On the estimation of the cost of equity in Latin America

Abstract

This paper researches the sources of stock market risk influencing the pricing of 921 Latin American stocks and computes their corresponding opportunity cost (COE) over the period 1997–2004 by firm and sector. Running an adjusted version of the Capital Asset Pricing Model (CAPM) it finds that systematic risk accounts on average for more than 32% of COE total variance. This implies that potential CAPM mispricing related to undiversified idiosyncratic risk in Latin America has been relatively lower (but absolutely higher) than in United States and other European and Asian stock markets (such as the United Kingdom, Canada or Japan). A first robustness test for the omission of international sources of un-diversifiable risk suggests that both global market and real currencies portfolios do not add significant information to domestic market portfolios. Moreover, a second robustness check offers further evidence that well-diversified portfolios constructed by sorting stocks according to their size and book-to-market ratios a la Fama and French do not improve the goodness of fit in the regressions based on the adjusted version of CAPM.