The Required Return on Equity: International Issues

There are two major issues when estimating the required return of equities in a global context:

1. Exchange rates.
2. Data and model issues in emerging markets.

There are difficulties in the estimation of the required return and risk premium in emerging markets. Two approaches can be used to supplement the traditional historical and forward-looking methods:

1. The country spread model for the equity risk premium, stated as:

$$\begin{align*}\text{Equity risk premium estimate}&=\text{Equity risk premium for a developed country}\\&+\text{Country premium}\end{align*}$$

The country premium represents a premium associated with the expected greater risk of the emerging market compared to the developed market. It is estimated as the difference between the yield on emerging market bonds and the yield on developed market government bonds.

2. The country risk rating model is a regression techniques are used to estimate the equity risk premium based on the relationship between developed equity market returns and their risk ratings.

Question

The most appropriate method of estimating the equity risk premium in emerging economies is:

1. Exchange rates.
2. Country spread models.
3. Data and model issues.

Solution

The correct answer is B.

The country spread model is an approach used to estimate the equity risk in emerging economies. It represents the greater risk of the emerging economy compared to the developed economy.

A is incorrect. The exchange rate is an issue to consider when estimating the required rate of return in a global context. It is not a required rate of return estimation method.

C is incorrect. Data and model issues are points to consider when estimating the required rate of return in a global context. It is not a required rate of return estimation method.

Reading 21: Return Concepts

LOS 21(f) Explains international considerations in required return estimation.