Estimation of equity risk premiums in emerging markets

Abstract

Abstract 40 1) Introduction and context description: In view of the challenges faced while using the historical risk premium approach for calculation of risk premiums in emerging markets, we have made an attempt to review various other measures that have been proposed for the calculation of risk premiums in emerging markets. 2) Research questions : Research done during the course of this project was focused on : • Estimation of Equity Risk premiums for emerging markets. • Estimate country risk premium for the markets selected. 3) Methodology The study of the various methods used was done based on articles together with verification of their applicability in the emerging markets context. An extensive study of journals articles on the subject was also undertaken to develop a better understanding of the approaches and their applications . Apart from these we also constructed a Global market index based on different weights given to different markets and computed the Matrix of correlations of the various indices. Based on the historical data of equity returns risk free rates and dividend yields, risk premium was calculated for various markets. The variability of risk premiums was analyzed and a model was made to determine the time period to keep the variability within a confidence interval. Risk premium was also calculated from credit ratings by adding the corresponding country risk premium to the premium calculated for a matured market . 4) Risk premium was determined for various emerging markets, using the historical data approach and country premium approach . Given the relatively smaller tenure of data available, the volatility in estimation of risk premium was observed and the reasons determined. A model was developed to determine the ideal time required for historical data approach to give results within a specified confidence interval. For a global investor investing in different markets, the correlation matrix was constructed . A global index with weights proportional to the market capitalization was also valued. 5) Limitations of the study: The first limitation in determining the risk premium from historical data is the duration of time. It has been calculated in this project that to get an approximate range for risk premium. Data should span for at least. 100 years. However in emerging economies, data is only available for 10-15 years. It does not account for changes in risk-averse behavior of investors over the years. 6) Scope for further work Risk premium can be determined by other ways by finding out the indifference curve of an investor to taking risk and the premium associated with the returns. That would given results closer to the true risk premium, as the confidence interval by the historical approach is too wide. 7) Keywords Risk premium , Global Index, Global index correlation, historical equity premium and dividend yields.

Abstract As the home-country biases for investing are reducing and global portfolio investment is one rise, the understanding and determination of country and currency risk has become increasingly significant. In this study, we have attempted to measure currency and country risk for an emerging economy like India in the context of global investor investing in India. The concept of country risk, unlike currency risk is not widely understood. There is abundant literature on country risk however there is no universally agreed definition for country risk . The literature differs on the terminology used for these types of risk (country/political/ cross-border risk), sources of risk and the type of investment which face these risks.