The Validity of Capital Asset Pricing Model: Evidence From the Nairobi Securities Exchange

Abstract

This study tests the validity CAPM in Kenyan Securities market, The Nairobi Securities Exchange. CAPM explains the links present between risk and return in efficient markets. Many investors face the challenge of determining with certainty the returns for their investments as well as choosing an efficient portfolio(s). A model such as CAPM that is capable of predicting the returns will be of great help. The objective of this study was therefore to establish if CAPM is valid at the NSE. The study has focused on the calculation of betas and excess returns of thirty firms listed on NSE using a four year data of share prices from 1st Jan, 2009 to 31st Dec, 2012. A simple regression model was employed to analyze the data in three stages i.e. portfolio formation, initial estimation and testing periods. A significance test at 95% confidence level was also conducted to evaluate the data and regression results available within the testing period. The data analysis revealed inapplicability of CAPM to the NSE, 20- share index, and the results confirmed that the standard CAPM is not verified in the NSE during the period of study. Using portfolio formation to diversify away most of the firm-specific part of risk thereby enhancing the beta estimates, the findings from the investigation appears inconsistent with the theory’s basic hypothesis that higher beta yields higher return and vice versa. The CAPM model implies that the prediction for the intercept be equal to risk free rate and the slope of SML equals the average risk premium. The findings from the test are also inconsistent with Theory of CAPM, indicating evidence against the model. Further studies may be conducted to check the applicability of the model, by taking a larger sample of firms.