measure would be market value and equity risk was depend upon the ratio of firm’s debt to market value of its total capital.

Fisher (1959) demonstrated firm’s size and financial leverage as important determinants of equity risk in corporate bonds. It was analyzed that total risk of firm’s equity was divided into two subcomponents: systematic risk and unsystematic risk. Research has proved that unsystematic risk can be eliminated through portfolio formation; financial research has more focused on systematic risk.

Hamada (1962, 1972) analyzed and empirically tested the relationship between operating characteristic of the firm and their systematic risk. Hamada (1969) also analytical showed that if a firm increases its leverage that directly affect the betas. Rubenstein (1973) gave a model which included two component of operating risk of firm: the amount of fixed and variable cost employed in the production technology and second, covariabilty of firm’s output with market return. Lev (1974) empirically tested that a negative relationship between level of unit variable cost and systematic risk. Hill and Stone (1980) empirically confirmed positive relationship between covariabilty of firm profitability and market return. Gahlon and Gentry (1982) gave a model which included financial and operating leverage and systematic risk tried to find a relationship between them. Peterson and Peterson (1985) included a degree of operating leverage was an independent variable in the regression model to explain a systematic risk but they failed to produce conclusive results. In the contemporary study, Mandelker and Rhee (1984) found positive relationship between both degrees of operating leverage and degree of financial leverage with systematic risk. Later, Huffman (1989) replicated the work of Mandelker and Rhee (1984) found positive relationship between systematic risk and degree of financial leverage in the analysis. Huffman (1989) conclusive result of degree of operating leverage was not so clear with systematic risk. The theoretical worked by Huffman (1983) and Prezas (1987) demonstrated that there might be an important relation between degree of financial leverage and degree of operating leverage. Prezas (1987) showed that the amount of debt employed in a firm which could be impact the degree of operating leverage.

Huffman (1983) found same results as Prezas (1987) demonstrated. Harold (1968) found that addition of debt to capital structure in a corporation directly affected the risk of common shareholders and also found that addition of debt to capital structure affected on earnings per dollar of common stock investment. Harold (1968) changed the rule of game and varied the size of firm. It was noted that add a debt to common stock investment and increased the size of firm. If addition debt earned interest rate at equal to interest rate currently being earned by firm on common stock investment, the addition of debt was not affected the expected return of the common stock. However, addition of debt affected the earnings per dollar of common stock investment. Rosenberg and McKibbon (1973) traditionally, accounting variables such as leverage and payout were used to assess the risk of return on common stock. Recently, historical security prices were used to predict the future risk of common equity in the firm. Beaver, Kettler, and Scholes (1970) used accounting variables as instrument variables which predicted the future market betas on the basis of past estimated betas and gave better results than the direct use of past betas. Beaver, Kettler, and Scholes et al. found that beta was empirically associated with several factors, including leverage, earning variability, payout, and growth as well as accounting earning beta.

Modigliani and Miller (1958) made a proposition that corporate leverage occupied central role in the eyes of finance students. Both of these made another proposition that personal leverage was perfect substitute for corporate leverage. If this proposition made true then corporate borrowing could substitute for personal borrowing in capital asset pricing model as well. Both in pricing model and MM found that borrowing whatever sources firms applied, while maintaining a fixed amount of equity and increased the risk to investors. Robichek, Higgins, and Kinsman (1973) empirically and theoretically analyzed the effect of leverage on cost of equity capital for electric utility firms. Topic was given an importance for the two reasons. First, the influence of leverage on cost of equity capital and second, from a regulatory point of view, how cost of capital change due to degree of variation in the leverage. Modigliani Miller (1963) tested the effect of leverage on value and required rate of return on equity share. Modigliani and Miller (1963) gave a proposition II which in the tax correlated version states k=k* + (I - T) (k* -i) D/S, where k denoted the cost of equity capital, k* showed the absence of leverage, T denoted the corporate tax, i showed the borrowing rate, and D/S denoted the debt/ equity ratio measured with market term. It was assumed that all variables kept constant for cross section of the firms. Then, equation was k = a, + a, D/S. finally they worked on K which denoted the earning/price ratio and D/S denoted the market value of debt equity. Barges (1963) criticized the work of MM due to presence of market value. Barges (1963) argued that the presence of share price in the denominators of both dependent and independent variables introduced the spurious correlation between variables which created the bias a, upwards. Instead, Barges (1963) used book value to measure leverage, but most theories used market weights. MM gave four assumptions; (1) rate of interest on debt was constant over the degree of leverage, (2) expected earning stream was constant and did not change due to leverage, (3) k (cost of equity capital) is given by the earning/price ratio; and in the tax case, (4) the effect of taxes on the value of the firm was equal to tD. Assumption (2) was the heart of MM model.

