The effect of inflation risk on the equity risk premium - evidence from Kenya

Abstract

This research is an analysis of the relationship between inflation volatility and Equity Risk Premium (ERP) volatility in Kenya. The study uses the Generalized Autoregressive Conditional Heteroscedasticity-in-Mean (GARCH-M) framework to model the evolution of the ERP and inflation volatility postulating that there is a relationship between the two variables. The 91-day Treasury Bill Rate from January 2000 to December 2010 is used as the proxy of the risk free rate, while the Nairobi 20-Share Index from the same period is used as the proxy of well-diversified equity returns. From these data monthly returns were used to compute the ERP. There is no relationship found between the ERP and inflation, meaning that investors do not price inflation risk in their investment decisions. Consequently, an autoregressive conditional mean equation of the ERP is used in this particular GARCH framework which shows high levels of persistence in the ERP due to economic shocks.