Economic Crisis and the Equity Risk Premium

Abstract

Investing in stocks is a risky activity and accordingly investors require adequate compensation in the form of additional return to undertake investment over the risk free rate, called equity risk premium. It is a risky activity in developed countries, and even riskier in emerging markets that have young and underdeveloped capital markets and high volatility of stock returns. Our paper gave an overview of the risk premium earned in developed versus emerging markets. We have shown that the average stocks market return is double in emerging markets, but also double volatile, i.e. more risky. Emerging markets enable investors to achieve 4.3 times higher compensation for the risk undertaken in the form of a risk premium, which in emerging markets accounted for 10.78%, while in developed markets amounts to 2.49%. Measured by the Sharpe ratio, we prove that investors in emerging stock markets achieved dramatically better risk-return relationship.

The purpose of this paper is to observe the equity risk premium in the developed and emerging markets through the history (i.e. historical equity risk premium). We will show that the economic cycles, macroeconomic shocks, global liquidity and other macro phenomena (i.e. global financial market integration) has great influence on the equity risk premium. We will put a great focus on the impact of the economic crisis on the equity risk premium in emerging markets.