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Implications For Foreign Investments In African Financial Markets

In a nutshell, the equity market is like the stock market, where stocks are bought and sold. The increasing prominence and rapid development of emerging equity markets across Africa has led to the attraction of foreign investment. Investors sought in emerging markets/ economies, anticipating high returns. Investing in an emerging market holds a lot of risk due to various reasons such as; currency volatility, political instability, limited equity opportunities, poor corporate governance and domestic infrastructure problems. In addition, outside investors may not be offered liquid markets by local stock exchanges, as many emerging stock markets display to their public a considerable size of risk premium, discouraging many potential foreign investors by increasing the cost of equity for listed domestic firms. However, the equity markets in many emerging economies are seen as important sources of investing funds, making it easy for both foreign direct investments (FDI) and foreign equity portfolio investment.

The primary focus of this paper forms an opinion about the cost of equity of the largest and most developed equity markets in Africa; South Africa, Kenya, Morocco and Egypt. London is also considered as part of the developed and emerging market. The highest cost of equity is in the developing Kenyan market which is the centre of the East African union, although the costs associated with the fledgling Alternative investment market (AIM) is more than that in the main market. This is because the political instability scares away investors, therefore leading to a high risk premium on equity portfolio (however this is changing with time) and the financial infrastructure is relatively under developed and this increases transaction costs making investments unattractive. International investors as well as multinational enterprises such as; Barclays and Standard charted bank, have interest in these markets.

There are low levels of liquidity in these four African markets as compared with the developed world markets, however more in Kenya and Morocco, which are smaller markets as compared to Egypt and South Africa. The rationale for this dissertation knows the importance of the problem, which is; the (Kenny and Moss, 1998) risks associated with liquidity are cited as a major concern for overseas institutional investors and hinder participation in emerging stock markets. There is some degree of risk and illiquidity in these markets, hence the need to conduct research making this sample appropriate for modelling a risk-adjusted Capital asset pricing model, which also helps in the estimation of the cost of equity in these markets.

Cost of equity can be defined as: ‘’ The required rate of return that a publicly-traded company gives a stockholder in exchange for buying a share and assuming the risk associated with it’’. However, in accordance to this definition, if companies are trying to increase funds on markets that have a high cost of equity, they are at a clear and definite disadvantage as compared to those who are able to source capital more cheaply. Although the buying and selling of stocks usually allows companies raise capital for their investments. In Kenya for example, when Safaricom and the Kenya Commercial Bank had their recent share issues, it was to generate capital for their operations.

Collins and Abrahamson (2006) provide costs of equity estimates for a variety of African markets but the analysis falters on the various forms of one-factor model used to model industrial sector time series.

This paper also examines the application of the Fama and French (1993) three-factor model that takes into account the African financial markets’ illiquidity factors as well as the size of a company, and also the Capital asset pricing model that estimates the cost of equity in these markets.

Problem statement (Research question)

Not to hinder the participation of investors in emerging stock markets and promote economic growth and development in Africa, it is important to know the following;

How the risks associated with liquidity can be reduced?

How can the equity markets attract capital and remain competitive?

Plan of work is mentioned in Appendix A. The remainder of this paper is organised as follows: the second section provides a brief review on the Fama and French (1993) three-factor model and the Capital asset pricing model (CAPM). The third section outlines the three-factor size and liquidity augmented CAPM. The fourth section discusses the research methodology. The fifth section concludes.

Literature Review

Liquidity by its very nature has proved a difficult concept to define. Liquidity is a financial term that can be defined as the amount of capital or money that is available for investment. It is also the ability to quickly convert an investment portfolio to cash with little or no loss in value. Much of this difficulty has arisen through its ability to transcend a number of transactional properties of markets including tightness, depth, resiliency (Lesmond, 2005) and information (O’Hara, 2003).

A much more recent literature is the research concerning liquidity risk and its applications as that of the importance of liquidity that had been prominent for over a decade.

Various studies have examined the effectiveness of the Capital asset pricing model (Sharpe, 1964, Lintner, 1965) and most have found that for emerging and developing country markets, this is subject to considerable ambiguity.

Fama and French (1993) in their three-factor model proposed new ideas based on US data, suggesting asset returns would be related to stock size and market liquidity. The inability of the traditional Capital asset pricing model and the three-factor augmented Capital asset pricing model of Fama and French (1993) , seeking to describe the cross-section of asset returns with additional size and book-to-market factors, in capturing liquidity effects represents a serious caveat in asset pricing. (Liu, 2006).

To provide a more dependable explanation of the cross-section of average returns, additional factors have been included more recently. These include; the book-to-market equity ratio, the price earnings ratio, cash flow to price ratio and the firm size. Hence Liu, (2006) in line with Daniel and Titman (1997) finds considerable evidence of the limited explanatory power of the Fama and French model in capturing the cross-section of asset returns.

