Illiquidity, Foreign Investor Preferences and Asset Pricing In Kenya

Abstract

In this paper we examine the role of illiquidity and foreign investor preferences in asset pricing in the Kenyan frontier stock market. Since stock illiquidity and heterogeneous foreign investor preferences are pervasive features of this market, investors are likely to demand higher compensation for holding illiquid and less foreign investor-preferred stocks, thereby increasing cost of equity. We test this hypothesis by incorporating an illiquidity and foreign stock holding factor into the classical Capital Asset Pricing Model (CAPM). Our analysis employs monthly data for the period January 2011 to September 2016. Our empirical results support a four-factor CAPM which incorporates size, illiquidity, and foreign preferences factor. Importantly, the illiquidity and foreign factors attract a risk premium ranging between 5-9 percent yearly. This implies that Kenyan firms can significantly reduce the cost of equity finance by improving liquidity and foreign investor holdings.

Keywords: CAPM, Illiquidity, Foreign Investor

JEL classification: G12, G15