Nerlove (1968) investigated the factors affecting the rate of return on investment in the common stock used multiple regression technique and concluded that firm’s sales growth was a only important explanatory variable. Financial decision did not affect the sales growth but financial policy affected the sales growth.

Brigham and Myron (1968) argued that firm could generate funds through two different sources for corporate investment; retained earning and long term debt. These financial decisions affected the corporation. Beaver (1968) argued the failure firm, was costly to supplier of capital because reorganization or liquidation cost consumed a major portion of firm’s value. Beaver (1968) tested that financial ratios were a good predictor tool to analyze a firm’s probability of failure and also gave another tool to predict the failure of firm was change in market price of stock. Ronald W. Melicher (1974) decomposed a risk into systematic or market risk and specific or diversified risk.

Hamada (1969) theoretically based analyzed that difference in degree of market risk was depend upon the financial management activities and practices. Melicher (1974) has proved that firm could not directly observe the true beta of capital assets. Instead, it must rely on estimated beta which was computed through the historical return data. The relationship between market risk and financial factor was expressed in term of estimated beta. Melicher included a study and focused on developing a multivariate link between estimated beta and financial data. Logue and Merville (1972) employed a multiple regression technique attempted to relate a financial variables and estimated beta. Assets size, return on assets, and financial leverage found a significant.

Hamada (1972) and Galai & Masulis (1976) linked the firm’s equity beta with other factors like, level of financial leverage, debt maturity, variation in income, cyclicality, operating leverage, dividends, or non optional growth.

Berg, Green, and Naik (1999) and Carlson, Fisher and Gaimmarino (2003) found that book to market ratio and firm size on dynamic relation between return and risk due to continuous changes in firm’s current business and its future growth. Lerner (1973) tested the beta variance through independent variables such as the ratio of debt to equity, growth of earning, stability of earning growth, size of company, dividend payout ratio, number of shares traded. These were the variables which affected the corporate activities and decisions. Sharp (1964), Lintner (1965), and Mossin (1966) gave a capital assets pricing model (CAPM) which measured the performance of assets in term of return. It was proposed that an assets risk could be measured by the covariance of assets return with the market portfolio return. Pradosh Simlia (2009) reinvestigated the performance of common stock return with respect to two characteristics: firm size and book to market ratio. Given empirical results showed that firm size and book to market ratio play significant role.

## CHAPTER 3:

## RESEARCH METHODS

## 3.1 Method of Data Collection

Data was collected from Karachi Stock Exchange KSE 100 Index as given by State Bank of Pakistan in publication of Balance Sheet Analysis of joint stock companies which were listed on the KSE (2004-2008). The period of study covered five years, 2004-08. The opted sample size of 60 non-financial firms was taken from KSE 100 Index, that were either manufacturing firms or service providing firms excluding the financial firms. The objective behind the exclusion of the financial firms from the sample was that equity risk impact of the financial firms and non-financial firms was entirely different.

## 3.2 Sample Size

A sample of 60 non-financial firms from KSE 100 Index was taken. Only firms were used in the samples that were only the non-financial firms that included the industrial firms and service providing firms listed on the KSE 100 Index form 2004-2008. The impact of the different financial factors on the equity risk was analyzed on all of the non-financial firms selected as the sample.

## 3.3 Research Model Developed

There were various financial factors of the non-financial firms which affected the equity risk of the firms. This research study analyzed the impact of different factors on equity risk. The factors’ relation with the equity risk, measurement formula and relationship with equity risk were discussed below following the discussion after ‘equity risk’.

## 3.3.1 Equity Risk

Equity risk occupied a central role in finance. When investment goes down due to stock market dynamics called equity risk. Risk on equity arises at many levels and situations.

Risk on their own stock in company: When corporation fails to design appropriate capital structure, weighting debt versus equity too much high and low. Equity risk exposed when mergers and acquisitions take place. Equity markets like other financial markets bear a risk in terms of market corrections. The various equity crashes (1929, 1973, and 1987) have had important macro economic consequences, like recession and rising unemployment. Measured the equity risk through Stock Turnover Ratio (TOR): This risk measured as the ratio of annual trading volume of each stock to number of shares outstanding.

