A Four-Factor Model for the Indonesia Stock Market

Abstract

We propose a four-factor model that includes market, size, value, and profitability factors to explain the cross-section of stocks returns for the Indonesian stock market (IDX). Asset spanning tests identify size (market capitalization), value (cash flow-to-price), and profitability (EBIT/NOA) as the most robust characteristics for forming factors. Our fourfactor model (IDX4) outperforms existing factor models in digesting stock market anomalies and explaining variation in returns on equity portfolios sorted by firm characteristics. The expected returns implied from the IDX4 model are close to the realized returns on characteristics sorted portfolios. The IDX4 model also performs well in subsamples including Sharia-compliant listings and listings on different exchange boards.

Keywords: Indonesian stock market, Factor models, Value premium, Profitability effect, Stock market anomalies