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There have been numerous studies that have attempted to explain the
cross-sectional variation in average returns in developed and emerging markets.
However, there is a dearth in the published evidence of research that has looked
at frontier markets regarding this aspect. Sri Lanka is considered to be a frontier
market and hence the objective of this study is to test the ability of the Carhart
four-factor model to explain the variation in the cross-section of average stock
returns in the Colombo Stock Exchange (CSE) and to evaluate it in comparison
to the capital asset pricing model (CAPM) and the Fama and French
three-factor model. The study finds that the four-factor model, incorporating
the market factor, size factor, value factor and momentum factor, provides a
satisfactory explanation of the variation in the cross-section of average stock
returns in the CSE. Further, it is found that the four-factor model performs
better than the CAPM and the three-factor model.
