Abstract
This paper proposes and tests market determinants of the equity risk premium (ERP) in Brazil. We use implied ERP, based on the Elton (1999) critique. We demonstrate that the calculation of implied, as opposed to historical ERP makes sense, because it varies, in the expected direction, with changes in fundamental market indicators. The ERP for Brazil is calculated as a mean of large samples of individual stock prices in each month in the January, 1995 to September, 2015 period, using the “implied risk premium” approach. As determinants of changes in the ERP we obtain, as significant, and in the expected direction: changes in CDI rate, country debt risk spread, US market liquidity premium and level of the S&P500. The influence of the proposed determining factors is tested with the use of time series regression analysis. The possibility of a change in that relationship with the 2008 crisis was also tested, and the results indicate that the global financial crisis had no significant impact on the nature of the relationship between the ERP and its determining factors. For comparison purposes, we also consider the same variables as determinants of the ERP calculated with average historical returns, as is common in professional practice. First, the constructed series does not exhibit any relationship to known market events. Second, the variables found to be significantly associated with historical ERP do not exhibit any intuitive relationship with compensation for market risk.
Highlights
Any stock’s risk premium, or “equity risk premium” (ERP), is given by the difference between the expected return on the market portfolio and the rate of return on the market’s risk-free asset
The basic specification proposes that the equity risk premium in Brazil is a function of the exchange rate, the volatility of the Brazilian stock market, the volume traded in the local stock market, the basic domestic interest rate, the U.S liquidity premium, Brazil’s country risk, the level of stock market prices in the U.S, the price of gold, and the domestic credit risk premium: DERP = f (RPTAX, DVOLATIBOV, RVOLUMEIBOV, DCDI, DLIQPREM, DRISKBR, (7)
This paper examines potential market variables that can explain the movements in the Brazilian market equity risk premium and, stock market prices
Summary
Any stock’s risk premium, or “equity risk premium” (ERP), is given by the difference between the expected return on the market portfolio and the rate of return on the market’s risk-free asset. Estimates of the market risk premium are made using averages of historical differences between returns on a stock. Firms may need to calculate their cost of equity capital as part of variable compensation schemes, or in the computation of their weightedaverage cost of capital when valuing new investment opportunities. This is done because the Sharpe (1964), Lintner (1965), and Mossin (1966) version of the capital asset pricing model (CAPM) is used in the construction of the relevant security market line for estimating the appropriate opportunity cost of equity
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