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The paper extends the evidence on factors determining stock prices on emerging markets by focusing on the most advanced stock market in Central and Eastern Europe, the Polish market. Besides market, size and value factors, we investigate whether liquidity is a priced risk factor, addressing the hypothesis of its particular relevance in emerging markets. Our results support existing evidence for developed markets regarding market, size, and value factors. Contrary to the expectation that liquidity is a priced factor on emerging markets, we do not find evidence supporting this hypothesis. Analyzing specific market characteristics, we consider possible explanations behind these findings.

There is substantial empirical evidence that stock returns can be better explained by a combination of risk factors rather than by a single-factor model. Starting in the late seventies and early eighties a number of factors contributing to the explanation of the cross-section of average returns have been detected. These include size (Banz, 1981, Fama and French, 1992, Keim, 1983 and Reingaum, 1981), price–earnings ratio (Basu, 1977 and Reingaum, 1981) and momentum effect (Brennan et al., 1998 and Jagadeesh and Titman, 1993). The seminal studies by Fama and French, 1992, Fama and French, 1993 and Fama and French, 1998 show that a combination of size and book-to-market effect is better able to capture the cross-section of stock returns than the market beta alone. The results of these studies have not remained uncontested, with a number of papers suggesting explanations behind the size and book-to-market factors and extensions to the original Fama–French three-factor model (Bauer et al., 2010, de Groot and Verschoor, 2002, Ferson and Harvey, 1999, Griffin, 2002, Hyde and Sherif, 2010, Liew and Vassalou, 2000, Llewellen, 1999, Malkiel and Jun, 2009 and Shum and Tang, 2005). In particular, the seminal paper of Amihud and Mendelson (1986) paved the way to numerous studies suggesting that liquidity may be the relevant factor that explains stock returns after the three Fama–French factors have been accounted for. The rationale behind is that illiquidity can be measured as costs of immediate execution and an investor willing to transact at a favorable price faces a trade-off: he may either wait to transact at a favorable price or insist to execute a transaction immediately at a current bid or ask price (Amihud and Mendelson, 1986). Transaction costs therefore represent a cash outflow that reduces future returns. Additionally, Brennan and Subrahmanyam (1996)and Glosten and Milgrom (1985) note that a primary cause of illiquidity in financial markets is the adverse selection, which arises from the presence of informed traders. If a marginal investor is uninformed, he may demand higher rates of return when the adverse selection problem is more severe. Since then a number of studies examined the relevance of liquidity as a driver behind asst prices, producing conflicting results. For developed equity markets, the influence of liquidity on stock returns has predominantly been studied for the US market, and also for Japan and other mature international markets. The studies include among others, those by Acharya and Pedersen, 2005, Amihud, 2002, Chang et al., 2010, Garleanu, 2009, Keene and Peterson, 2007, Limkriangkrai et al., 2008, Liu, 2006, Marcelo and del Mar Miralles Quiros, 2006, Nguyen et al., 2007 and Pastor and Stambaugh, 2003. A recent analysis by Lam and Tam (2011) shows that liquidity is indeed an important factor for asset pricing even after accounting for other well-established risk factors. The recent findings by Hearn (2011b) suggest a less clear effect of liquidity on asset pricing, depending on characteristics of the surveyed stock market. Studying the relationship between liquidity and asset pricing in an international setting Lee (2011) finds that liquidity is priced even after controlling for market, size and value factors. In addition, the study illustrates the link between market liquidity and liquidity of individual securities. Dey (2005) shows that the notion of risk differs between emerging and developed markets, which has to be considered in asset pricing analyses.1Bekaert et al. (2007) point out that liquidity risk is particularly important for the less sophisticated markets where the number of both securities and investors is scarce. The findings by Lee (2011) indicate that stocks listed in emerging markets are generally characterized by a high liquidity risk compared to developed markets. So far, however, the empirical studies analyzing the influence of the above mentioned risk-factors on stock returns have concentrated on the more developed markets. However, as investments in emerging markets play an increasing role in asset allocation, related asset pricing studies gain importance. So far related literature (among others Bekaert et al., 2007, Brown et al., 2008, Dey, 2005, Hearn, 2010a, Hearn, 2010b, Hearn, 2011a, Hearn and Piesse, 2009, Hearn and Piesse, 2010, Jun et al., 2003 and Lee, 2011) either omitted Central and Eastern European emerging markets altogether or included only very limited sets of data.2 Central and Eastern European emerging stock markets are gaining importance, however, necessitating corresponding empirical research. Since investments in those markets are typically associated with substantial risk premia and consequently with high costs, the present findings are of interest for fund managers and investment professionals. Being the most advanced stock market in the region, the WSE is a clear leader in terms of development and financial integration in Eastern and Central Europe. Its market capitalization, trading volume, the number and variety of traded securities make the Polish market the leading stock exchange in the region, satisfying all necessary conditions for reasonable empirical research. The regulatory