Capital Control Premium and Investable Risk in Emerging Capital Markets

Abstract

This article surmises the presence of an investable premium in emerging equity markets segmented by foreign investment restrictions and validates its existence in 26 emerging markets. Principal Component Analysis and stepwise regression are employed in tandem to whittle down from 22 political, economic, and financial country risk factors, to the one factor that best explains the investable premium. The political, economic, and financial risk measures that load on this factor are determined. We use a multifactor CAPM model to investigate whether country investable risk drives cross-sectional expected returns in investable emerging market stocks in addition to established firm-specific risk components such as beta, size, and price-to-book-value ratio. We document a significant positive investable premium for the aggregate sample. This finding supports our research hypotheses that investable risk is priced. We also find a significant positive relationship between risk premium and size at the aggregate level. Our findings suggest that these two risk metrics, investable premium and size, are important to price emerging market firms.