New Evidence on the Role of Size Effect in Determining the Pricing of Risk, Volatility Dynamics, and Economic Exposure of Firm Returns

New Evidence on the Role of Size Effect in Determining the Pricing of Risk, Volatility Dynamics, and Economic Exposure of Firm Returns

Faisal Khan (City University College of Ajman, UAE) and Sharif Ullah Jan (Management Sciences, FATA University, TSD Dara, NMD Kohat, Pakistan)
Copyright: © 2020 |Pages: 25
DOI: 10.4018/IJABE.2020070101
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This research study analyses the role of size effect in detecting the pricing of risk, various volatility dynamics, and economic exposure of firm returns on the Pakistani stock market by employing monthly data for the period from 1998 to 2018. Three generalized autoregressive conditional heteroskedasticity models were applied: GARCH(1,1) for capturing different volatility dynamics, GARCH-M for pricing of risk, and EGARCH for asymmetric and leverage effect. The findings of the study are as follows: Firstly, the authors untie that pricing of risk is subject to considerable variations with respect to firm size. Secondly, in the process of detecting whether the firm size matters in the case of asymmetry and leverage effect, they find that it is indeed the case. Thirdly, size effect plays a substantial role in determining various volatility dynamics. Finally, they uncover that economic factors affect stock returns differently based on firm size, signifying the role of size effect.
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The quest for stock returns has attracted considerable attention in the financial literature; however, the economists have generally paid little attention to the issue of firm’s returns in the context of its size (Narayan & Sharma, 2011). This research study desires to contribute to closing this gap. The following part of this section further elaborates the motivations for all the dimensions spotlighted along with the literature survey therein.

Motivation for Size Effect

The size effect became popular in the literature (e.g., Keim, 1983; Chan et al., 1985) and showed diversified results across the firms. A cluster of the literature has concluded that managers of small firms have lack of experienced or research resources compared to managers of large firms (Wyn, 1998; Salman & Yazdanfar, 2012). Thus, large firms due to more experienced and competent management and larger financial resources can diversify their investment and benefit from economies of scale (Elyasiani et al., 2007; Vilkov, 2007; Vickery, 2008; Huynh & Petrunia, 2010). Further, investors may have long historic records of old firms and thus they may check how their stocks responded through different upswings and are able to make more informed decisions. The studies of Fama and French (2004) and Chun et al. (2008) concluded that small firms have lower survival rate and exposed to negative changes in economic factors. Moreover, a small firm is less flexible to its changing market (Elyasiani et al., 2007; Salman & Yazdanfar, 2012) and are more risky because of its lack of financial and research resources, poor quality, lack of employee’s training and development and absence of qualified and experience management (Abdullah et al., 2012). Researchers (Adams et al., 2005; Chun et al., 2008; Cheng, 2008; Jaing et al., 2011) also argue that investor’s uncertainty decreases with increases in firm size. Accordingly, stock returns variability also decreases with increases in size, they further added (Trevino & Grosse, 2002; Jiang et al., 2011; Rasli et al., 2013).

However, a counter argument, as discussed by researchers (Tripsas & Gavetti, 2000; Foster & Kaplan, 2001; Loderer & Waelchli, 2010) are that large firms are symbols of organizational rigidity and inertia, thus exhibit reduction in their productive efficiency, slower growth, older and obsolete assets, reduction in R&D and investment activities (Loderer & Waelchli, 2010; Jiang et al., 2011; Loderer et al., 2013). Owing to organizational rigidity and moral hazard (Nimbleness theory), larger firms are relatively slower at adapting and learning new technology, innovations and practices (Barringer & Jones 2004; Jiang et al., 2011). However, Uhlaner et al. (2013) empirically proved the dominance of nimbleness theory in promoting sales. Further, in a related work from the point of old firms, not surprisingly, Elyasiani et al. (2007) and Loderer and Waelchli (2010) determined that with increases in firm size, corporate governance worsens which raises internal conflicts, reduces internal control and results in mismanagement.

Consequently, the above discussion indicates that firms react to economic factors, risk premia, the asymmetry and leverage behavior and various volatility dynamics differently with regard to the size and age group they belong to. Moreover, the existing financial literature has unfortunately ignored the size effect in terms of all these dimensions and thus serves as basis of the contribution to the literature of research study (Mandimika & Chinzara, 2012; Jan et al., 2018).

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