Dynamics of return volatility and firm characteristics in explaining average abnormal portfolio returns: evidence from Indian stock market

Abstract

Abstract

Abstract Volatility in emerging equity markets presents a distinct challenge for investors and policymakers, necessitating an understanding of the interplay between firm-level characteristics and aggregate market dynamics. So, the present study examines how return volatility and firm characteristics jointly shape abnormal portfolio returns in an emerging economy like India. This study investigates twenty-five size–volatility portfolios constructed by using the Fama–French [17] method to determine if these portfolios generate abnormal returns for the Indian investors. The study further evaluates the effectiveness of Fama–French three factor model (FFTF) in explaining portfolio returns and compares them with a modified Fama–French three factor model (MFFTFM) that substitutes the value factor with a volatility measure. Empirical analysis revealed that small-sized stocks with low volatility (P1) generate 3.2% return, whereas large-sized stocks with high volatility (P25) generate 1.4% return for investors, suggesting the existence of abnormal return patterns in the Indian stock market. Notably, MFFTFM outperforms the traditional Fama–French three factor model by explaining the abnormal returns of size–volatility sorted portfolios. The GRS test also supports the above findings as the R-square value for MFFTFM is higher than that of the FFTF model. These findings will contribute to existing literature in asset pricing by providing new perspectives on volatility as a potential priceable factor.