Downside systematic risk in Pakistani stock market: role of corporate governance, financial liberalization and investor sentiment
| DOI | https://doi.org/10.1108/JABS-09-2020-0356 |
| Published date | 12 July 2021 |
| Date | 12 July 2021 |
| Pages | 137-160 |
| Subject Matter | Strategy,International business |
| Author | Shahzad Hussain,Muhammad Akbar,Qaisar Ali Malik,Tanveer Ahmad,Nasir Abbas |
Downside systematic risk in Pakistani
stock market: role of corporate
governance, financial liberalization and
investor sentiment
Shahzad Hussain, Muhammad Akbar, Qaisar Ali Malik, Tanveer Ahmad and Nasir Abbas
Abstract
Purpose –The purpose of this paper is to examine the impact of corporate governance, investor
sentiment and financial liberalization on downside systematic risk and the interplay of socio-political
turbulenceon this relationship through static and dynamicpanel estimation models.
Design/methodology/approach –The evidence is based on a sample of 230 publicly listed non-
financial firms from Pakistan Stock Exchange (PSX)over the period 2008–2018. Furthermore, this study
analyzes the data through Blundell and Bond (1998) technique in the full sample as well sub-samples
(big and smallfirms).
Findings –The authors document that corporate governance mechanism reduces the downside risk,
whereas investorsentiment and financial liberalization increasethe investors’ exposure toward downside
risk. Particularly,the results provide some new insights that the socio-politicalturbulence as a moderator
weakens the impact of corporate governance and strengthens the effect of investor sentiment and
financialliberalization on downside risk. Consistentwith prior studies, the analysis of sub-samplesreveals
some statistical variations in large and small-size sampled firms. Theoretically, the findings mainly
supportagency theory, noise trader theory and theKeynesians hypothesis.
Originality/value –Stock market volatility has become a prime area of concern for investors,
policymakers and regulators in emerging economies. Primarily, the existence of market volatility is
attributed to weak governance, irrational behavior of market participants, the liberation of financial
policies and sociopolitical turbulence. Therefore, the present study provides simultaneous empirical
evidence to determine whether corporate governance, investor sentiment and financial liberalization
hinder or spur downsiderisk in an emerging economy. Furthermore, the workrelates to a small number of
studies that examinethe role of socio-political turbulence asa moderator on the relationshipof corporate
governance,investor sentiment and financial liberalizationwith downside systematicrisk.
Keywords Corporate governance, Financial liberalization, Investor sentiment, Downside risk,
Socio-political turbulence
Paper type Research paper
1. Introduction
Market participants are more conscious of the cataclysmic causes and consequences of
stock market volatility (Dai et al.,2020;Liang et al.,2020) as these deter investors’
participation,risk sharing and distort investmentdecisions (Fang et al.,2020).The presence
of persistent market volatility is detrimental for the smooth functioning of the stock market
thereby raising the required rate of return for bearing higher systematic risk and
discouraging firms from capital expansion, which, in turn, thwartsproductive investment and
impedes economic growth (Maitra and Dash, 2017;Mathew et al.,2018;Wang et al.,2020).
Shahzad Hussain is based at
the Faculty of Management
Sciences, Foundation
University Islamabad,
Islamabad, Pakistan.
Muhammad Akbar is based
at Birmingham City
University, Birmingham, UK.
Qaisar Ali Malik is based at
the Faculty of Management
Sciences, Foundation
University Islamabad,
Islamabad, Pakistan.
Tanveer Ahmad is based at
the Kohat University of
Science and Technology,
Kohat, Pakistan.
Nasir Abbas is based at the
Department of Business
Management, University of
Baltistan, Baltistan,
Pakistan.
Received 10 September 2020
Revised 24 January 2021
27 March 2021
11 April 2021
Accepted 14 April 2021
Authors are extremely grateful
to the anonymous reviewers
and editor for their worthy
suggestion.
DOI 10.1108/JABS-09-2020-0356 VOL. 16 NO. 1 2022, pp. 137-160, ©Emerald Publishing Limited, ISSN 1558-7894 jJOURNAL OF ASIA BUSINESS STUDIES jPAGE 137
Theoretically, conflicting views exist in the literature regarding the accurate methodology for
the estimation of the required rate of returns, as the seminal work of Markowitz (1952).
