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This study investigates the impact of institutional development and regulatory policy changes on common stock price behavior in Pakistan during January 2003 to December 2016. The research uses suitable models to empirically analyse the daily stock prices of listed companies to identify and distinguish the stochastic behavior during the period when the stock market was highly regulated and segmented, as compared to the period when regulatory and financial reforms, and legal framework were introduced by the SECP and the SBP after January 2009. After institutional development and financial reforms, risk premia estimated through different asset pricing models, increased significantly during the period of reforms (January 2009 to December 2016) than the period of non-reform (January 2003 to December 2008) in Pakistan. Higher returns were observed particularly during the second sub-period of reforms (January 2013 to December 2016). The time-varying risk premium (GARCH-M) model provided evidence of a significant relation between risk and return during the overall study period and during both the non-reform and reform periods. The volatility in returns increased after regulatory policies and financial reforms. Allowing the risk factor(s) to vary over time to capture the stochastic behavior of stock returns, the findings showed a significant relationship between risk and average return for most of the portfolios. The results indicated that the relative size of reward to risk did not vary much over the period, although it was higher during the reform period as compared to the period of non-reform in most of the cases. The non-synchronous trading effect was evident during both reform and non-reform periods. The degree of persistence in volatility was higher during both the first and second sub-periods of reform than the non-reform period. The stochastic behavior of stock returns was more predictable and persistence during the period of reform than the non-reform period. The risk premia for industry portfolio were higher during the reform period. Most of the industries showed evidence of the theoretical relation of risk and return during the reform period. The volatility in industry return was more pronounced during the period of reform, particularly during the second sub-period of reforms. The impact of nonsynchronous trading and the degree of persistence in volatility were significant during both the non-reform and reform periods. Consistent negative and significant relationship of return and volatility change was observed which indicated leverage effect in industry portfolios. However, the leverage effect causing volatility was better explained during the non-reform period than that of reform period. In conclusion, the institutional development and financial reforms in Pakistan had a significant impact on the stochastic behavior of stock prices. In particular, the volatility in returns and risk premia had been higher and more predictable during the reform period. The findings of this study recommend coherent and sound policy implications for investors, portfolio managers, security analysts, policy makers and financial market regulators. The portfolio managers and investors may consider risk premia and its stochastic behaviour while making investment decisions and predicting return and volatility for trading in the market. The insight of this research is of importance for policy makers who may be weighing the costs and benefits of various liberalization policies towards capital mobility and pricing of risk in Pakistan.
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