The applicability of the capital asset pricing model and Fama-French three factor model on stocks listed in the Nairobi securities exchange
Abstract
In studying risk and return characteristics, the conventional approach of Capital Asset
Pricing Model (CAPM) developed by Sharpe (1964), Lintner (1965) and Mossin (1966)
is followed. The attraction of CAPM is that it offers powerful and intuitively pleasing
predictions about how to measure risk and the relation between expected return and risk.
Fama & French (1993) developed a three factor model in response to CAPM anomalies.
This study tests the applicability of CAPM and Fama-French Three Factor Model on
stocks listed in the Nairobi Securities Exchange over six year period from 1st January
2008 to 31st December 2013. The entire population of 61stocks listed in the NSE is
considered for analysis. Monthly data is analyzed for CAPM and quarterly data analyzed
for Fama-French Three Factor Model. For CAPM, the study focuses on calculation of
betas, excess returns and testing significance of excess returns at 95% confidence level.
The difference between expected returns predicted by CAPM and actual returns are not
statistically significant. The research finding reveals the applicability of CAPM and is
therefore recommended as a stock valuation model for stocks listed in the NSE. On the
other hand, research finding reveals that the Fama-French Three Factor model has very
limited potential in explaining variations on the return of portfolios. Statistical results
show that there is a positive relationship between average return and the size of the
portfolios. In other words, big size portfolio overwhelm small size portfolio on realized
excess returns. Moreover low book-to-market equity stocks outperformed high to bookto-market
equity stocks. The study recommends that cost of capital estimates would be
more accurate using a multiple factor model such as the Carhart four-factor model rather
than the Fama-French Three Factor Model.
Publisher
University of Nairobi