How does the Singer-Terhaar model work for setting international capital market expectations?
I'm studying the Singer-Terhaar approach for CFA Level III and it combines the ICAPM with adjustments for market segmentation. I follow the ICAPM part, but I'm confused about how you blend the fully integrated and fully segmented risk premiums. Can someone explain with numbers?
The Singer-Terhaar model is a practical approach for estimating risk premiums across global asset classes. It recognizes that real-world capital markets are neither fully integrated (all investors can access everything freely) nor fully segmented (each market is isolated). The truth lies in between.
Step 1: Estimate the Fully Integrated Risk Premium
Under full integration, the risk premium for asset class i depends on its correlation with the global market portfolio and its relative volatility:
RP_integrated = ρ(i,GMP) × σ_i × Sharpe_GMP
Where:
- ρ(i,GMP) = correlation of asset i with the global market portfolio
- σ_i = volatility of asset i
- Sharpe_GMP = Sharpe ratio of the global market portfolio
Step 2: Estimate the Fully Segmented Risk Premium
Under full segmentation, the asset is priced in isolation, so its correlation with the global portfolio is irrelevant — it's effectively 1.0 (the asset is its own market):
RP_segmented = 1.0 × σ_i × Sharpe_GMP = σ_i × Sharpe_GMP
Step 3: Blend Based on Degree of Integration
The actual risk premium is a weighted average:
RP_i = φ × RP_integrated + (1 - φ) × RP_segmented
Where φ is the degree of integration (0 to 1).
Numerical Example:
Estimate the equity risk premium for Kenyan equities.
| Input | Value |
|---|---|
| Kenyan equity volatility (σ_i) | 28% |
| Correlation with global portfolio (ρ) | 0.35 |
| Global market Sharpe ratio | 0.30 |
| Degree of integration (φ) | 0.55 |
- RP_integrated = 0.35 × 0.28 × 0.30 = 2.94%
- RP_segmented = 1.0 × 0.28 × 0.30 = 8.40%
- RP_Kenya = 0.55 × 2.94% + 0.45 × 8.40% = 1.62% + 3.78% = 5.40%
Add the risk-free rate (say 4.0%) to get the expected return: 4.0% + 5.40% = 9.40%
Key Insight: More segmented markets (lower φ) receive higher risk premiums because investors demand compensation for illiquidity, capital controls, and political risk. As markets integrate over time (φ increases), risk premiums compress.
Exam Tip: Be prepared to calculate both the integrated and segmented premiums, then blend them. Also watch for questions testing how φ changes as a country opens its capital markets.
Practice Singer-Terhaar calculations in our CFA Level III question bank.
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