CALCULATING THE EQUITY COST OF CAPITAL USING THE APT - THE IMPACT OF THE ERM

One of the expected benefits of membership of the Exchange Rate Mechan ism (ERM) was a reduction in risk which should lead to a lower cost of capital and foster investment and growth. Using the APT, we investiga te the behavior of the equity market risk premium for the London Stock Exchange prior to and during sterling's membership of the ERM. We fin d that prior to and during the first year of membership the equity mar ket risk premium fell quite dramatically. However, when conflict betwe en domestic and ERM policy requirements arose at the turn of 1991, the equity risk premium increased and continued to do so until sterling's exit, partially wiping out the benefits of membership of the ERM. (C) 1998 Elsevier Science Ltd. All rights reserved.