let her rip! Suppose an analyst is valuing two markets. Market A is a developed country market and Market B is an emerging market. What is the expected return for the emerging market given the following information? Sharpe ratio of the global portfolio 0.29 Standard deviation of the global portfolio 8.00% Risk-free rate of return 4.00% Degree of market integration for Market A 80% Degree of market integration for Market B 65% Standard deviation of Market A 18.00% Standard deviation of Market B 27.00% Correlation of Market A with global portfolio 0.86 Correlation of Market B with global portfolio 0.61 Estimated illiquidity premium for A 0.00% Estimated illiquidity premium for B 2.50% A) 8.35%. B) 9.85%. C) 12.35%.

C 1. Compute ERP assuming complete segmentation ERP_A_Segmented 5.22% ERP_B_Segmented 7.83% 2. Compute ERP assuming complete integration ERP_A_Integrated 4.49% ERP_B_Integrated 4.78% 3. Compute real ERP ERP_A 4.64% ERP_B 5.85% 4. Compute return R_A 8.64% R_B 9.85% 5. Final R_B = 9.85% + 2.50% = 12.35%

wow, can you remind me which section in schweser this is discussion. my brain is totally blank here.

book 2 Capital Market Expectations.

and the answer is…not B.

Dude, just how do you compute this???

You have to calculate based on a totally segmented market then a totally integreated market an then figure out the actual by using the actual degrees on market integration.

This is the Level 3 forum right…I’m not in the wrong place am I. What the flip is going on, I’ve never covered this. Is this in Schweser?

yup, SS 6. ran into this problem on a practice exam, so i did cap markets expecatations last night. CFAI loves this theoretical shit, so i hope its on the exam.

KRochelli Wrote: ------------------------------------------------------- > yup, SS 6. ran into this problem on a practice > exam, so i did cap markets expecatations last > night. > > CFAI loves this theoretical shit, so i hope its on > the exam. Thanks, I’ll have to look into this now.

I would have a quick question about that case. Does anyone understand why the complete segmentation assumes a correlation of 1 between the Market and the global portfolio? In my twisted mind, I would tend to think that a perfectly integrated country would have a correlation of 1 with the global market, i.e. following perfectly the moves and trends due to its integration. Thanks. -N

nicolargol Wrote: ------------------------------------------------------- > I would have a quick question about that case. > > Does anyone understand why the complete > segmentation assumes a correlation of 1 between > the Market and the global portfolio? > > In my twisted mind, I would tend to think that a > perfectly integrated country would have a > correlation of 1 with the global market, i.e. > following perfectly the moves and trends due to > its integration. > > Thanks. > > -N Yeah, I was wondering about this too. I think understanding this point and the assumptions of ERP is probably more important than knowing how to calculate the whole darn thing.

Thanks a lot for the tip. lxwqh Wrote: ------------------------------------------------------- > book 2 Capital Market Expectations.

Do anyone have the full answer to this one please. I just don’t get it

that’s a great question. i think it might show up on the exam. good job, lxwqh!

Grey Arrow Wrote: ------------------------------------------------------- > Do anyone have the full answer to this one please. > I just don’t get it Using lxwqh’s answers: 1. Compute ERP assuming complete segmentation ERP_A_Segmented 5.22% = 0.29*18% ERP_B_Segmented 7.83% =0.29*27% 2. Compute ERP assuming complete integration ERP_A_Integrated 4.49% = 5.22*0.86 ERP_B_Integrated 4.78% = 7.83*0.61 3. Compute real ERP ERP_A 4.64% ERP_B 5.85% = 7.83*(1-0.65)+4.78*(0.65) 4. Compute return R_A 8.64% R_B 9.85% = 5.85%+4% (RFR) 5. Final R_B = 9.85% + 2.50% (Liquidity premium) = 12.35% Does that help?

Thanks for the detailed explanation. So: ERP fully integrated = sd(B) * r(B,M) * ERP(M) ERP segmented = sd(B) * ERP(M) Calc both extremes then factor in the degree of integration by weighing each where w= the degree of int: w * ERP integrated + (1-w) * ERP segmented Then get the ERP for market B by adding in any illiquidity premium. If they are asking for the expected return you simply add the ERP(B) to the RFR. As for the inputs into the ERP equations, I vaguely recall something about a fully segmented market is not correlated with the global market as a result of the segmentation. And for an integrated market the degree to which it is correlated with the global market needs to be factored in to the ERP. But I am not certain on that.

Did we ever come to a conclusion as to why a fully segmented market would have a correlation of 1 with the global portfolio when it seems it should just be a lower number than the correlation for an integrated market?

If the market is fully integrated, then how is the illiquidity premium justified? Does full integration mean liquidity ?

From Schweser “Under the full segmentation assumption, the relevant global portfolio is the individual market so that the correlation between the market and the global portfolio in the formula is 1.0”