When Market Misbehaves: An Irrational Version of the Asset Pricing Model in the Emerging Market of Pakistan

Abstract

The traditional asset pricing model assumes investors’ rationality, yet the emerging markets misbehave, and our most fundamental pricing models simply fail to defend their myth.

Purpose—This study aims to develop the Behaviorally Extended Capital Asset Pricing Model (BECAPM), an irrational version of the CAPM by incorporating six behavioral variables in the traditional single-factor model to check predictability improvement of returns in the context of emerging capital markets like the Pakistan stock exchange.

Study Design/methodology/approach—Accumulating the daily data of 100 listed companies of the KSE-100 Index from 2005 to 2024 from PSX official website, SBP data center, and investing.com, behavioral variables have been constructed using price dispersions, cumulative abnormal returns, Cross-Sectional Absolute Deviation (CSAD), principal component, and dividend announcements as highlighted by the existing literature. Seven nested regression models with Newey-West robust standard errors were estimated and compared for prediction accuracy.

Findings—The fully extended BECAPM demonstrates a 48% improvement in explanatory power over single-factor CAPM. Though the primacy of systematic risk remains dominant, herding exhibits the strongest negative impact (β = -1.052), and dividend preference emerges as the most significant positive factor (β = 0.387). Model selection criteria unanimously support behavioral extensions. Structural break analysis reveals amplified behavioral effects during crisis periods (2008 financial crisis, 2020 pandemic).

Practical Implications—This study would be helpful to the portfolio managers in better decision making for investments, the regulators in devising a better monitoring system for speculative trading, and the academics to enhance financial literacy programs that target the reduction in cognitive bias to enhance market efficiency and snub mispricing.

Limitations—The construction of behavioral factors relies on market-based proxies rather than direct psychological measures. Analysis of single market limits generalization.

Originality/value—It is the first study in our knowledge to incorporate multiple psychological factors into a unified pricing model and provide empirical validation of behavioral risk factors simultaneously.