The Risk-return Trade-off of Companies Listed at the Nairobi Stock Exchange

Abstract

CAPM is basically a linear model that relates risk and return in which beta is the coefficient of the difference between the market return and the risk-free rate. However, in this research beta is not the gradient but the independent variable, while by rearrangement of the model the difference between the, market return is the gradient. The research sought to find out whether this relationship between return and risk captured by beta is as linear as suggested by the CAPM. To achieve this objective data were collected from the NSE for the period 4th January 2006 to 29th December 2010 which included Wednesday stock prices, Wednesday stock volumes, and the dividends. This was used to calculate the returns of stocks, the average Wednesday market returns and the betas of the companies. The values of beta and return were reduced to annual values thereby enabling every company to have five paired values of return and beta. Regression analysis was conducted on the paired values of risk and return for each company. The tests used in the regression tests were the T test and the F test. Most of the companies did not pass the linearity test as only thirty-two out of the forty- three had their F-values greater than the critical values of F. The test for the significance of the coefficient term also revealed that thirty-eight companies did not pass this test. The results therefore testify that the relationship between return and beta of firms at the NSE is not linear based on the Wednesday return.