In finance there are several approaches used to explain the relationship between risk and return in captial markets. Such theories are called financial equilibrium models and include the Black–Litterman approach and the international CAPM–based approach presented in Singer and Terhaar (1997).
Many of us are familiar with the traditional CAPM model frequently used to estimate the cost of equity. The international CAPM is simply an extension of this approach that tries to take into account barriers to capital mobility globally which is coined as the degree of market integration.
For those of us interested in the method used in the ICAPM - the approach is as folows:
Recall the two key formulae:
1. Risk Premium Asset = Corr (Asset, Market) x Risk Premium Market x std asset / std market = Corr (A,M) x SR (M) x std asset
(perfectly integrated markets risk premium
This first formula comes from the original CAPM formula E(r) = rf + beta x (rm-rf) and is arrived by rearranging it. Note beta asset = Cov (Return asset, Return Market) / Var (Return Market)
2. Risk Premium Asset = Risk Premium Market x std asset / std market = SR (M) x std asset
(completed segmented markets risk premium)
Once we have the formula we can then apply them to estimate the expected equity return for an asset taking into account an assumed degree of integration.
Example:
Say we assume the following:
a) degree of integration = 80%
b) asset expected standard deviation = 7%
c) sharpe ratio of the market (global investable market/GIM) = 0.28
d) correlation of the asset to the market = 0.54
Risk Premium Asset (eq 1) = 0.28 x 0.54 x 7 % = 1.06%
Risk Premium Asset (eq 2) = 0.28 x 7 % = 1.96%
Overall Risk Premium Asset = 0.8 x 1.06% + 0.2 x 1.96% = 0.392% + 0.848% = 1.24%
Assuming a risk free rate of 5% we get the Singer–Terhaar approach expected return of:
5%+ 1.24% = 6.24%
The calculation could also include a liquidity premium manifesting itself in an extra return for lower liquidity. It will therefore be added to 6.24%.
It is worthwhile also to recall the formula:
Cov (A,B) = beta (a) x beta (b) x variance of the market
Note: formula and example based on the CFA 2018 study materials
Many of us are familiar with the traditional CAPM model frequently used to estimate the cost of equity. The international CAPM is simply an extension of this approach that tries to take into account barriers to capital mobility globally which is coined as the degree of market integration.
For those of us interested in the method used in the ICAPM - the approach is as folows:
Recall the two key formulae:
1. Risk Premium Asset = Corr (Asset, Market) x Risk Premium Market x std asset / std market = Corr (A,M) x SR (M) x std asset
(perfectly integrated markets risk premium
This first formula comes from the original CAPM formula E(r) = rf + beta x (rm-rf) and is arrived by rearranging it. Note beta asset = Cov (Return asset, Return Market) / Var (Return Market)
2. Risk Premium Asset = Risk Premium Market x std asset / std market = SR (M) x std asset
(completed segmented markets risk premium)
Once we have the formula we can then apply them to estimate the expected equity return for an asset taking into account an assumed degree of integration.
Example:
Say we assume the following:
a) degree of integration = 80%
b) asset expected standard deviation = 7%
c) sharpe ratio of the market (global investable market/GIM) = 0.28
d) correlation of the asset to the market = 0.54
Risk Premium Asset (eq 1) = 0.28 x 0.54 x 7 % = 1.06%
Risk Premium Asset (eq 2) = 0.28 x 7 % = 1.96%
Overall Risk Premium Asset = 0.8 x 1.06% + 0.2 x 1.96% = 0.392% + 0.848% = 1.24%
Assuming a risk free rate of 5% we get the Singer–Terhaar approach expected return of:
5%+ 1.24% = 6.24%
The calculation could also include a liquidity premium manifesting itself in an extra return for lower liquidity. It will therefore be added to 6.24%.
It is worthwhile also to recall the formula:
Cov (A,B) = beta (a) x beta (b) x variance of the market
Note: formula and example based on the CFA 2018 study materials
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