Empirical Analysis of the Effects of Macroeconomic Variables on the Equity Market Risk Premium in South Africa

Abstract

The relationship between the Equity Market Risk Premium (MRP) and macroeconomic variables has been a subject of extensive debate in the finance literature. The MRP is a central component of the main asset pricing models which are used to estimate the cost of equity which is mainly used in investment appraisal, performance measurement and valuation of equity assets. Prior studies have identified a number of macroeconomic variables such as inflation rate, interest rate, foreign exchange rate and political risk as the key macroeconomic variables that determine the size of the MRP. Grounded on previous literatures, the test of the impact of these macroeconomic variables on the MRP is mainly based on data obtained from the developed countries and a few emerging countries, leaving a huge knowledge gap in African based literature. This necessitated the investigation of inflation rate, interest rate, foreign exchange rate and political risk on MRP within the South African context, as these fundamental variables vary across countries. Using secondary time series data for the period 2002 to 2017, a total of 192 observations per variable was used in the study. The model used were tested for possible misspecification errors that could arise from using a secondary time series data and the regression model was fitted using the Ordinary Least Square (OLS) estimator. The results show that inflation rate, interest rate and foreign exchange rate have a negative impact on the MRP whilst political risk has a positive impact on the MRP. Furthermore, the result shows that the inflation rate is the only variable amongst other variable tested that has a significant influence on the MRP for the study period. The study recommends that inflation rate should be monitored and kept within the inflation target to increase investors’ confidence in the security market and also foster economic growth.

Keywords: All Share Index, Equity Market Risk Premium, Macroeconomic Variables, Risk-Free Security, South Africa.

DOI: 10.7176/RJFA/13-16-03

Publication date:August 31^st 2022