The Capital asset pricing model tests are limited on markets. Shum and Tang (2006) test common risk factors in assessing returns in Asian stock markets using a sample of assets listed on the Hong Kong, Singapore and Taiwan stock exchanges. When market factors are used, these results confirm those of Fama and French (1993). But over the traditional Capital asset pricing model, there is no significant improvement reported by the enlarged model that includes size and book-to-market ratios.

It is very surprising that with the increased interest in the emerging African market, the Fama and French model has not been tested as was done by Drew and Veerarachavan (2003) on South Korea, Malaysia, Philippines and Hong Kong. The test of this model on these markets showed that size and value effects can be identified in the markets using a cross-section approach. There are serious limitations in obtaining accounting book values of firms that are unchanging from emerging markets with regard to the benefits of including the book-to-market variable.

Large firms dominate emerging stock markets, leading them to highly slant, whereas the rest of the market is being populated with SMEs. The traditional Capital asset pricing model is outperformed, as evidence suggests that size and liquidity factors are significant in explaining cross section of returns.

The Fama and French method are incorporated in this paper, as well as the liquidity augmented Capital asset pricing model in line with the findings of Liu, (2006), stating the nature of liquidity as well as guessing that liquidity risk better captures firms distress risk. Liquidity is thus a major factor in explaining asset returns.

The Model

Instinctive knowledge shows that the investors in the small emerging markets will be attracted to the large companies as these are considered safer to invest in and would give a more reliable dividend pay-out as compared to the small markets whose levels of development are low. These larger companies are those that are privately owned companies or Multinationals, or former state-owned enterprises. These usually show profitable investments, as these companies comply with international corporate governance standards, hence increasing investors’ confidence, whereas the smaller companies would find this costly to implement. Although the literature documentary methods of liquidity premium measurement remains scarce, it is set upon a permanent basis that investors absolutely price a liquidity premium into valuation and expected returns.

Although the literature reports a number of variable constructions to capture liquidity depending on which essential trading statistics are used to assess liquidity, there are limitations which originate either from order flow, price determination or from an analysis of market micro-structure. In the spirit of the three-factor CAPM model of Fama and French (1993), this work follows the reasoning of the more recent work of Martinez et al (2005) and Shum and Tang (2005) in modifying the augmented factors taking into account the factors of size and liquidity effects that offer improved performance in capturing anomalies across the cross section of stock returns which are particularly prevalent in emerging markets. The model is enlarged by the excess returns attributed to size (SMB) and those attributed to illiquidity (ILLIQ).

This restated the three factor CAPM as the expected return on a risky portfolio p, in excess of the risk free rate E(Rρ)-Rf is a function of; (i) excess return on the market portfolio, Rm-Rf; (ii) the difference between the return on a portfolio of small-size stocks and large-size stocks, size (SMB); and (iii) the difference between the return on a portfolio of high illiquidity stocks and of low illiquidity stocks, ILLIQ. Therefore, of emerging market stocks, the expected returns on a portfolio p can be as;

E(Rρ)- Rf= βρ[E(Rm)- Rf] + SρE (SMB) + SρE (ILLIQ).

The equilibrium relation of the Fama and French (1993) three factor model is stated in terms of expected returns. It is important to transform the above equation to the following estimating equation, in order to test the model with historical data.

Rρt-Rft= ρ+ βρ (Rmt- Rft) + Sρ SMBt+ Hρ ILLIQt +єρt.

The variables are described above and the єρt is an iid disturbance term.

The market, size and liquidity factors used in the CAPM model are formed through the universe of available stocks. The market portfolio itself is the simple arithmetic mean of the cross section of total returns in the universe. By the lack of regional bench marks in the African region, the construction of market variable is complicated. By the unreasonable assumptions, it is further complicated that full integration of asset markets would impose on the highly segmented markets across the continent. Therefore, as a result, a North African universe including Egypt and Morocco was formed and a South African universe including South Africa was formed, and by virtue of its shared trading link, it is included within the South African universe. A sub-Saharan universe was also formed which included Kenya. Market universes formed in this market seek to minimise the difficulties of including extremely heterogeneous markets within the common integrated market assumption.


Research design

A qualitative design will be applied to explore the emerging Kenyan market- the daily processes in the Nairobi stock exchange and what the people perceive, describe, eel, make sense of and talk about informatics in the stock exchange. A qualitative design provides a naturalistic or constructivist perspective to the methodology, where a space is created within which participants can share their personal thoughts and experiences related to the phenomena in question: in this case, how cost of equity may be lowered in Kenya and what implications may be faced by foreign investors. ‘’’Qualitative research has a unique goal of facilitating the meaning making process. The complexity of meaning in the lives of people has much to do with how meaning is attributed to different objects, people and life events’’ (Krauss, 2005, p.763).

A quantitative method will also be applied, where variables are quantified generating precise results as the activities in the emerging African markets over a certain period of time.

Data collection

For my project, the following resources are available.

Libraries: There are several universities and public libraries I have access to (London School of Economics, Stratford library etc).

