Significance of volatility components in pricing: case for an emerging market

Abstract

This research is an investigation of the volatility structure of the Kenyan financial market and its influence on stock returns. Using the little-known component GARCH, I decompose market volatility into its long run and short run components then examine their significance in explaining stock returns in a multifactor model. Performance of this model is also compared against the decades old Sharpe and Linter (1965) CAPM. Issues of whether the component GARCH accurately captures the volatility structure of the Kenyan Stock Exchange are highlighted. The results also allow some inference into the interaction between the business cycle and market movements of a developing country like Kenya. Results have been made robust by implementing the model using both daily and weekly data.