environment, which is compliant with EU standards, and the well-developed infrastructure make the WSE particularly attractive to foreign investors (Warsaw Stock Exchange, 2011). Due to the pioneering role of the Polish market in Eastern and Central Europe, our empirical results are of relevance for the other closely related emerging markets of this region. The present findings allow conclusions for those markets and might therefore be of interest for policy-makers and regulators in other Central and Eastern European countries. Additionally, the institutional characteristics of this market, such as presence of a large number of small firms as opposed to a large number of medium-size and large firms on developed markets provide an interesting backdrop for testing what has become an established model. The current analysis therefore provides important insights into this so far under-researched investment environment. The present paper therefore contributes to the literature in several ways. Firstly, it provides evidence on pricing of market, size, value and liquidity factors in the largest and most developed of the CEE markets. Up to our knowledge, ours is the first paper to formally investigate which risk factor(s) help(s) to explain Polish stock returns. Secondly, when we study the importance of liquidity, we address the issue pointed out by Liu, 2006 and Subrahmanyam, 2009 about the robustness of the results to different controls for risk. We therefore use a comparably wide range of liquidity measures to confirm our findings with regard to liquidity and capture the multiple dimensions of this factor. Such an approach may also help to identify which aspects of liquidity may have more prominence for asset pricing. We use a hand-collected and carefully compiled dataset on Polish equities. This allows us to ensure that the dataset is representative of the entire stock market and free from selection and survivorship biases. Methodologically, we rely on a pooled cross-sectional time-series estimation with Newey–West standard errors. We apply the single-factor CAPM model and the three-factor Fama and French (1993) model both with and without the liquidity factor. Our findings will therefore provide additional evidence on the extent and significance of the size and value premiums on international markets and also give an insight into the influence of the liquidity factor in an important emerging market. Our findings indicate that market, size and value factors play an important role in explaining returns of the Polish stocks. However, despite the significance of these factors and the expected direction of their effect, they do not fully explain returns on the Polish stock market. Contrary to our expectations and to findings by earlier studies on other emerging markets, we do not find evidence that the liquidity factor helps to improve the explanatory power of the three-factor model. The latter result is robust across various measures of liquidity and different estimation time periods. The structure of the paper is as follows. Section 2 reviews the literature on the risk factors in emerging stock markets. Section 3 describes the data used and the construction of the portfolio returns, liquidity measures and factor portfolio returns. Section 4 presents the methodology used in the paper. Section 5 describes the empirical findings. Finally, Section 6 offers a summary of the estimation results and, based on them, conclusions.

The empirical evidence of previous literature suggests that a number of factors may help to explain the pattern of asset returns. This paper extends this evidence by studying the return patterns of the largest and the most developed stock market in the Central and Eastern Europe. Despite the size and significance of the Polish stock market in the region, up to our knowledge, there have been no studies into risk factors affecting its stock returns. The present paper investigates whether the factors that are found to be important for the developed and other emerging markets also play a role for asset pricing in this market. In particular, we investigate the relevance of the market, size, book-to-market and liquidity factors. While the first three factors have been well-established in the empirical finance literature, liquidity as a risk factor has only very recently been studied for few emerging markets. Findings on the influence of liquidity on important emerging markets may potentially have relevant implications for making accurate inferences with regard to asset pricing. This is especially true for liquidity as a risk factor, as it is deemed to be particularly important in the context of emerging markets where the number of securities, number of traders and efficiency of trading mechanisms is likely to be lower than in the developed markets. We use a hand-collected and carefully compiled dataset. This helps us to avoid representation and survivorship biases which are often cited in relation to the price and company data on emerging equity markets. Our results confirm some of the existing evidence for developed markets, while challenge some of the other. We find that small stocks outperform large stocks and value stocks outperform growth stocks. The small value stocks show highest return while large growth stocks show the lowest return in the Polish stock market. We find evidence that the market factor, size, and book-to-market value factors all have explanatory power for the Polish stock returns. However, these three factors fail to fully capture the entire equity premium. The extension of the model by the liquidity factor, while reducing the occurrence of the statistically significant risk-adjusted excess returns, also fails to explain them fully. We therefore conclude that liquidity risk is less relevant for the Polish stock market. We leave the question about the other factors which may improve the explanatory power of the three-factor model for further research.