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.