Expected return in integrated and segmented markets

CFA Level III
#1

Referring to Schweser concept checker reading 16 q 4 here, the question gives: - risk-free rate 4.5% - equity risk premium assuming full integration = 4.54% - equity risk premium assuming full segmentation = 5.22% - weighting segmented and integrated risk premiumsby degree of segmentation and integration gives: equity risk premium = (0.8 x 0.454)+(0.2 x 0.0522) =4.68% - Expected return = 4.5 + 4.68 = 9.18. But why is expected return not: risk-free x Beta(equity risk premium)? E.g. why is there no beta in the calc given?

#2

It’s there, just hidden:

Erp = correlation * st deviation i * (Rm - Rf) / st deviation m = B(Rm- Rf)

#3

Sorry how does: correlation * st. dev i * (Rm-Rf) / st. dev m simplify to B(Rm-Rf)?

#4

becos beta = corr * std dev i / std dev m

#5

ERP here is for the purpose of calculating for specifica market. Isn’t BETA for the market is 1, therefore BETA x ERP = ERP?

#6

Unemployed, how do we know that the beta for the market is 1?

#7

john

r = rf + beta (rm - rf) is the traditional CAPM formula.

This approach here is to account for segmentation, and integration of the individual markets.

per your own statements

  • risk-free rate 4.5% - equity risk premium assuming full integration = 4.54% - equity risk premium assuming full segmentation = 5.22%

so fully integrated market -> 4.5 + 4.54 --> remember the 4.54 came from using the corr * std i / std m (which has the beta inbuilt) - you used the SRp formula. = 9.04%

fully segmented -> 4.5 + 5.22 = 9.72

market is 80% integrated -> so market return including both effects = .8 * 9.04 + 0.2 * 9.72

#8

B of market is always 1.

#9
  1. Beta of the market portfolio is always 1, but beta for Market A or Market B (the two individual markets being analyzed) is not given. 2. Normal equity risk premium = required return on equity - risk-free rate. Equity risk premium with integrated/segmented markets = correlation x std. i/ std. m x sharpe ratio So why does the equity risk premium with integrated/segmented markets suddenly include beta and sharpe ratio?
#10

The equity risk premium assuming full integration and equity risk premium assuming full segmentation already include the beta calcuation in it.

Otherwise you would have needed to calculate:

equity risk premium assuming full integration = SDmarket i x correlation x Sharpe of the GLOBAL market

equity risk premium assuming full segmentation = SD market i x 1 x Sharpe of the GLOBAL market

But since they already gave you the result, you don’t have to. The final result is Rf of the market i + ERP

Expected return = 4.5 + 4.68 = 9.18.