Financial frictions and stock return: A novel least minus more frictional factor for asset pricing models in emerging economies

The primary objective of this study is to empirically evaluate the role of various levels of financial friction in explaining stock returns through different asset pricing models. This study enhances asset pricing model estimates by incorporating diverse levels of financial friction by introducing a novel least minus more frictional asset pricing factor specifically constructed for emerging economies. The empirical analysis is conducted using data from a sample including five countries: China, India, Pakistan, Bangladesh, and Sri Lanka. Monthly data from 735 listed manufacturing firms is used to estimate stock returns from 2009 to 2024. These models are rigorously tested for optimal estimation using panel data models. The findings indicated that different levels of financial friction collectively exert inverse effects on stock returns. Macroeconomic and microeconomics frictions are found to be more pronounced in Pakistan compared to other countries, while financial market frictions are more acute in India, and firm-level frictions are most significant in China. The results further reveal that stock returns are overestimated in conventional asset pricing models. Incorporating different levels of financial frictions into these models substantially reduced the abnormal returns. This study has profound implications at macroeconomic, microeconomics, financial market, emerging the economies that are. Managers can leverage these insights to formulate superior strategies aimed at enhancing profitability, fostering robust business-to-business relationships, and minimizing costs across various levels. The findings enable firms to preemptively optimize their operations within the context of prevailing financial frictions.