## 3.3.2 Firm Size and Equity Risk

Recent research showed that small firms were presumed more risky, where large firms presumed less risky (Ben-zion & Shalit, 1975). Firm Size was supported by these assertions. (a) Marketability: this argument developed by fisher (1959) that large firms’ securities were presumed marketable assets and could be easily turned into cash, thereby being less risky. (b) Probability of Bankruptcy: since large firms do not appear in single night, but they grow over a period of time. Failing firms disappear early years of operation. It follows that firm’s size constitute a measure of its past performance and also predict the future performance and its risk. (c) Diversification: large firms were presumed less risky, however, if firms can diversify their operations efficiently in different portfolios than individual investors. Large firms had low variance of return than small firms overall return. In the perspective of portfolio theory, lower variance would not mean that firm has a lower risk, except the covariance with market returns is also lower. (d) Economies of Scale: Firms enable to incur lowest per unit cost and tried to earn above normal profit and latter cope against losses, thus reduce the probability of bankruptcy and hence, risk.

Firm size was measured by taking logarithm of annual sales, rather than taking market value of equity, because of that show a real picture of firm size. While market value equity correlated with leverage and is not independent of risk.

H1: There is negative impact of firm size on equity risk.

## 3.3.3 Leverage and Equity Risk

Leverage of firm occupied a central role, when investigate the determinants of equity risk since senior securities have priority over common stock equity in distribution of firm’s income as well as distribution of assets in case of bankruptcy. Larger debt in capital structure, show a higher risk of default and lower the valuation of its equity.

The financial leverage was calculated by the ratio: total assets- common stock equity/market value of common equity.

H2: There is positive impact of leverage on equity risk.

The model developed was a linear model and its specifications are provided below:

TOR = a0 + β1FIRM SIZE + β2LEV + є

TOR= the ratio of annual trading volume of each stock to number of shares outstanding.

FIRM = natural log of the Annual sales

LEV = (total assets- common stock equity)/market value of common equity.

Є = the error term

## 3.4 Statistical Technique

Multiple Linear Regression Analysis (MLR) technique was used for this research study to examine the impact of the distinctive financial characteristics of the non-financial firms on equity risk of the selected firms; Statistical Package for the Social Sciences (SPSS) was used for the examination of the secondary data.

Multiple Regression Analysis technique was used for the purpose of prediction of the decision of the non-financial firms to investigate the equity risk in Pakistan. The selected technique was used to study the impact of the different independent variables (financial factors as listed in the previous chapters) on the dependent variable i.e., equity risk. The multiple regression analysis was selected for this study because the multivariate analysis was more suitable than univariate investigation. In such a way, to openly taking into consideration, the interaction between multiple regressing variables, the study included the derivation of the linear regression function. It showed the intensity of the impact on equity risk during year 2004-2008 based on several independent variables.

## CHAPTER 4:

## RESULTS

The sample of 60 non-financial firms from the Karachi Stock Exchange KSE 100 Index was taken; Multiple Regression Analysis (MLR) technique was used for this research study. Researcher examined the distinctive financial characteristics of non-financial firms which affected the equity risk of the non financial firms. The selected technique was used to study the impact of the different independent variables on the Equity Risk.

## 4.1 Findings and Interpretation of the results

Due to non-normality, the results were not providing the true picture of the impact of the different predictors on the study variable.

In resolving the issue of normality, Ln transformations were applied on the variable in order to normalize the variable so that the results could be more reliable; and accurate outlook of the true picture of equity risk can be made. Ultimately, all the issues were successfully resolved which were creating hindrances in the way of accuracy of results. Now, proceeding with the analysis of the results because the data was normal and there was no multicollinearity issue in the data. The interpretation and analysis is presented in the next sections of this research study.

## TABLE 4.1 : Model Summary

Mod.

R

R Sq.

Adj.

R Sq.

1

.331a

.110

.103

Table 4.1 showed the summary regarding the regression model. The Adjusted R square of 10.3% in the above table showed that the both of the predictors of equity risk combined together explained 10.3% variation in the dependent variable and the remaining variation was unexplained or latent predictors were not included in the model.

## TABLE 4.2 : ANOVA

Models

Sums of Sq.

Df

Means Sq.

F

Sig.

1

Regressions

239.315

2

119.658

17.619

.000a

Residuals

1942.377

286

6.792

Total

2181.692

286

The table 4.2 checked the significance of the linear regression model in such a way that the reliability of the data file regarding the applicability of the regression technique can be understood from the above table; however, ANOVA table was reliable test of checking the linear regression model’s ability to explain any variation in the dependent variable of equity risk. This was perfectly obvious from the sig value of .000 that meant that the linear regression model was highly significant for the data collected for the research study conducted.

