Can someone explain this sentence from the end of reading 11 on Capital Market Expectations (pag. 261) when referring to Global Integration:
All else the same, the Singer-Terhaar model implies that when a market becomes more globally integrated, its required return should decline. As prices adjust to a lower required return, the market should deliver an even higher return than was previously expected or required by the market.
Why is the expected return higher if it will have to decline? Am I missing something here?
Thanks!
Just did an exercise from Kaplan Qbank and think I got the answer:
An increase in integration will reduce the risk of the equity market, thus reducing required returns. The reduction in required returns will increase equity prices and result in higher returns over the period of increased integration.
Hi all, does anyone know the answer to this question? It really puzzles me as well⌠if EM are more integrated the required return goes down, and prices will decrease â> but then the curriculum claims: as a result the market should deliver an even higher return (?) than was previously expected by the market. Not sure how that would be possible (if everyone moved their capital for example because they expected the returns to go down)⌠maybe Im missing something here
I am guessing it is something like, as EM becomes more integrated Risk Premium goes down (denominator is lower) = Valuation goes up.
âif EM are more integrated the required return goes down, and prices will decreaseâ - I am not sure where you got this - did you mean prices will increase?
âas a result the market should deliver an even higher return (?) than was previously expected by the marketâ - so you thought the asset was worth 5 bucks then the RP went down (valuation goes up) so now itâs worth 10 bucks (higher returns than expected)
Hi GAT thanks for your reply, do you have an example of a formula I can relate to for this? Im guessing 110 stock price / 1.1 expected return = 100 new price? IF expeted return goes to 1.05 the ânew stock priceâ will be higher â ie 110/ 1.05 = 104.7?
However to me it sounds very counterintuitive to transfer money to a country where expected returns will decrease. In my brain it feels like I have a stock of 100 bucks and the expected return will be 5% instead of 10% - then why would someone offer more money for this? (Ie for my current stock) Hope you understand where im coming from⌠I believe there is probably a mistake in my reasoning here.
Yes, I see what you are saying. But I also think it is somewhat similar to investing in a bond when you think TYM would go down (because prices would go up).
I guess the way I understood it was, expected returns are 10% now but the economy is becoming integrated so I expect expected returns to become 5% in the future, so you are really getting in now at a âdiscountâ.
As it says in the post from 2020 âThe reduction in required returns will increase equity prices and result in higher returns over the period of increased integration.â So think about getting in when not integrated, be invested âover the period of increased integrationâ.
Thanks so much, that last bit really helped. I see now I just need to trust indeed that we will know for sure that the rate of return will go down in the future and therefore are safe to invest in that country now, knowing the Req rate of return will decrease and Eq prices will increase.
I think I sometimes struggle with all the hypothetical future scenarioâs.