Transparency & Risk Premium

A study of 41 countries (Lau, Ng, and Zhang, 2011) shows that the price of equity risk is more stable in countries with high levels of transparency. Additionally, sensitivity to information significantly increases during periods of crisis.

The impact of the quality and quantity of information is growing due to three main factors:

1. Technological Advances: The development of technological sectors has made financial statements more complex and harder to interpret. For example, regulators have been forced to classify resources spent on R&D as expenses rather than capital expenditures.
2. Conflicts of Interest in Auditing Firms: Auditing companies are often accused of conflicts of interest. There are instances where favorable financial statements are produced, which naturally affects credibility and risk perception.
3. Earnings Manipulation: The trend of “earnings management” leads to managerial tendencies towards manipulation. Analysts initially make highly optimistic forecasts, which management then tries to meet, ultimately resulting in short-term manipulations.

These factors collectively increase the importance of information quality and transparency in determining the price of risk.

*Equity Risk Premiums (ERP): Determinants, Estimation and Implications – The 2013 Edition Updated: March 2013; Aswath Damodaran; Stern School of Business

Source:
Equity Risk Premiums by Country: Higher Risk, Higher Potential Reward (visualcapitalist.com)