Equity Markets and Economic Development: What Do We Know

2.1.1 Full market segmentation

Full market segmentation can be theoretically analyzed using the Capital Asset Pricing Model
(CAPM) as developed by Sharpe (1964) and Lintner (1965). In this framework, the relevant
risk that investors face is the asset’s contribution to variance of a diversified portfolio within
the domestic country, i.e the variance of the country portfolio. For any individual stock in the
segmented stock market we have:

- E (Ri) = r, + βim [E ( Rm )- r, ]

■^[E(^Rm )^- rf ^]= ^γW)^σ'2m

E (R,) = r_j + γEOV ( Ri, Rm )

Where E(R_i) is the required rate of return on firm i’s stock, r_f is the risk-free rate in the
domestic market, β_im is the beta coefficient of firm i with the domestic market portfolio, and
E(R_m) is the expected return on the domestic market. The aggregate risk premium can be
decomposed as the product of the coefficient of relative risk-aversion γ(W ) by the variance of
the domestic market portfolio σ²m . COV(R_i,R_m) is the covariance between the individual
stock and the domestic portfolio.

2.1.2 Mild market segmentation

The mild segmentation model was introduced by Errunza and Losq (1985). Mild
segmentation occurs when government introduce one restriction to financial liberalization:
while domestic investors are allowed to invest in the world market portfolio, foreign investors
can only hold a subset of domestic equities. This situation can be represented using a hybrid
CAPM in which assets are divided into freely tradable and restricted. Freely tradable assets
are priced according to the world factor, which remains the relevant source of systematic risk

<<   15   16   17   18   19   20   21   >>

More intriguing information