Asset Pricing Risk Premia, Investor Sentiment and Stock Returns in Kenya

Abstract

Stock returns form an essential element in capital allocation and investment decisions across the economy by providing an approximation of the cost of capital for a project, division or firm. In a stock market where return generation process is well established, investors are able to quantify risk and translate it into expected returns for the purpose of making right investment choices. Returns at Kenyan market are however generally depressed and experience high volatility arising from changes in overall market risk. Consequently, investors have often suffered heavy losses in terms of unrealized market valuation whenever foreign investors exit the market to seek other safer investment options with guaranteed returns in developed markets. This has consequently ignited a long-standing debate over the ability of the Kenyan equity market to correctly price securities and hence predict returns. This study investigated the pricing effect of premium on market, size, value, profitability and asset growth. It also explored the moderating effect of investor sentiment on the relationship between Asset Pricing Risk (APR) premia and stock returns in Kenya. The study was underpinned by the Modified Equity Valuation Model, Noise Trader Theory and principles underlying the Capital Market Theory. Quantitative causal time series design was applied in the analysis of cause-effect relationship among the study variables. The study was a census all listed the 64 listed firms at the NSE as on 31st December 2019. Analysis was on monthly time series data on variables spanning the period 2011-2019. The results of Augmented Dickey Fuller (ADF) and Philips-Perron (P-P) tests indicated a mix of variables stationary at level and 1st difference. The F-bounds cointegration test revealed long-run relationship among the variables and therefore the Auto-Regressive Distributed Lag (ARDL) and Error Correction Models (ECM) were used for estimation. Residual diagnostic tests were conducted to ensure stability of estimates. The findings indicated that market and size had positive significant coefficients while profitability was negative and significant. This implies that investors require higher rate of return for increases in market-wide risk and for exposure to small stocks. Investors however require low rate of return on profitability investment strategy. The coefficients on value and asset growth were not significant. The study further established that investor sentiment moderates the individual effect of market, value and asset growth. The study did not however find evidence for moderating effect of sentiment on APR premia and stock returns relationship. This implies that overall, the effect of asset pricing risk premia on stock returns does not vary with level of sentiment at the Kenyan market. The study recommended an optimal model that incorporates market, size, profitability and sentiment as proxies for systematic risk in the investment decisions by market players in Kenya.