It says that the expected return according to the ICAPM is the Rf + B (Rm-Rf). Where Rf is the domestic risk free rate, and Rm is the expected return on the GIM (or otherwise).
If used for an emerging market, then the Rf would most likely be larger than Rm, giving a negative ERP, is this normal?
Is government debt in an emerging market really risk free? I haven’t read the material yet so I’m speaking more generally but perhaps from a logical perspective the “risk free” rate in an emerging market actually needs to be revised heavily downward to get into the realms of truly risk free.
So basically, it’s the real risk free rate according to the PPP, and then you add the currency’s expected inflation?
That makes sense in practice, but that’s not what is implied in the material.
From a logical point of view (not read that part yet), it seems to me that you have tu update the whole formula, and of course apply it consistently in terms of currency, no?
I think if you take Rf for an emerging market, this Rf should reflect the risk-free rate of that market, and the Rm should also be the respective of that market. Then, it makes sense to me to factor in the currency’s expected appreciation/deppreciation to get the domestic return.
That makes sense. But since we are trying to find out the discount rate for the local currency, then I guess the correct thing to do is either
a) Derive the real return of the market portfolio, then add the expected inflation rate for the local currency
b) Convert the nominal return of the market portfolio in local currency terms, and use that for the expected market return
If either of these methods is used with the PPP domestic risk free rate, then it makes sense.
I highly doubt any of this is explicit in the material, but it’s the most correct nonetheless.
I believe that any formula where you see Rf only works if you believe that the government bonds you are looking at are really risk free. This is very theoretical because you may say that no treasury bond is 100% risk free. But in quite a few countries you can actually say the risk is close to nil.