When do you add illiquidiy?
lets stick to Intergrated part for now.
a) corr x SD x GIM Sharpe…then add illiquidity …x DEGREE of INTEGRATION
OR
B) corr x SD x GIM sharpe x degree of INTEGRATION x 100 …then add illiquidity
When do you add illiquidiy?
lets stick to Intergrated part for now.
a) corr x SD x GIM Sharpe…then add illiquidity …x DEGREE of INTEGRATION
OR
B) corr x SD x GIM sharpe x degree of INTEGRATION x 100 …then add illiquidity
Add once you’ve calculated premium assuming integration and segmentation and when you’re calculating the final Risk premium figure.
A
B is used when you are computing for the total risk premium for both markets -> you then add illiquidity
You add illiquidity premium if it is offered as data for the market you are calculating it. You add it both in the integrated and segmented portion of calculations. Basically, if the data is provided, you add it. If not, no worries.
A SD×corr×Sharpe + Illiquidity premium B SD×Sharpe + Illiquidity premium
Then, return from A is multiplied by degree of integration while return from B is multiplied by 1 - degree of integration.
You get ERP and if you need to get total return, you increase it by R(f).
All i know is schweser does a horrible job covering this in comparison with CFA text
Singer-Terhar was designed to use in developed markets. Illiquidity premium should be added when ERP is being calculated for emerging/developing markets.
Singer-Terhaar Steps
Find ERP_{INTEGRATED} = p x o x Sharpe Ratio_{GIM} + illiquidity premium (if given)
Find ERP_{SEGMENTED }= o x Sharpe Ratio_{GIM} + illiquidity premium (if given)
Weight ERP_{INTEGRATED }and ERP_{SEGMENTED }to using the degree of integration, So w_{INTEG}(ERP_{INTEG}) + w_{SEG}(ERP_{SEG})
Once you have the ERP_{WEIGTED}, add R_{f} to ultimately get the ER (expected return).
They may ask you what the Betas are in each market and you can either cross cancel and do all this unncesssary work to derive Beta from Cov / o^{2} or you can just simply solve for Beta by doing p o_{1} / o_{GIM} . Do this for both markets.
Lastly, you may have to solve for the Covariance between both markets, in which this is B_{1} B_{2 }(o_{GIM}^{2}), where o_{GIM }is a WHOLE number and not a decimal point.
You can add illiquidity premium before or after- you’ll get the same results.
If you add it at the end, you’re adding 100% of it; i.e. if illiquidity premium is 60 bps, you’re adding 60 bps at the end. (100% x 60 bps)
If you add it before combining the integrated RP calculation with the segmented RP calculation, you will be adding it to each formula on a weighted basis, at the weight of the degree of integration.
EX: Let’s say you add 60 bps of illiquidity premium to the integrated RP side and degree of integration is .6. Since you’re multiplying, illiquidity premium is reduced to (.6 * 60) = 36 bps. On the segmented side, you multiply that formula by (1- degree of integration) so illiquidity premium gets multiplied by .4 (1-.6) for a total of 24 bps.
When you add both sides, you are adding 224+36 bps of illiquidity premium and getting back to 60 bps.
probably just a choose B and move on. or if you’ve noticed, there’ll be an answer with a Rf added to it and one missing it (or the illiquidity value). since the problem asks for it here, i’ll figure out which answer choice is including it and select it. hopefully get a few that way without having to work them out (or at least, know which answer is the probable one as i do the calcluation). While they are pretty devious in including both answers i’ve finally realized they also open themselves up to a pretty simple workaround if you know the formula in the first place.