The effects of firm characteristics on systematic risk of firms quoted at the Nairobi stock exchange: An empirical study

Abstract

The business environment, in which firms operate, is characterized by scarcity of resources and numerous uncertainties and as such, investors need to factor in the element of risk in business decisions. In financial theory, it is predicted that the higher the risk of an investment, the higher the expected return demanded by an investor. The capital asset pricing model leads to the conclusion that there are two types of risk in the economy: systematic and unsystematic risk. In efficient markets unsystematic risk (the assets risk that can be diversified away) should not be important to the investor. The systematic risk is measured by the beta coefficient. A central role of financial information is to alter investors' belief about the assets return and risk. For a fully diversified investor, information about unsystematic risk will be of little value; but will need asset information useful in altering assessment of market risk (beta). This is because for a fully diversified portfolio the problem of risk reduces to choosing portfolio level for beta. This paper investigates the determinants of the beta coefficient of firm's stock returns through analysis of the firms underlying characteristics. We examine those firm characteristics that have an impact on the individual firm's stock movements in relation to the market. In this study, the influence of a firm's financial leverage, operating leverage, size, profitability, dividend payout ratio, business risk, liquidity and growth on beta are examined. The study aims to establish whether there is a relationship between certain firm characteristics and systematic risk. The research findings are mixed with the relationship between firm characteristics and systematic risk being found to be relatively weak when betas are derived from unweighted returns are regressed against the firm characteristics. There is however a significant relationship between firms financial characteristics and systematic risk when betas derived from the weighted returns are used. Using five-year predictor variables, growth, liquidity and size are found to be statistically significant. The relationship is stronger when three year average independent variables are used with profitability, growth, dividend payout ratio and firm size being significant. This indicates that these firm characteristics can be useful in the prediction of systematic risk of firms.