Back for his second appearance as our guest blogger is Dr. Aswath
Damodaran from the Stern School at NYU. Dr. Damodaran is a noted
expert on valuation and publishes his own blog, Musings on Markets. Here, he discusses the equity risk premium in
emerging markets, a shortened version of his more
detailed post. If you are interested in more on the U.S equity,
check out Dr. Damodaran’s updated
article on the U.S. equity risk premium.
As you have figured
out from the textbook, estimating the U.S equity risk premium (ERP) is not a simple
task. Things get even more complicated when we are attempting to estimate the
ERP in emerging markets. In a recent
discussion, Dr. Damodaran examines the factors that affect the ERP in emerging
markets. The first factor is the sovereign credit rating and credit default spreads.
A country with a higher probability of default on sovereign debt is more risky,
and therefore would have a higher ERP as financial instability in the government
would extend to the private market as well. Next is the country risk score,
which measures economic, political, and legal risks in the country. Finally, the
volatility of the individual country’s equity market as measured by standard
deviation impacts the ERP. Using this method, Guinea, Sudan, Somolia, and
Zimbabwe share the highest ERP, at 22.25 percent. In contrast, the ERP for the
U.S is 5.75 percent.
