Erasmus university rotterdam

The local CAPM

When dealing with emerging markets, investors often believe that financial market integration is constrained. If financial markets are integrated, investors do not have to worry about country risk, since it is diversified away through a geographically diversified portfolio (Pereiro, 2001). However, in the case investors are constrained form entering and leaving specific country markets, they may come to bear country-related risk. Only 5% of respondents in a survey by Keck et al. (1998) believed world financial markets to be deeply integrated. The local CAPM defines expected return as follows:

_[7]

Where:

being the local risk-free rate

the local company beta against a local market index

the return of the local market

the country risk premium

is the composite of the global risk-free rate and the country risk premium .

The country risk premium is usually computed as the spread of sovereign bonds over the global bonds of similar denomination, yield and term e.g. a US Treasury note if the US market is considered as the global market proxy (Pereiro, 2001). In this study the country risk premium is computed as the spread between a US 10-year Credit Default Swap (CDS) and a similar sovereign CDS.

The following models previously discussed will be analyzed using stock market data of four emerging markets; the Global CAPM, the three moment CAPM, the four moment CAPM and the local CAPM.