## TABLE 4.3 : Coefficients

Model

Unstandardized Coefficients

Standardized Coefficients

t

Sig.

Collinearity Statistics

B

Std. Error

Beta

Tolerance

VIF

1

(Constant)

-7.136

.917

-7.783

.000

Leverage

.033

.077

.025

.427

.670

.940

1.063

Firm Size

.557

.099

.324

5.637

.000

.940

1.063

In the table 4.3, the final model of regression included only one independent variable that was firm size. This was included in the model because this was the only variable that was highly significantly explaining the discrepancy in dependent variable of Equity Risk. In short, these results were not consistent with the results of Ben-Zion and Shalit (1975). The other independent variable of leverage was not significant in explaining the discrepancy in the dependent variable of equity risk because firstly, the economic and the financial environment was different; secondly, the behavior of the non financial firms was not same as that of the foreign firms in regard of equity risk; and lastly, the decisions of the firms regarding the generation of the funds through issuing shares or bonds were affected by the political situation and the security threats of Pakistan.

## 4.2 Hypotheses Assessment Summary

The hypothesis of the study was distinctive financial factors had significant impact on the non-financial firms’ equity risk. These financial characteristics were firm size, and financial leverage. In this study, each of the financial characteristic of non financial firms was tested and concluded the results.

## TABLE 4.4 : Hypotheses Assessment Summary

S.NO.

Hypotheses

β

SIG.

RESULT

H1

There is positive impact of leverage on equity risk.

0.333

0.670

Rejected

H2

There is negative impact of firm size on equity risk.

0.557

0.000

Rejected

## CHAPTER 5:

## DISCUSSIONS, CONCLUSION, IMPLICATIONS AND FUTURE RESEARCH

## 5.1 Conclusion

It is concluded based on the results of this research study that equity risk to firms’ size and financial leverage. The results showed only one significant variable which was firms’ size that explained the variation of equity risk in Pakistan. However, financial leverage was insignificant and could not play a significant role in explaining the variation in equity risk. These results were not similar with the study conducted by Ben-Zion and Shalit (1975). These results were varying because in various countries, there was difference in environments, political, economical and circumstances and firms usually made decision accordingly.

## 5.2 Discussions

Firms’ size played a crucial role in defining equity risk but that was not similar with the study conducted by Ben-Zion and Shalit (1975) because in his study the sample of firms’ size was not enough. The other variable financial leverage was not playing a significant role in predicting the equity risk in Pakistan but this was not the case with the research study undertaken by Ben-Zion and Shalit (1975) because of differences in economic factors which induced investment were entirely different in USA where the research was done by Ben-Zion and Shalit (1975) from Pakistan.

## 5.3 Implications and Recommendations

This research was limited to the various firms listed on Karachi Stock Exchange of Pakistan only. The data taken from 60 non financial firms which were took through various sectors of the KSE 100 Index for the year 2004-08. It recommended that such type of study should be carried out in other countries of Asia as well, as to have comprehensive idea about the equity risk. Moreover, it also suggested that other factors should be included in the study in order to have a perfect idea about equity risk. Besides that, this study can also be replicated in other developing countries.

## 5.4 Future Research

This study helped various firms, management and other research conductors in analyzing and observing the behavior of firms regarding equity risk. Research students who want to work further on equity risk can be benefited by this research study. Further more, the non financial firms will become advantageous from this study because the study shows the distinctive characteristics of different firms which significantly explain the equity risk.

## CHAPTER 6:

## REFERENCES

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Barberis, N., Huang, M. & Thaler, R. (2003). Individual preferences, monetary gambles and the equity premium. Working paper, University of Chicago, Chicago, IL.

Barges, A. (1963). The Effect of Capital Structure on the Cost of Capital. England Cliff, New Jersey: Prentice- Hall, Inc.

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## APPENDIX (A)

Variable View

S.No

Name

Type

Width

Decimals

Label

Values

Missing

Columns

Align

Measure

1

LnRisk

Numeric

8

1

Ln Equity risk

None

None

10

Right

Scale

2

TurnoverRate

Numeric

8

2

Equity Risk

None

None

8

Right

Scale

3

Leverage

Numeric

8

2

Leverage

None

None

8

Right

Scale

4

LnSales

Numeric

8

2

Firm Size

None

None

8

Right

Scale

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