Equity risk premium: the characteristics and determinants in crisis affected emerging markets

Abstract

The flow of foreign portfolio investment in emerging markets is growing but is lower than market capitalization growth due to the relatively higher investment risk inherent in those markets. This is exacerbated by the fact that most emerging markets have been adversely affected, albeit with varying degree, by financial crises. As a central component in the risk and return concept, research in equity risk premium (ERP) is imperative, particularly if financial crisis dimension is coalesced into the study. Hence, this study is conducted to examine the characteristics and determinants of the equity risk premium in the emerging markets inflicted by various financial crises. In the first part, panel regressions are utilized to examine the determinants of ERP, while in the second part, event study methodology is used to investigate the immediate impact that financial crises had on the levels of ERP in the emerging markets. The findings in the overall panel regression are different from the findings in the group regressions that take into account the various crises and different time periods. Although GDP per capita growth rate and inflation rate are consistently positively significant in the overall regressions, the results do not persist in the crises-grouped regressions. These findings extend the current literature on the determinants of ERP as well as the characteristics of emerging market crises. In the event study analysis, the mixed results indicate that each emerging market is uniquely different in terms of how the ERP was affected at the onset of the crises. Furthermore, the grouped cumulative abnormal equity risk premium (CAERP) findings indicate that the crises also are distinctly different from each other. The Tequila crisis is the worst hit crisis, followed by the Russian crisis and the Asian crisis, as far as the CAERP findings are concerned. Furthermore, there are also differences in the results calculated using estimates from different regressions, namely, the OLS, ARCH and GMM regressions. Thus, the findings of this study have contributed to the current literature, as well as having practical implications to the practitioners such as fund managers and corporate managers who rely heavily on the equity risk premium as a key input in their decision-making processes.