Market liquidity and stock size premia in emerging financial markets: The implications for foreign investment

Equity markets are increasingly seen as important sources of investment funds in many emerging economies. Furthermore, many countries see the development of such markets as a means to facilitate both foreign equity portfolio investment and foreign direct investment (FDI). This may occur through acquisition of shareholdings in domestic companies, which supplements the low levels of funding from domestic savings. But many emerging stock markets exhibit substantial risk premia that increases the cost of equity for listed domestic firms and deters potential foreign investors. This paper estimates the cost of equity in four major African markets: South Africa, Kenya, Egypt and Morocco. These represent the largest and most developed equity markets in Africa and also act as regional hub markets. London is also included as a link between the emerging and developed financial markets. The Fama and French [Fama, E., & French, K. (1993). Common risk factors in the returns on stocks and bonds. Journal of Financial Economics, 33, 3–56] three-factor model capital asset pricing model is augmented to take account of company size and illiquidity factors that feature in African financial markets. The results show that the premia associated with size are more prevalent than with liquidity although both are highly significant in both valuation and cost of equity estimates. The evidence suggests that the lowest cost of equity is achieved in the two major international markets of London and Johannesburg, while the less-advanced North African markets of Morocco and Egypt have higher costs of equity. The developing Kenyan market has the highest cost of equity, although the costs associated with the main market are less than one-third of that in the Alternative Investment Market.