Modeling equity risk premium in emerging and developing economies: do financial globalization and financial sector development have explanatory power?

A significant body of literature has examined the role of traditional macroeconomic and institutional factors in determining the equity risk premium. However, these studies exclude essential financial variables, such as financial globalization and financial sector development. Hence, this paper examines the individual and joint explanatory power of financial globalization and financial sector development for equity risk premium parameterization in 42 EDEs using data collected from 2000 to 2021, and analyzed using the PCSE, with the DKSE estimator employed for robustness analysis. The empirical findings demonstrate that financial sector development can lower equity risk premiums in EDEs. In contrast, financial globalization is weak in reducing the equity risk premium. Furthermore, empirical results suggest that financial sector development can mitigate the increasing impact of financial globalization on equity risk premiums. Regarding the control variables, inflation emerges as a major driver of equity risk premium. However, economic growth, a strong external position, domestic savings, and political stability can help reduce the equity risk premium. Therefore, policymakers should pursue financial reforms aimed at expanding the domestic capital base, ensuring sound macroprudential supervision, and maintaining financial system stability. Additionally, sound monetary and fiscal policies should be implemented to promote economic growth and control inflation.