Investing in equities hopefully provides investors a return that exceeds the risk free rate of return. The difference between the two is also known as the equity risk premium, or ERP. The average long-term ERP exceeds the level that classical equilibrium theory predicts. Mehra and Prescott [1985] showed that for the US in the period 1889-1978 the ERP has been in excess of 6% per annum. In a consumer CAPM framework this corresponds with a level of relative risk aversion of 26. This is far higher than experimental theory predicts; values between 1 and 10 can be seen as normal within this framework. Being incapable of associating the measured risk with the observed return, Mehra and Prescott dubbed the phenomenon the equity premium puzzle. Ever since, the issue caught the attention of academics as well as practitioners and spawned a whole new literature based on two classes of explanations for the existence of the ERP puzzle: theoretical and empirical. This paper is a contribution to the empirical research.
From the empirical side Siegel [1992] extends the Mehra-Prescott sample to 1802-1990 and observes an ERP of 5.3% per annum over the entire period. Moreover, early stock returns did not exceed the risk free rate of return by nearly the same magnitude as they did in recent data. Brown, Goetzmann and Ross [1995] and Goetzmann and Jorion [1999] suggest the high equity premium in US equities to be the exception rather than the rule. They hint at the issue of survivorship bias by only observing the US, a clear survivor in a turbulent century. Blanchard [1993], Fase [1997] and Dimson, Marsh and Staunton [2001] show the robustness of the puzzle by studying a number of developed countries. Fase finds the theory to be even more at odds with reality for Belgium, France, Germany, The Netherlands, and the UK in the post-war period compared to those in the US. This, however, still does not completely resolve the issue of survivorship bias.
Empirical finance has mostly focussed on advanced markets and exchanges. We aim to extend the analysis to include emerging markets. Among others, Bernartzi and Thaler [1995] and Campbell and Cochrane [1999] claim that the high equity risk premium in the US was necessary to entice people into the market. Where does this leave us for emerging markets? As emerging markets are perceived to be more risky, one would expect a higher incentive. Barry, Peavy and Rodriguez [1997] and Claessens, Dasgupta and Glen [1995] have shown that investing in emerging markets is beneficial in a risk/return framework. These papers and numerous others claim that investors are compensated for bearing the risks in terms of higher average returns and a low correlation with developed markets and among other emerging markets. We leave aside the issue of diversification to focus specifically on return and test whether the perceived risk is reflected in larger ERP for emerging markets. In this paper we provide differences and similarities of the ex-post ERP for emerging markets compared to developed markets and show that the ERP is significantlyhigher in emerging markets.
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The Equity Risk Premium: Emerging versus Developed Markets
