Understanding Frontier Markets through the African KINGs

Several asset-­pricing models have attempted to explain the cross sectional variation in asset prices notably index models and multi factors models. Although much evidence has established the diversification benefits and risk-return tradeoff in Frontier Markets, little has been done on the factors driving returns in these markets. After giving a comprehensive definition of Frontier Markets, this work explores risk factors in African Frontier Equity Markets and subsequently proposes a 3-factors cost of equity model with implications for investment strategies and risk management. A sample of 4 African equity markets (Kenya, Ivory Coast, Nigeria, Ghana) coined as the African KINGs was used to decompose Frontier Markets risks factors and therefore identify elements of equity risk premium over and above the risk free rate. By combining quantitative and qualitative analyses we find that equity risk in Frontier Markets is a function of Macro, Market and Micro factors driving returns. These "3-Ms" form the basis of the proposed 3-factors cost of equity model that can be an alternative to the limited CAPM framework currently used in Frontier Markets.