The Impact of the Financial Sector on Asset Pricing Tests: Evidence from the Colombo Stock Exchange

Abstract

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This paper aims to identify how the inclusion o f financial sector affects the ability o f asset pricing models to explain the average stock returns in the CSE. M ost o f the asset pricing researches, the firms in the financial sector are excluded on the basis that their characteristics and the leverage are notably different than firms in other industries. Therefore the objective o f this study is to identify the impact o f the inclusion o f financial sector on the ability o f the Carhart four-factor model to explain the average stock returns in the CSE and to compare its performance with the Capital Asset Pricing M odel (CAPM) and the Fama and French three-factor model. The study finds that the four-factor model; incorporating the market premium, size premium, value premium and momentum premium provides a satisfactory explanation o f the variation in the cross-section o f average stock returns in the CSE, even when the financial sector is included. It is found that the Carhart four-factor model performs better than the CAPM in all scenarios; and that it performs notably better than the Fama and French three-factor model.However, there is no notable difference in the findings either the financial sector is included or not.