Fundamental Sources of Risk in Frontier Equity Markets

2024-02-12 07:51:54 Viewed: 980 Downloads: 321
  • Fundamental Sources of Risk in Frontier Equity Markets

      Wycliffe Nduga Ouma

     Publisher: African Review of Economics and Finance

    Pub: 2024-02-12 07:51:54

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  • Asset pricing has attracted innumerable attention from many stakeholders in capital markets. However, a considerable lack of consensus exists regarding the full list and identity of risk factors and the ability of the already studied risk factors to optimally price risk. This problem is pronounced in frontier equity markets due to the unpredictability of the underlying risk fundamentals. We highlight that frontier equity markets are largely characterised by market frictions that misalign with the established asset pricing fundamentals, thereby complicating risk pricing using the existing frameworks. Other confounding factors include sizeable downside risk, stale prices, acute illiquidity, and unstable macroeconomic fundamentals. This study is based on these constraints. Using monthly data on a list of 16 macroeconomic variables from 20 countries between January 1996 and February 2020, we arrived at interesting results at a country level and in a combined sample. At the country level, the results were mixed. However, a pooled sample of the 20 markets revealed the existence of some commonalities among both domestic and global macroeconomic factors. The empirical evaluation using both Fama and MacBeth (1973) two-step and GMM regressions established that unanticipated inflation (UI), market-wide volatility (VOL), market liquidity (LIQ), consumer confidence index (CC), trade-weighted US dollar exchange rates (TW$) and VIX volatility index (VX) were not only significant drivers of risk variations but also priced in the returns of frontier equity markets. Given these results and the increased investor attention to these markets, a favourable policy environment is needed to accelerate capital market development and investment in these countries.

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  • Keywords

    Equity risk premia; Risk factors; Frontier markets


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