The Impact of Downside Beta on Stock Price Behavior in Pakistan

Purpose- The purpose of this study is to construct a portfolio based on downside beta as a measure of downside risk. The analysis uses data from all listed companies on the Pakistan Stock Exchange (PSE) over the period from January 2000 to December 2021. Study Design/Methodology/Approach - The study employs a rolling window approach with 36 consecutive months to estimate downside beta values for portfolios ranked from lowest to highest downside beta. Portfolio returns are evaluated using the Generalized Method of Moments (GMM) in conjunction with the Capital Asset Pricing Model (CAPM) and the Fama-French three- and five-factor models. A six-month Treasury bill rate is used as the risk-free rate. Findings- The study reveals a significant spread between the downside beta values of the constructed portfolios, confirming that downside risk can be effectively captured through this approach. The hypothesis of equal mean downside beta across the portfolios is rejected, indicating that portfolios based on downside beta exhibit different risk-adjusted returns. Furthermore, the rejection of the alpha equal to zero hypothesis suggests that these risk-adjusted returns are statistically significant. However, the study finds that lower partial moments do not fully explain the variation in downside risk. Practical Implications- These findings are particularly relevant for investors focused on managing downside risk. The study offers alternative methods for constructing portfolios that account for downside risk, which could enhance risk management strategies. However, the reliance on historical data from the PSE may limit the generalizability of these findings to other markets. Originality/Novelty - This study contributes to the literature by constructing portfolios grounded in downside beta as a measure of downside risk, offering a novel approach to portfolio formation and risk-adjusted return evaluation. It highlights the importance of incorporating downside risk in portfolio management and presents an innovative application of downside beta within the context of emerging markets.