of equity returns for a particular country index that could be accounted for by the industry composition of the index. As shown in Exhibit 18.15, on average, 50 percent of the equity returns could be explained by the industry composition of the index. While not reflected in this data, an extreme case would be Nokia, the consumer electronics company that alone accounted for more than two-thirds of the Finnish index in 1999.

An ideal global market risk premium would be based on a global index measured over a long time. Unfortunately, global indexes don't go back very far. As a fallback, we resort to the U.S. market, which is the most diversified and has the longest history. As we explained in Chapter 10, we recommend a 4.5 percent to 5 percent premium for the U.S. market. The U.K. market actually has a longer history than the U.S. market, but it is not as diversified. A study by the securities firm BZW gives a market risk premium for the United Kingdom in the same range as the United States.

Since we are using a global market risk premium, we should also use beta relative to a global stock market index. Company betas measured against a global market index are now available. These global indexes are usually measured in U.S. dollars. Accordingly, currency fluctuations will affect a company's beta.

This discussion raises an important issue about the comparability of market risk premiums around the world. In addition to industry concentration,

Exhibit 18.15 Share of Equity Returns Explained by Industry Composition of Index

Exhibit 18.15 Share of Equity Returns Explained by Industry Composition of Index

there is theoretical support for the equalization of the cost of capital around the world and a related caveat about how to estimate the cost of capital. This theory is based on the fact that smaller companies have higher returns than larger companies (Exhibit 18.16) and that the average company size in many markets is smaller than in the United States (Exhibit 18.17).5

Use Exhibit 18.18 to follow the logic. Start with the CAPM expressed in U.S. dollars, the solid line that begins at the risk-free rate in the United States and goes through the point where beta equals one. Next, plot the U.S.

Exhibit 18.16 Long-Term Returns by Size Decile

U.S. Dccilc

Arithmetic average

Premium over

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