Estimating the Equity Risk Premium for Economies in the Asian Region

Apr 30, 2010 by admin

Abstract

The Equity Risk Premium (ERP) is widely used in economic and financial analysis, yet it is difficult to find empirical estimates of the ERP that are generally accepted. The paucity of data in Asian economies exacerbates the problems of estimation.  This study estimates the ERP for the larger market-orientated Asian economies and compares the estimates with those of the United States. Surprisingly, of the seven economies examined, the ERP of four cannot be statistically differentiated from that of the United States.

1. Introduction

The economic growth of an economy is affected by the decisions of myriads of individuals to acquire investment assets.  The returns  on such assets  are, by their nature, uncertain. Investors need to balance the expected return on their investments with the  risks associated with those investments.

In a market economy the financial markets adjust asset prices (and therefore rates of return) so that the returns reflect the risk appetite of the members of that economy.  There is no a priori  assumption about the risk preferences of individuals, save that they regard risk as undesirable. Importantly there is no assumption that risk preferences of individuals remain constant over time, or are the same between various geographical areas. The concept of the

Equity Risk Premium (ERP) provides an intuitive measure of  the extent to which  the members of an economy, in aggregate, need to be compensated for the riskiness  of the productive assets of that economy. More specifically,  the ERP  represents the amount that investors require to induce them to hold a well diversified portfolio of risky assets rather than the risk-free asset. The usefulness of the ERP as an explanation of investor behaviour has led to its use in the fields of corporate finance, asset valuation, and portfolio management.

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