This study empirically analyze the effect of banks’ and insurance companies’ systematic risk and firm specific idiosyncratic risk factors on stock excess returns. Traditional CAPM model is used to measure the market or systematic risk, idiosyncratic risk exposure is measured by the idiosyncratic variables from Fama and French (1993) three factor model. This study contributes with the dynamic firm specific risk exposure, which is measured by Claim incurred ratio for insurance companies and advances to deposits and borrowings for banks. The objective of the study is to estimate the risk return dynamics of banking and insurance sector of Pakistan. The results indicate that Market beta of banks close to one indicates high volatility of banks due to low liquidity, high leverage and strong regulatory influence. Insurance sectors’ firm specific operational idiosyncratic risk factor (claim incurred ratio) has very limited explanation of stock returns. Investor should consider the significance of explanatory power of Size and value factor before making and investment in financial sector. Banks and insurance companies with low operational management are highly expose to risk of loss in the market. Operational performance is the important factor deriving market returns. Findings of this study is original and can be generalized to financial sectors. This study provide implication to investors about which risk factors they should consider while making investment in banks and insurance companies. Further operational performance should be considered as important factor for stock excess returns.
Keywords: Risk, CAPM, Fama & French, Idiosyncratic risk, Systematic Risk, Operational Risk, Banks, Insurance