Sorry for bringing this up but I have some confusion about market segmentation. 1. Assume i = a segmented market, m = global market 2. We’re trying to calculate the risk premium for a market that is segmented = i 3. We substitute the segmented market for the global market in the integrated formula: [E®i - Rf] = SDi x Correlatoin of I,M X [(E®m - Rf)/SDm] 4. If i = M basically (isn’t that what we’re doing in step 3?), then the final equation has everything being cancelled out [E®i - Rf] = SDi x 1 X [(E®i - Rf)/SDi] [E®i - Rf] = [E®i - Rf] What the hell does this mean? Why are we STILL using the Standard deviation of the INDIViDUAL market and sharpe ratio of the GLOBAL market if the market is segmented?
never mind, had to read the footnote which states that for simplicity, sharpre ratio of global market and local market are assumed to be same lol. Which brings me to my next question: If we’re given with the individual market’s and global market’s sharpe ratio and asked to calculate the segmented risk premium for a market. Will we use the sharpe ratio of the local market or the global market then? My bet is to use the sharpe ratio of the individual market then.
I could be completely wrong on this as I have not even thought about this stuff in two months, but I believe that the sharpe ratio would be of the global market…if you are calculating the risk premium of a fully integrated market, the correlation between it and the global market would be 1. The market risk premium assuming a segmented market, however, would use the standard deviation of the individual market multiplied by the individual market’s correlation with the the global market, times the sharpe ratio of the global market. Best, TheChad
TheChad Wrote: ------------------------------------------------------- > I could be completely wrong on this as I have not > even thought about this stuff in two months, but I > believe that the sharpe ratio would be of the > global market…if you are calculating the risk > premium of a fully integrated market, the > correlation between it and the global market would > be 1. The market risk premium assuming a segmented > market, however, would use the standard deviation > of the individual market multiplied by the > individual market’s correlation with the the > global market, times the sharpe ratio of the > global market. > > Best, > TheChad I think you’ve subsituted integrated with segmented. As seen on Page 45, Volume 3, 2010 Curriculum, the segmentated market’s risk premium is calculated as the standard deviation of the individual local market times the sharpe ratip of individual OR global market portfolio (this was my question) If we assume the global market portfolio to be the local individual market, we should be using the local market’s sharpe ratio in the equation. CFAI has made an assumption in the example that the sharpe ratio of the individual and global markets are the same so i’m not sure which one is being used.
Zain Zafar and TheChad Let’s step back and look at the definition of SF ratio SF = (Portfolio Return - Risk Free return) / Stddev of portfolio or in the case of a segmented market SF = (Segmented Market Return - Risk Free return) / Stddev of segmented market = Segmented Market premium /stddev of the segmented market or SF * stddev of the segmented market = Segmented Market premium so the correct SF ratio to use is the one of segmented market, not global market SF. Now CFAI is making life a bit easier by assuming SF (global portfolio) = SF (segmented market). What does it mean in practice? 1. It does not mean segmented market premium = global market premium since the stddev of them are not the same. 2. The investors expect to get compensated proportionally for unsystematic risk as systematic risk, i.e., Risk premium segmented /total stddev of segmented = Risk premium / stddev of global (see example below). 3. if you are given different SF ratios, one for global and one for segmented, you should use the segmented for the calculation of segmented market premium. Take the example above: SF global = .29 = Global risk premium/8% --> Global risk premium = 8%*.29 = 2.32% SF global = .29 assumed to be same as Segmented risk premium–> Segmented risk premium = .29*27% = 7.83% Here, you see that the assumption of equal SF means that the investors expect to get proportionally compensated for unsystematic risk , so .29= 2.32% (global market risk premium)/8% (global portfolio stddev ) = 7.83% (risk premium segmented market) / 27% (stddev of segmented market). Just to complete the example Completed open RP: 2.32%*(27%*.61/8%) = 3.1% Segmented RP: 7.83% Combined RP = 65%* 3.1% + 7.83%* (1-65%) = 5.85% Total = 4% + 5.85% + 2.5%= 12.35% Let me know if I have answered your question
^ Seriously elcfa… have you created all of the above from memory… hats off either ways!!!
rp77 haha. Not much help if the exam result in a few days turns negative, so we see.