Hey everyone, I stumbled upon a question that said something like the following :
Country A is moving toward perfect integration with the world. Beta of country A relative to world is 0.9.
Equity risk premium (A) = 5%, Risk-free (A) = 4%, Risk-free (World) = 7%.
The question is to find the Equtiy Risk Premium for the World and which risk-free rate to use in the international CAPM to estimate the required return ?
The answer was ERP (world) = ERP (A) / Beta (A to world) = 5% / 0.9, and use the country A risk-free rate.
I haven’t found anything clear and close to this in the curriculum, so my guess is the following :
Given that markets are integrated : Return A = Return World
where : Return(A) = Rf(A) + Beta(A,A) * ERP(A) where Beta(A,A) = 1 (beta of country A with itself)
and Return(world) = Rf(A) + Beta(A,world) * ERP(world)
So we have :
=> Rf(A) + Beta(A,A) * ERP(A) = Rf(A) + Beta(A,world) * ERP(world)
=> ERP(A) = Beta(A,world) * ERP(world)
=> ERP(world) = ERP(A) / Beta(A,world) (same as answer of the question)
Does this formula exist somewhere and do you think it is correct ?
Country A is moving toward perfect integration with the world. Beta of country A relative to world is 0.9.
Equity risk premium (A) = 5%, Risk-free (A) = 4%, Risk-free (World) = 7%.
The question is to find the Equtiy Risk Premium for the World and which risk-free rate to use in the international CAPM to estimate the required return ?
The answer was ERP (world) = ERP (A) / Beta (A to world) = 5% / 0.9, and use the country A risk-free rate.
I haven’t found anything clear and close to this in the curriculum, so my guess is the following :
Given that markets are integrated : Return A = Return World
where : Return(A) = Rf(A) + Beta(A,A) * ERP(A) where Beta(A,A) = 1 (beta of country A with itself)
and Return(world) = Rf(A) + Beta(A,world) * ERP(world)
So we have :
=> Rf(A) + Beta(A,A) * ERP(A) = Rf(A) + Beta(A,world) * ERP(world)
=> ERP(A) = Beta(A,world) * ERP(world)
=> ERP(world) = ERP(A) / Beta(A,world) (same as answer of the question)
Does this formula exist somewhere and do you think it is correct ?