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Market segmentation means that there are some meaningful impediments to capital movement across markets. Although many barriers to international capital flows have come down, some do per- sist and a number of asset markets are in practice at least partially segmented across national borders. The more a market is segmented, the more it is dominated by local investors.
When markets are segmented, two assets in different markets with identical risk characteristics may have different expected returns. If an asset in a segmented market appears undervalued to a nondomestic investor not considering barriers to capital mobility, after such barriers are considered, the investor may not actually be able to exploit the opportunity.
To address the task of estimating the risk premium for the case of complete mar- ket segmentation, we must first recognize that if a market is completely segmented, the market portfolio in Equations 9 and 10 must be identified as the individual local market. Because the individual market and the reference market portfolio are identi- cal, ρi,M in Equation 10 equals 1. (For example, if Canadian equities were a completely segmented market, the reference market portfolio and the individual market portfolio would each be a broad-based index for Canadian equities, and the correlation of such an index with itself would of course be 1.) The value of 1 for correlation is the max- imum value, so all else being equal, the risk premium for the completely segmented markets case is higher than that for the perfectly integrated markets case and equal to the amount shown in Equation 11:
RPi = σi * RPM / σM = σi * Sharpe Ratio GIM