Emerging and Frontier Markets for Risk Averse Investors? : A study on equity risk premium and correlation in 96 markets.

University essay from Linnéuniversitetet/Institutionen för ekonomistyrning och logistik (ELO)

Abstract: Introduction: The portfolio theory states that an investor has to take into consideration expected return and variance to construct an optimal portfolio along the efficient frontier. The equity risk premium suggests that an investment’s expected return is related to the amount of risk it consists of. By including several assets in a portfolio the variance can be reduced. Only non-diversified risk is rewarded and therefore a reduction of risk thorough diversification should not reduce the expected return. A large number of assets do not necessarily diversify a portfolio, thus covariance between assets has to be taken into consideration. Prior studies have indicated increasing correlation between markets and a decreasing equity risk premium. This would shift the efficient frontier in an undesirable direction, so it is of interest for pension funds and other risk averse investors to seek new assets with higher expected return and low correlation with current assets. Emerging and frontier markets might consist of these characteristics, which could shift the efficient frontier in a desirable direction. Purpose: The purpose with this research is to investigate to which level emerging and frontier markets can be used to increase portfolios’ performance. Further the paper aims to determine which kind of markets as well as regions that are more beneficial to invest in. Method: The study has a deductive approach and is based on the portfolio theory and prior empirical studies concerning the equity risk premium and correlation between equity markets. From theory several hypotheses are generated, which by empirical testing can provide answers concerning correlation and equity risk premium for developed, emerging and frontier markets. Markets are grouped into indices to test differences between market development levels. Pearson’s correlation test, regression models and calculation of equity risk premium are used to answer the hypotheses. Conclusion: There is a trend of increasing correlation between the US market and markets of all levels of market development, where a larger difference in market development level leads to a lower correlation. This suggests that American investors can find diversification benefits in frontier markets. Further the study obtains a lower equity risk premium compared to prior studies, which indicates a trend of decreasing equity risk premium. The frontier markets index has the highest return and lowest standard deviation among the indices. This supports the conclusion that frontier markets generate high returns and that frontier markets are not homogeneous with low covariance among themselves. Further, evidence suggests that there are differences, both concerning equity return and risk among developing markets in different regions. This study’s results indicate that the efficient frontier can be shifted in a desirable direction by including frontier markets in a portfolio

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