Testing the Capital Asset Pricing Model on Weekly Returns at Nairobi Securities Exchange

Abstract

The capital Asset Pricing Model (CAPM) is the most widely used approach in asset valuation. The theory predicts that the expected return on an asset above the risk-free rate is proportional to non-diversifiable risk, which is measured by the covariance of asset return with a portfolio composed of all existing assets, called the market portfolio. Since its development, numerous researches have been carried out to test the model in different stock markets across the globe. Findings have been divided over its practicality in the finance literature. This research therefore tested the validity of CAPM on the Nairobi Securities Exchange. The study used the Nairobi Securities Exchange weekly data from January 2005 to June 2012. The sample size included twenty companies that are also the constituent companies for the NSE 20-share index. The average weekly return of these companies was used as proxy for the market return. The companies were grouped into four portfolios of five companies each in order to diversify away most of the firm-specific part of returns thereby enhancing the precision of the estimates of beta. The finding of the study was that the portfolio which had the highest beta also had the highest return and the portfolio which had the lowest beta also had the lowest return and from the findings it was concluded that higher risks are associated with higher returns, that is, the study is in support of the CAPM principle. Investors and market regulators should therefore take into account risk-return trade off while making investment decisions.