Testing Applicability of Capital Asset Pricing Model in the Kenyan Securities Market

Abstract

The capital asset pricing model (CAPM) developed by Sharpe (1964), Lintner (1964) and Black (1972) stipulate that the expected return on a stock is determined by the risk free interest rate and a risk premium. Early empirical tests of the model generally supported its main prediction as Beta being the only explanatory factor in explaining the cross sectional variation across stock. However, more recent empirical work on asset pricing has identified a number of variables that help explain cross sectional variation in stock returns in addition to the market risk. The validity of the capital asset pricing model, as well as the firm specific factors that explain stock returns in Nairobi Stock Exchange (NSE) has not been conclusively addressed. The purpose of this seminar paper is to investigate the risk-return relationship within the CAPM framework, and explore whether CAPM is a good indicator of asset pricing of stock returns in the Kenyan stock market for the period January 2009-December 2010. That is, to examine empirically how well the market equilibrium model explains the risk return relationship in the Kenyan market. Secondary data was collected from the monthly Bulletin of the Nairobi Stock Exchange and the Central Bank of Kenya. A methodology similar to that of Fama and French (1992) was employed by taking into account the constraints imposed by a smaller sample both in time and in terms of number of stocks. Both market return and security return were computed. The empirical findings indicate that the Sharpe-Lintner-Black CAPM inadequately explains the Kenya’s equity market economically and statistically significant role of market risk for the determination of expected returns. The empirical findings do not support standard CAPM as a model to explain assets pricing in Kenyan equity market.

Keywords: Arbitrage Pricing Theory, Capital Asset Pricing Model, Market Returns, Nairobi Securities Exchange.