Back testing Equity Risk Premium in the Kenyan stock market

Abstract

This study focuses on the estimation of the Equity Risk Premium (ERP) in the Kenyan market, with a specific focus on the Nairobi Securities Exchange (NSE) 20 Share Index. The ERP is a critical component in asset pricing models, used to gauge the extra return that investors demand for taking on the higher risk of equity investments compared to risk-free assets. However, the estimation of ERP in emerging markets like Kenya presents unique challenges, including market inefficiencies, limited data availability, and heightened economic volatility. This research addresses these challenges by employing a dual approach, back-testing ERP using historical excess returns over the 90-day Treasury bill rate and forward-looking projections using ARIMA and GARCH models. The ARIMA struggled to model monthly ERP due to its volatility and predominantly negative values, but the GARCH model effectively captured volatility of the ERP over the observed period. The findings reveal that risk-free rates in most cases exceed stock returns in the Kenyan market, emphasizing the need for tailored risk management strategies. This study bridges a critical gap in the literature and provides actionable insights for enhancing investment strategies and policy development in Kenya.