Effect Of The Pricing Of Foreign Exchange Risk On Stock Returns At Nairobi Securities Exchange, Kenya

ABSTRACT

The exits of purchasing power parity stipulates that different countries differ in prices for

goods when a common digit is applied and therefore, random changes in exchange rate has

often been implicated to be the key cause of fluctuations in prices leading to more risk in the

assets pricing models. This implies that Exchange rate is a crucial variable that affect both

the international competiveness of both multinationals and investor’s wealth as they

participate in international stock markets. It then follows that investors and other players who

participate by investing in stocks at the Nairobi Securities Exchange are not exceptional and

therefore, this research seeks to empirically ascertain effects of the pricing of foreign

exchange risk on stock returns on listed securities trading at Nairobi Securities Exchange,

Kenya. The study covered a period of ten years starting from January 2003 to December

2012, with specific interest being to determine the degree at which inflation rate differential

affected stock returns at Nairobi Securities Exchange, to examine the magnitude at which

interest rate differential affected stock returns at Nairobi Securities Exchange and to analyze

the extent to which current account deficit affected stock return at the Nairobi Securities

Exchange. This research therefore employed monthly time series data while adopting the use

of Unconditional three factor international arbitrage pricing model which formed the

backbone on which the empirical model was based on. Moreover, all the sixty one (61) listed

securities on Nairobi securities Exchange formed the population of this study. However by

employing inclusion - exclusion criteria for survivorship biasness, only those securities that

were in trade for the entire period formed a sample of thirty six (36) securities summing up to

(59.02%) of the entire population. Empirically this study made use of linear regression

equations that is orthogonalized based on actual values of the underlying factors. However,

the researcher adopted the use of Generalized Method of Moments estimation technique to

empirically analyze the data corresponding to the entire period under the study. This was

supported with inbuilt E–Views computer software for data analysis. Since Generalized

Method of Moments posits many advantages that make it free from Ordinary Least Square

problems. It then follows that, by employing the services of Generalized Method of

Moments, the data was presented in form of figures and tables with much emphasis being on

descriptive analysis, testing of normality, stationarity and the prevalence of Ordinary Least

Square problems. Using F and t– Statistics, Null hypothesis was tested at 5% confidence

levels. This study is of critical use to academicians as it forms a foundation for future studies,

to economists to draw implications of macroeconomic policy, investors to allocate

appropriate risk level to their investment opportunities in Kenyan securities market as well as

by multinational firms in diversifying their portfolio risk globally. The result revealed that

foreign exchange risk was weakly priced and there existed a long run relationship between

the interest rate differential and abnormal return, Current account deficit and Interest rate

differential and between Interest rate differential and inflation rate differentials respectively.

This meant that policy makers should consider regulating the interest rates and capping the

inflation rate since they affect the purchasing power negatively. Moreover the CBK should

consider empowering other currencies like Euros, yen, sterling pounds to diversify the impact

of currency risk and integrate the Nairobi Securities Exchange to rest of the world securities

markets.