722 CHAPTER 19. SETTING THE COST OF INTERNATIONAL CAPITAL
exact, we need theCAPMassumptions to justify why the expected return on an asset
should still be the same as the expected return on its best replicating portfolio, and
why the market portfolio is the only replication instrument that is to be considered.
In theCAPMlogic, investors do not care about the imperfections in the replication
(that is, the part of Apple’s return not “explained” by the market) because they all
hold the market portfolio anyway; the part of Apple’s return not correlated with ̃rm
is simply diversified away.
19.2.7 When to Use the Single-CountryCAPM
TheCAPMas derived in Section 19.2 is routinely used in capital budgeting to deter-
mine the return that shareholders expect on investments with a given level of beta
risk. For many countries, financial institutions provide estimates of the betas for
various industries. Yet, one ought to interpret these figures with some caution. The
assumption that underlies many of these estimates is that theCAPMholds country-
by-country, in the sense that the market portfolio is equated with the portfolio of all
assets issued by firms from that country alone. For example, beta service companies
in theustend to compute the beta of, say, theuscomputer industry by regressing
the returns from a portfolio ofuscomputer firms on the Vanguard index, which is
an index of thousands ofusstocks traded on the New York Stock Exchange, Amex,
andNASDAQ. Likewise, in France, one would often estimate the risk of, say, the
French steel industry by regressing the returns from a portfolio of steel companies
on the index of French stocks. In the same vein, the expected excess return on the
market would be estimated from past returns on the Vanguard index or on the index
of French stocks traded at the Paris section of Euronext, respectively.
Is the market portfolio of assets held by a country’s investors the same as the
portfolio of assets issued by the country’s corporations? This is only true if investors
have access to local shares onlyand all local shares are held by residents of the
country. That is, if one equates the market portfolio with the portfolio of locally
issued shares, capital markets are assumed to be fully segmented. However, in
most countries there are no rules against international share ownership; investors
can easily diversify into foreign assets, and foreigners are allowed to buy domestic
shares. Thus, the traditional interpretation that the market portfolio consists of the
index of stocks issued by local companies is valid only in segmented markets.
Example 19.7
Until the later 1990s, the stock markets of India, South Korea, and Taiwan were
almost perfectly segmented from the rest of the world in the sense that foreigners
could buy only a small fraction of the local stocks, and local investors could not
easily buy foreign assets. Thus, the Indian market portfolio was essentially the
same as the portfolio of stocks issued by Indian firms, and similar for Korea and
Taiwan.
In the presence of market segmentation, the cost of capital to be used by, say, a