Fama and French Three-factor Model and Liquidity Risk: Evidence from Tehran Stock Exchange Market

One of the main criteria for deciding on stock exchange market is stock return. Stock return includes information content and most actual and potential investors in financial analysis and forecasts use it. Many studies have been conducted about the relationship between risk and return. The three-factor model of Fama and French is one of the most important models. In this paper we consider Fama and French three-factor model augmented by the Pastor and Stambaugh (2003) market liquidity risk factor. Then it is compared with three-factor model of Fama and French. Unlike most previous studies, in this model, stock level beta is allowed to vary with firm-level size and book-to-market ratio. We use monthly time series data for sample companies of Tehran stock exchange market for the period 1380 to 1389, and evaluate them by using Eviews software by panel method. The results show the effects of excess market return, firm size and book-to-market ratio is significant and the effect of market liquidity factor is insignificant. Also the market beta is only a function of size variable. Finally we find that market liquidity factor of Pastor and Stambaugh and the time variation in the market beta increase the explanatory power of Fama and French three-factor model.