An Analysis of the Relationship between Risk and Expected Return in the BRVM Stock Exchange: Test of the CAPM

Abstract

One of the most important concepts in investment theory is the relationship between risk and return. This relationship drives the theoretical foundation of many investment models such as the well known Capital Asset Pricing Model which predicts that the expected return on an asset above the risk-free rate is linearly related to the non-diversifiable risk measured by its beta. This study examines the Capital Asset Pricing Model (CAPM) and test it validity for the WAEMU space stock market called BRVM (BOURSE REGIONALE DES VALEURS MOBILIERES) using monthly stock returns from 17 companies listed on the stock exchange for the period of January 2000 to December 2008. Combining Black, Jensen and Scholes with Fama and Macbeth methods of testing the CAPM, the whole period was divided into four sub-periods and stock's betas used instead of portfolio's betas due to the small size of the sample. The CAPM's prediction for the intercept is that it should equal zero and the slope should equal the excess returns on the market portfolio. The results of the study refute the above hypothesis about the slope and offer evidence against the CAPM for all the sub-period and even for the whole period. The tests conducted to examine the nonlinearity of the relationship between return and betas support the hypothesis that the expected return-beta relationship is linear. Additionally, this paper investigates whether the CAPM adequately captures all-important determinants of returns including the residual variance of stocks.The results demonstrate that residual risk has no effect on the expected returns of stocks for the whole period and the entire sub –periods except for the last period of 2003-2008 which shows that returns are affected by non-systematic risks during that specific period, justifying the fact that the operating activities of the firms have an impact on their stocks returns