Cost of Equity Dynamics: A Comparison Across Emerging and Developed Markets
The purpose of the study is to investigate the changing dynamics of validity of CAPM in the wake of its different models. For this study various existing models have been selected and transformed to measure the cost of equity for both emerging and developed markets. In addition, industry risk premium as suggested by extant literature is examined empirically in a comprehensive setting. Although prior literature suggests incorporating industry risk premium in the CAPM framework, but no empirical evidence is currently available in this context. For the purpose, aforementioned, the study gathers monthly data for six emerging and six developed countries from the year 2000 to 2017. Fama-Macbeth cross sectional regression is applied for calculation of estimators which is a proposed methodology to test the validity of different risk factors for capital assets pricing framework by the contemporary literature.
Results suggest that overall local, global, downside, hybrid and industry adjusted betas significantly explain the average variations of stock returns in both emerging and developed markets. So it is recommended to employ CAPMs, which have originated in the developed markets for the estimation of cost of equity in developing markets and the other way round after required modifications. Results for Local CAPM are validated for Pakistan, India, and South Africa from emerging markets and Germany and Japan from developed markets. Furthermore, results for Global CAPM are validated for Pakistan and Russia from emerging markets and Canada, Germany and Japan from developed markets. While UK and USA report a significant negative relationship between global beta and stock returns. Results for Downside CAPM are validated for Pakistan and India from emerging markets and for Canada and Japan from developed markets. Results for emerging risk premium for the Hybrid model are significantly positive for Pakistan market while industry risk premium is significantly positive for Pakistan, India, China and Brazil from emerging markets and for Canada and Germany from developed market. Although the issue of non-linearity and significance of unsystematic risk (residuals) persists.
Conclusively, CAPM is still a viable solution in determining cost of equity for most of the stock markets. Further, Extended CAPM formulated in this study is noted more sophisticated in assessing the cost of equity as compared to rest of the models. In nutshell, this study offers a comprehensive insight for corporate manager, financial analysts, policy makers, and individual investors for estimation of cost of equity. It also offers the dynamics of cost of equity in multiple country’s setting, that provide an insight for global investors, FPI holders and local and global mutual fund managers to align their investment decisions in this regard.