Risk and Return 75Some countries have low and some countries have negative risk premium. What factors affect risk premium?
Why are risk premia so high in some countries? Can we expect future premia to be high as well? Can we
predict short term (say, one month) and long term (say, 30 years) of equity premia?
Several factors (such as the following) might affect risk premium.
Extent of Globalization
Due to increasing globalization of companies, the reliance on any one nation is decreasing leading to reduced
sensitivity of economies and hence systematic risk. The flip side is that, due to increasing mobility of capital
across national boundaries stock markets are increasingly getting integrated. Due to integration of capital mar-
kets, volatility in one market gets propagated to other countries as demonstrated in the Asian financial crisis.
Market Sophistication
Individuals now invest in stock markets through professional investors like mutual funds. Fund managers,
as informed investors, are better equipped to assess and manage risk. Consequently, stock market volatility
in sophisticated markets is usually lower than underdeveloped capital markets.
Shareholder Activism
The pressure on managers to increase shareholder value is increasing. One way to increase value is to reduce
systematic risk.
State of the Stock Market
Larger stock markets such as the US market are more liquid, less volatile and hence less risky. The less
developed markets like Latin American markets are more volatile and risky.
Riskiness of Stocks Relative to Bonds
Over time the risk of investing in stocks may decrease while the risk of investing in bonds may increase
thereby reducing risk premium. Since equity premia occupies an important place in modern finance theory,
academicians are struggling to devise a method to estimate future premia.^4 Academic studies indicate that a
simple regression predicting equity premia one year ahead with dividend yields works quite well.
DOES THE CAPM WORK?
The Capital Asset Pricing Model implies that each security’s expected return is linear in its beta. A possible
strategy for testing the model is to collect securities’ beta at a particular point in time and to see if these betas
can explain the cross sectional differences in average returns. Consider the following cross sectional regression.
(^4) Campbell, John and Robert Shiller (1988). ‘The Dividend-Price Ratio and Expectations of Future Dividends and Dis-
count Factors’, Review of Financial Studies, Vol. 3; Fama, Eugene and Kenneth French (1988). ‘Dividend Yields and Expected
Stock Returns’, Journal of Financial Economics, Vol. 22, No. 1.