Understanding emerging market equity risk premia: Industries, governance and macroeconomic policy uncertainty☆
Graphical abstract
Panel A reports the dynamic unconditional correlations between the world equity portfolio excess return and the emerging regional industry portfolio excess returns and the US industrial stock market excess returns. Panel B reports the dynamic unconditional correlation between the regional industrial stock market excess returns and the US economic policy uncertainty index.
Section snippets
Introduction and motivations
During the last three decades the emerging market asset pricing and international finance literature has largely focused on the following five issues: (i) the behavior of the emerging markets ERP (i.e. performance measurements); (ii) the predictability of emerging stock markets excess returns (i.e. local vs global information variables, country effects vs industry effects); (iii) the effects of financial liberalization on emerging stock prices, cost of capital and expected returns; (iv) the
The stock excess returns
We download ten industrial stock market indices from Datastream Global Equity Indices (DGEI) for 20 national markets. The sample includes 19 emerging countries (see Table 1), as well as the United States, which we use for comparisons in some of our analyses. Emerging countries follow the IFC country classification (see IFC, 1999).9
The world CAPM: a static analysis
The Capital Asset Pricing Model (CAPM) has been widely used in the financial literature during the last two decades for a range of applications, such as estimating the cost of capital for firms and evaluating the performance of managed portfolios. The CAPM also represents a standard approach for estimating the risk of a national stock market with respect to a “market index” (e.g. world market index), and this is the approach that we use in our analysis here to determine the industries which
Country-level governance and ERP variation
Governance issues feature prominently in the global finance literature as explanatory variables for a range of market and firm-level performance outcomes, hence a brief assessment of the role of country-level governance in explaining industrial excess returns is also warranted here. Much existing empirical work around governance has demonstrated that the quality of governance in a country affects its ability to benefit from foreign direct investments (FDI) and international capital flows. In
Implications for portfolio diversification: assessing the role of macroeconomic policy uncertainty and global co-movements
Our results in Section 3 suggest that certain industries drive the higher observed emerging market ERP, although the particular industries vary by region. On the surface, this finding could suggest a potential portfolio performance benefit towards industry diversification in a risk-return framework (rather than country diversification). To explore this further we augment our earlier analyses with an assessment of the extent to which emerging market industries’ returns are independent of each
Conclusion
Over the last twenty years, and especially after liberalization,31 emerging stock markets have captured the attention of many scholars as well as many practitioners. Emerging markets’ empirical regularities are well known (e.g. high returns, high volatility, time-varying moments). Using industry-level data for 19 emerging stock markets across three regions and over two different sub-periods (i.e.
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We thank Thomas Lagoarde-Segot (the editor) and an anonymous reviewer for their helpful comments and suggestions. All remaining errors are our own.