Association of Computing Machinery: This provides several valuable resources. Most of them can be directly accessed online via the “Digital Virtual Library”.

Personal network: A few years of experience put me into the position of having a well-populated address book at hand, where the individuals not only have the required level of expertise, but also want to participate in the project because they are interested in the subject.


The paper proposes a unique size and liquidity augmented CAPM to explain the cross section of expected returns in the emerging African market, which has previously been largely excluded from empirical valuation model research. The markets used include; South Africa (Johannesburg stock exchange, Egypt and Morocco (smaller regional hub) and Kenya (less active Eastern hub market in Nairobi). The Kenyan market is split into two components, the Alternative investment market and the main listing.

Illiquidity series were constructed on a time-series cross-section basis and augment the Fama and French (1993) risk-adjusted CAPM, which is used to form cost of equity estimates. Cost of equity is found to be highest in Kenya, followed by Morocco, Egypt and South Africa. There are higher costs of equity in the high profile financial sectors as compared to that of the overall aggregate market. The market risk premium and the premiums attributed to size factor and illiquidity are important factors in pricing asset returns in all countries, although the premium associated with size has a greater impact on overall explanatory power than that associated with illiquidity. It is difficult to model very small firms, hence leading to anomalies being found in the model.

Firstly, these affect the betas in terms of their being more illiquid and consequently having greater returns volatility. Since the South African market is overwhelmingly dominated by small and illiquid firms, this is largely responsible for the South African market having the highest cost of equity. Secondly, when size premium increases, returns decrease, and in very high illiquidity firms, when the illiquidity premium increases, return also increase. The variations in the costs of equity strike the differences between the sample countries. London has the lowest cost of equity, encouraging prominent South African firms to migrate their primary listings from Johannesburg to London. Morocco reflects its level of development in the market by having a cost of equity that is only slightly higher than London.

Egypt and Kenya have a considerable increase in the cost of equity. The Kenyan market itself exhibits a substantial differential of ten percent in the cost of equity between the main listings board and the AIMS market. This suggests that the development policy of established stock exchanges that aims to attract the SME sector is seriously flawed, and that companies in Kenya are only able to access equity finance at a distinct disadvantage to other locations.

When compared to funds raised from the banking sector, there is evidence of the uncompetitive mature of AIMS market as a source of finance for SMEs. The banking sector dominates in many African economies, where longer term relationship-based monitoring and surveillance of company performance does allow firms to achieve lower costs of financing.

Due to high costs of equity in the markets, the African companies that are seeking to raise domestic finance are placed with a restrictive burden on their ability to finance international expansion and overseas projects. African companies are forced to raise finance on local markets where the cost of equity is substantially high due to the expense of meeting the much more stringent corporate governance and regulatory requirements of developed markets such as London. These firms are therefore at a distinct competitive disadvantage. Due to higher costs of equity, the profit margins of these firms have to be considerably higher than competitors to break-even.

The very different risk premiums and cost of equity highlights that for international investors there is considerable evidence of segmentation amongst the African emerging markets, thus suggesting that investment in these markets would be subject to high and variable levels of transaction costs. Where there is poor corporate governance regimes and incomplete regulation, the investor information search and verification costs are substantial. However, through stakes in listed equities, considerable benefits can be achieved by explicitly incorporating size and liquidity premiums into models that would capture the subtle differences of these markets and facilitate equity portfolio investment and FDI.


Collins, D. and Abrahamson, M. (2006) Measuring the cost of equity in African financial markets, Emerging Markets Review, 7, 67-81

Daniel, K. and Titman, S. (1997) Evidence on the characteristics of cross sectional variation in stock returns. Journal of Finance, 52, 1-33.

Drew, M. E., & Veerarachavan, M. (2003). Beta, firm size, book to market equity and stock returns in the Asian region. Journal of the Asia Pacific Economy, 8, 354-379.

Kenny, C and Moss, T. (1998). Stock markets in Africa: Emerging lions or white elephants? World Development, 26(5), 829-843.

Lesmond, D. A. (2005) Liquidity of emerging markets. Journal of Financial Economics, 77, 411-452.

Lintner, J. (965) The valuation of risk assets and the selection of risky investments in stock portfolios and capital budgets. Review of Economics and Statistics, 17, 13-37.

Liu, W. (2006) A Liquidity-augmented capital asset pricing model. Journal of Financial Economics, 82, 631-671.

Martinez, M. A., Nieto, B., Rubio, G. and Tapia, M. (2005) Asset pricing and systematic liquidity risk: An empirical investigation of the Spanish stock market. International Review of Economics and Finance, 14, 811-103.

O’Hara, M. (2003) Presidential address: liquidity and price discovery. Journal of Finance, 58, 1335-1354

Sharpe, W. F. (1964) Capital asset prices: A theory of market equilibrium under conditions of risk. Journal of Finance, 19, 425-442.

Shum, W. C., and Tang, G. Y. N. (2005) Common risk factors in returns in Asian emerging stock markets. International Business Review, 14, 695-717.

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