ured and compensated. In fact, it is this view of risk that leads models of risk to break
the risk in any investment into two components. There is a firm-specific component
that measures risk that relates only to that investment or to a few investments like it
and a market component that contains risk that affects a large subset or all invest-
ments. It is the latter risk that is not diversifiable and should be rewarded.
While all risk and return models agree on these fairly crucial distinctions, they part
ways when it comes to how to measure this market risk. The capital asset pricing
model assumes that you can measure it with one beta, whereas the arbitrage pricing
and multifactor models measure market risk with multiple betas. In all of these mod-
els, the expected return on any investment can be written as:
where,
Note that in the special case of a single-factor model, such as the capital asset pric-
ing model (CAPM), each investment’s expected return will be determined by its beta
relative to the single factor.
Assuming that the risk-free rate is known, these models all require two inputs. The
first is the beta or betas of the investment being analyzed, and the second is the ap-
propriate risk premium(s) for the factor or factors in the model. We would like to
measure how much market risk (or nondiversifiable risk) there is in any investment
through its beta or betas. As far as the risk premium is concerned, we would like to
know what investors, on average, require as a premium over the risk-free rate for an
investment with average risk, for each factor. Without any loss of generality, let us
consider the estimation of the beta and the risk premium in the CAPM. Here, the beta
should measure the risk added on by the investment being analyzed to a portfolio, di-
versified not only within asset classes but across asset classes. The risk premium
should measure what investors, on average, demand as extra return for investing in
this portfolio relative to the risk-free asset.
In practice, however, we compromise on both counts. We estimate the beta of an
asset relative to the local stock market index, rather than a portfolio that is diversi-
fied across asset classes. This beta estimate is often noisy and a historical measure of
risk. We estimate the risk premium by looking at the historical premium earned by
stocks over default-free securities over long time periods. These approaches might
yield reasonable estimates in markets like the United States, with a large and diver-
sified stock market and a long history of returns on both stocks and government se-
curities. We will argue, however, that they yield meaningless estimates for both the
beta and the risk premium in emerging markets, where the equity markets represent
a small proportion of the overall economy and the historical returns are available
only for short periods.
(ii) Historical Premium Approach: An Examination. The historical premium ap-
proach, which remains the standard approach when it comes to estimating risk pre-
miums, is simple. The actual returns earned on stocks over a long time period is es-
Risk PremiumjRisk Premium for factor jbjBeta of investment relative to factor jExpected returnRisk-free Rate ajkj 1bj 1 Risk Premiumj 29 • 6 VALUATION IN EMERGING MARKETS