Estimating market risk premium using Markov switching : Tunisian Case

Abstract

The general increase in volatility of the …nancial markets can be partly explained by the growing uncertainly of the economic environment. It is, on the other hand, a reflection of the growing efficiency and integration of the financial markets allow the almostinstantaneous move of capital from one market place to another and therefore the rapid
assimilation of any new, available information. Until the last years, the investors had not seen consecutive negative annual stock market returns since the 1970s. In contrast, during the 1980s and 1990s the market produced its best 20-year performance ever.

In fact, Most investors, portfolio managers, corporate financial analysts, investment bankers, commercial bank loan o¢ cers, security analysts and bond-rating agencies are concerned about the uncertainty of the returns on their investment assets, caused by the variability in speculative market prices (market risk) and the instability of business performance (credit risk) Derivative instruments have made hedging of such risks possible.
Hedging allows the selling of such risks by the hedgers, or suppliers of risk, to the speculators, or buyers of risk, but only when such risks are systematic, i.e., when they show a certain form on inertia or stability. Indeed, the current derivative markets are regular markets where "stable, » . Unfortunately, all there financial markets su¤er from major deficiencies.

The notion that risk matters, and that riskier investments should have a higher expected return than safer investments, to be considered good investments, is intuitive. Thus, the expected return on any investment can be written as the sum of the risk-free rate and an extra return to compensate for the risk. The risk premium is a fundamental
and critical component in portfolio management, corporate finance and in valuation. Given its importance, it is surprising that more attention has not been paid in practical terms to estimation issues. The disagreement in both theoretical and practical terms remains on how to measure the risk, and how to convert the risk measure into an expected return that compensates for risk.

The estimation of the equity risk premium is in general a di¢ cult task, but in emerging markets the challenge is simply formidable, for at least two reasons. First, usually in emerging markets researches have to cope with the general lack of relevant data, particularly the long series that are needed to study the equity premium. Second, even if
the world equity premium were stable, the equity risk premium of an emerging market may change over time, as its degree of integration to world capital markets change.

The objective of this work is to provide an estimation of the Tunisian Market Risk
Premium following the papers of Damodaran (2002) , Godfrey, S. and R. Espinosa, (1996),
Fama, Eugene F., and Kenneth R. French, (2002) and Hamilton, J. (1989).

To attempt this objective, our works will be structured as follows. First, we present some generalities about the financial market and the financial assets. Next, we present the financial risk and the methods of measurement. In the third chapter, we will define the market risk premium and present some methods which will be used to estimate this number for the Tunisian market. Finally, we use these models to estimate the Tunisian Market
Risk Premium over more than one decade. This last chapter is based upon BVMT index, the money market rate, the inflation rate and dividend data collected from "La Bourse des Valeurs Mobileres de Tunis" and "Banque Centrale de Tunisie".