Research studies in the strand of mean-variance behavior (MVB) hypothesis advocate the
suitability and reliability of variance for the measurement of the volatility of returns for any
asset. Based on the MVB, Sharpe (1964) outlined beta as a measure of systematic risk for
any asset in the capital asset pricing model (CAPM). However, due to poor empirical
evidence, the original CAPM framework has been extended and other models that
incorporate lower partial moments have been introduced based on prospect theory [1].
Prospect Theory postulates that investors generally feel the stronger impulse to avoid losses
than to acquire gains (Tversky and Kahneman, 1979). Hence, investors are concerned with
downside risk;both downsides total risk and downsidesystematic risk based on mean semi-
variance behavior (MSB) framework. The MSB risk measures are considered more suitable
in accurate estimation of the required rate of return (Mitra, 2020;Harris et al.,2019;Atilgan
et al.,2019;Rashid and Hamid, 2015;Estrada, 2002). The most prominent of these MSB
based alternatemodels is the downside risk capital asset pricingmodel (DCAPM) of Estrada
(2002), where downside systematic risk is defined as the ratio of the covariance of the
downside (below mean) variations in stock and market returns and the semi-variance of
market returns.
Weak corporate governance mechanismis one of the main contributors to excessive market
volatility (Mathew et al., 2018).The agency theory of Jensen and Meckling (1976) posits that
the separation of ownership andcontrol creates the problem of asymmetric information that
enables managers to divert available resources to serve personal interests (Malik et al.,
2021). Compliance with the code of corporate governance reduces the problem of
information asymmetry thereby ensuring effective and transparent managerial decision-
making (Akbar et al., 2019;Ali et al., 2018;Hussainand Shah,2017a, 2017b). Further, there
is a plethora of empirical research on the theoretical notion of the role of investor sentiment
in shaping capital market volatility (Audrino et al.,2020;Hussain and Shah,2017a, 2017b;
Kumari, 2019;Maitra and Dash, 2017;Pandey and Sehgal, 2019;Seok et al., 2019;
Shahzad et al., 2017). Mispricingof securities triggered disproportionate volatilityduring the
financial crises of 2007–2008 that reinforced the considerable influence of emotional
aspects on investment decisions (Fang et al.,2020). Persistent mispricing of assets vis-a
`-
vis their fundamental values induces excessive market volatility. Contrary to the efficient
market hypothesis, the noise trader theory attributes the mispricing of stocks to the
presence of irrational investorsi.e. noise traders.
Excessive market volatility has also been associate with the financial liberalization in
developing and emerging countries in the 1990s (Gaies et al.,2020;Kassimatis, 2002).
Stiglitz (2004) argued that liberation of the financial system substantially increases the
volatility in the consumption and output level due to the presence of pro-cyclical nature of
foreign capital flows that impairs financial and economic development. On the contrary, the
investor-base broadening hypothesis implies that financial liberalization attracts foreign
investors, which, in turn, provides stability to the financial markets (Wang, 2007). However,
the empirical evidence is inconclusive on the liberalization and volatility relationship (Gaies
et al.,2020
;Li et al., 2020;Umutlu et al., 2010;Hamdaoui and Maktouf, 2020;Li et al.,2020;
Bekaert and Harvey, 1997) and the extant literature in the context of Pakistan offers no
empirical evidence on the relationshipat the firm level.
The present study contributes to the existing literature in several ways. First, it covers the
gap in extant literature in the context of Pakistan by empirically investigating the relationship
between financial liberalization and downside risk. Second, it provides simultaneous
empirical evidence to determine whether corporate governance, investor sentiment and
financial liberalization hinder or spur downside risk for listed firms in the Pakistani equity
market. Emerging markets such as Pakistan exhibit extreme market volatilityand suffer from
socio-political turbulence. There are several factors that contribute to the prevalence of
PAGE 138 jJOURNAL OF ASIA BUSINESS STUDIES jVOL. 16 NO. 1 2022
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