On Risk and Return in MENA Capital Markets

Abstract

This paper investigates relationships between market risk premium, time-varying variance and time-varying covariance in eleven Middle Eastern and North African (MENA) markets and eight developed markets from 1990 to 2001. Following Pettengill, Sundaram and Mathur (1995), we argue that the Capital Asset Pricing Model has only been partially examined because the negative portion of the market risk premium distribution has not been priory fully investigated. This issue is addressed by implementing a state-dependent multivariate GARCH methodology to proxy for a riskreturn relationship. As a result, significant positive and negative relationships between risk premiums and conditional variance (covariance) are found in MENA capital markets (developed markets). We conclude that MENA markets are highly segmented and provide diversification benefits to the global investor. We test for asymmetric patterns of reward to risk and observe that six out of the eleven MENA markets return series exhibit overly pessimistic reactions unwarranted by market variance alone. This finding supports the overreaction hypothesis and sets grounds for contrarian portfolio strategies.