Shariah-compliant Five-factor Pricing Model

Abstract

The development of Islamic finance necessitates the availability of shariah-compliant asset pricing models that capture the relevant sources of systematic risk for which investors must be compensated. This study extends Fama and French (2015) five-factor model by replacing risk-free rate with return on AAA Sukuk and the market portfolio factor with Shariah-compliant market portfolio. The model was tested using ten-year monthly data from 2007 to 2016 on non-financing firms listed on Saudi Stock exchange. The model inputs were returns on mimicking portfolios that proxy for the relevant underlying sources of risk that affect cross-section of returns. Excluding market portfolio factor, the independents portfolios were obtained from double sort of the listed firms on size and each of book-to-market value, profitability, and investment; the dependent portfolios were created from the double sort of firms on size and book- to-market value. For estimation, generalized method of moments was applied. The test results indicate that all factors in the model explain returns on small size portfolios, while in case of on big size; high BM only investment factor was found significant in explaining the returns. The model of this study is expected to provide investors with a robust tool in investigating the sources of systematic risk and make investment decisions based on their risk-return preferences.