Abstract
Abstract When estimating a firm's cost of equity for valuation and other purposes in emerging markets without (or with only partial) capital market integration, many practitioners include a premium for country risk. In principle, the inclusion of such a risk factor would be justified if the particular country of interest was not sufficiently integrated into the global capital market. Initially, the paper measures and tests the degree of integration for the Brazilian market and does not reject the hypothesis of integration. The paper then tests directly the relevance of country risk premium in individual stocks' expected returns in the Brazilian market. Monthly data for the stocks of 57 of the most actively traded, non-financial firms, over the 2004 to 2014 period are used, using EMBI (Emerging Markets Bond Index) as a proxy for country risk, and this is found not to be significant. Finally, a premium for the size factor, also commonly used by practitioners, is also tested. Although it is found to be significant, the premium is negative, in contrast with current practice, which entails the addition of a positive premium to the required returns on small stocks. The inclusion of both a country risk and a size premium, in addition to the market portfolio risk premium, corresponds to the use of the Goldman Sachs model, as proposed by Mariscal and Lee (1993).
Highlights
IntroductionIt certainly goes without saying how crucial the estimation of a firm’s cost of equity is, especially for practical purposes – for equity and firm valuation in mergers and acquisitions, security analysis for investment recommendation purposes, for the determination of value creation by managers, and various other essential corporate finance decisions.The starting point in most of the current practice is to begin with the Sharpe-Lintner-Mossin (SLM) version of the capital asset pricing model (CAPM), in which values for the rate of return on a proxy for the risk-free asset and a premium for exposure to market portfolio risk would be sufficient, including an estimate for the asset’s degree of exposure (beta).in many cases practitioners add premiums for other risk factors, for at least two reasons: (a) they do not believe the SLM version of the CAPM is valid, as indicated by the Fama and French (1992) results, or (b) they feel the need to adjust the SLM version of the CAPM for conditions in the specific market in which an investment is to be evaluated
The starting point in most of the current practice is to begin with the Sharpe-Lintner-Mossin (SLM) version of the capital asset pricing model (CAPM), in which values for the rate of return on a proxy for the risk-free asset and a premium for exposure to market portfolio risk would be sufficient, including an estimate for the asset’s degree of exposure
We initially provide information on how we are testing for capital market integration, a necessary condition for the economic relevance of a country risk premium
Summary
It certainly goes without saying how crucial the estimation of a firm’s cost of equity is, especially for practical purposes – for equity and firm valuation in mergers and acquisitions, security analysis for investment recommendation purposes, for the determination of value creation by managers, and various other essential corporate finance decisions.The starting point in most of the current practice is to begin with the Sharpe-Lintner-Mossin (SLM) version of the capital asset pricing model (CAPM), in which values for the rate of return on a proxy for the risk-free asset and a premium for exposure to market portfolio risk would be sufficient, including an estimate for the asset’s degree of exposure (beta).in many cases practitioners add premiums for other risk factors, for at least two reasons: (a) they do not believe the SLM version of the CAPM is valid, as indicated by the Fama and French (1992) results, or (b) they feel the need to adjust the SLM version of the CAPM for conditions in the specific market in which an investment is to be evaluated. An example of the second reason is the addition of a premium for country risk, in the belief that the country’s market is not sufficiently integrated into the world market, so that this country risk would not be diversifiable, from the perspective of an international investor. This procedure is reported through a survey by Keck, Levengood and Longfield (1998)
Sign-in/Register to view highlights & summary Talk to us
Join us for a 30 min session where you can share your feedback and ask us any queries you have
Schedule a callDisclaimer: All third-party content on this website/platform is and will remain the property of their respective owners and is provided on "as is" basis without any warranties, express or implied. Use of third-party content does not indicate any affiliation, sponsorship with or endorsement by them. Any references to third-party content is to identify the corresponding services and shall be considered fair use under The CopyrightLaw.
