Predictability of Small Firm Premiums in Emerging Markets

Abstract

Small capitalization stocks in Emerging Markets have become increasing investment opportunities for international investors. The thesis is aimed at investigating the predictability of small firm premium in Emerging markets. Using the stock market quarterly data in 9 Emerging countries from first quarter 1990 to the fourth quarter 2012 this paper tries to find out which factors can predict return spreads between small and large firms. The predictive model includes 11 financial, technical and macroeconomic variables. Both in–sample and out –of –sample tests are undertaken.The out- of- sample tests are done under a recursive scheme, ensuring the stability of the model. The predictive power of each variable is tested both in Univariate model and in Multivariate model. The results show that the size premiums in Emerging Markets are predictable. The most powerful predictive variables are Short term interest rate, Momentum and Price earning. This thesis also demonstrates that comparing with traditional large cap holding portfolio investors can be better off by implementing a style diversification strategy. In this style rotation strategy the forecast results are efficiently used in asset allocation between large cap and small cap stocks. This investment strategy exhibits better performance relative to large cap stock holding in term of absolute returns as well as risk adjusted returns.