Capital asset pricing model and the three factor model: empirical evidence from emerging African stock markets

This thesis explores two celebrated asset pricing models by investigating whether or not the capital asset pricing model (CAPM) and the Fama-French three factor model apply in Emerging African Stock Markets (EASM). While Sharpe (1964) and Lintner (1965) developed the capital asset pricing model (CAPM), it has been widely tested by finance researchers and applied in practice. The central theme of the CAPM is that the only risk variable that affects asset returns is the market factor (beta). However, empirical evidence suggests that the beta alone is not sufficient to wholly explain variation in asset returns (Jensen, 1968; Jensen et al, 1972). A search for an appropriate asset pricing model has led to the development of multifactor models (Ross, 1976; Fama and French, 1992; Carhart, 1997). Fama and French (1992 and 1993) introduced the size and BE/ME anomalies to the academic literature and advocates that it might be driven by changes in microeconomic factors missed by the single factor CAPM. This study adopts Jensen (1968) version of Sharpe-Lintner CAPM and follows Jensen et al. (1972) and Fama and French (1993) time-series approaches. The study provides substantial evidence of the benefits of volatility as augmenting factor in the classic CAPM in explaining asset returns in a new application to Africa and other emerging markets with similar economic characteristics. It was demonstrated that a pricing model that includes both market risk premium and volatility risk premium significantly captures patterns of returns in Africa than the classic CAPM or Fama-French model. Furthermore, this study makes three more important contributions to the literature on emerging African capital markets as follows: 1. That beta on its own cannot fully explain risk in Africa per CAPM’s assertion as returns can be related to other non-beta factors. 2. The evidence here produces firm contradiction to the growing literature that size and BE/ME are fundamental risk factors. These two variables are not risk factors and indeed, small and value firms do no attract additional compensation for risk in Africa. 3. Lack of integration of African stock markets with the world market means that country specific risk as measured by volatility is persistent across all five countries and therefore volatility augmented asset pricing model is more appropriate than classic CAPM or multifactor model with size and BE/ME. Unlike Fama-French and liquidity augmented models, this model is underpinned by theory. Even, in circumstances where volatility risk premium is negative as documented elsewhere and in this study for certain assets in Africa; the model provides useful information for portfolio construction/allocation and hedging in line with Merton (1973) ICAPM.