The Equity Market Risk Premium and the Valuation of Overseas Investments

Abstract

There is little agreement among academics or practitioners about how to measure the size of the equity market risk premium, particularly when it relates to investments in emerging markets. Using monthly equity returns for 22 developed and 24 emerging markets covering the period 1976–2006, the authors find that developed capital markets have experienced significant increases in their degree of integration with the U.S. and world market indexes, while emerging markets remain at least partly segmented from those of the U.S. and the world.For countries that are reasonably well integrated into global capital markets, the authors suggest using the U.S.—based equity market risk premium. But when valuing investments in emerging markets, they recommend use of the Capital Asset Pricing Model adjusted for political risk and a measure of co‐movement between the foreign and U.S. stock markets. The authors also remind readers that the equity market risk premium is supposed to be a forward‐looking measure, and that the common practice of inferring the future from the past can be misleading, particularly in the case of rapidly developing emerging markets.