1. Copyright © 2009 Pearson Prentice Hall. All rights reserved. Chapter 4 International Asset Pricing

2. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 4 - 2 International Market Efficiency  In an efficient market, any new information would be immediately and fully reflected in prices.  In an efficient market, the typical investor could consider an asset price to reflect its true fundamental value at all times.  The general consensus is that individual markets across the world are quite efficient.

3. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 4 - 3 Impediments to Capital Mobility  Although each national market might be efficient, numerous factors might prevent international capital flows from taking advantage of relative mispricing among countries.  Such impediments include:  Psychological barriers  Legal restrictions.  Transaction costs.  Discriminatory taxation.  Political risks  Foreign currency risks.

4. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 4 - 4 Asset Pricing Theory - Domestic CAPM’s Main Assumptions  Investors are risk averse and prefer less risk and more expected return.  A consensus among all investors holds, and everyone agrees about the expected return and risk of all assets.  Investors care about nominal returns in their domestic currency.  A risk-free interest rate exists, with unlimited borrowing or lending capacity at this rate.  There are no transactions costs or taxes.

5. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 4 - 5 Asset Pricing Theory – The Domestic CAPM  Two conclusions emerge from the domestic CAPM:  Separation Theorem  Risk-Pricing Relation

6. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 4 - 6 Separation Theorem  Separation Theorem: Everyone should hold the same portfolio of risky assets, and the optimal combination of risky assets can be separated from the investor’s preferences toward risk and return.  All investors should hold a combination of: the market portfolio and the risk-free asset.

7. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 4 - 7 Risk-Pricing Relation  The relation can be expressed as: E(R i ) = R 0 + β j x RP m  E(R i ) is the expected return on asset i  E(R m ) is the expected return on the market portfolio  R 0 is the risk-free interest rate  β i is the sensitivity of asset i to market movements  RP m is the market risk premium equal to E(R m ) - R 0  The intuition

8. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 4 - 8 Asset-Returns and Exchange Rate Movements  The expected return on an unhedged foreign investment is: E(R) = E(R FC ) + [E(S 1 )-S 0 ]/S 0  E(R) is the expected domestic-currency investment return.  E(R FC ) is the expected foreign-currency investment return  S 1 and S 0 are the time 1 and time 0 spot rate respectively.

9. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 4 - 9 Asset-Returns and Exchange Rate Movements  The expected return on a hedged foreign investment is: E(R) = E(R FC ) + (F – S 0 )/S 0  E(R) is the expected domestic-currency investment return.  E(R FC ) is the expected foreign-currency investment return.  F is the forward rate.  S 0 is the time 0 spot exchange rate.

10. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 4 - 10 The CAPM extended to an International Context  All assumptions of CAPM still hold.  Add two unreasonable assumptions:  Investors throughout the world have identical consumption baskets.  Real prices of consumption goods are identical in every country. In other words, purchasing power parity holds exactly at any point in time.

11. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 4 - 11 Foreign Currency Risk Premium (SRP)  The foreign currency risk premium (SRP) is defined as the expected return on an investment minus the interest rate differential (domestic risk-free rate minus foreign risk- free rate).  Example 4.4

12. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 4 - 12 ICAPM Conclusions  Two conclusions emerge from the ICAPM.  One conclusion is separation theorem.  The other conclusion is risk-pricing relation.

13. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 4 - 13 ICAPM: Separation Theorem  The optimal investment strategy for any investor is a combination of two portfolios:  A risky portfolio common to all investors. This is the world market portfolio optimally hedged against currency risk. (The optimal hedge ratios depend on variables such as differences in relative wealth, foreign investment position and risk aversion.)  A risk-free asset in their own currency.

14. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 4 - 14 ICAPM: Risk-Pricing Relation  The expected return on an asset i is the sum of the risk-free rate plus the market risk premium plus various currency risk premiums: E(R i ) = R 0 +  iw  RP w +  i1  SRP 1 +…+  ik  SRP k where  is the world market exposure of the asset  ’s are the currency exposures RP w is the world market risk premium SRP k are the currency risk premiums Example 4.6

15. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 4 - 15 ICAPM versus Domestic CAPM  The ICAPM differs from the domestic CAPM in two respects:  the relevant market risk is world (global) risk, not domestic market risk.  Additional risk premiums are linked to an asset’s sensitivity to currency movements. The different currency exposures of individual securities would be reflected in different expected returns.

16. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 4 - 16 Practical Implications  To use the model, one needs to estimate two types of variables:  The market and currency exposures on each asset;  The risk premiums on the (global) market and on currencies.

17. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 4 - 17 Exhibit 4.1: Example of Relation between Beta and Risk Premiums of Various Asset Classes Assume SRP=0 ICAPM: E(R i ) = R 0 +  iw  RP w An investor who believes that markets are not fully efficient could deviate from the global market line.

18. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 4 - 18 Estimating Currency Exposures  A local currency exposure is the sensitivity of a stock price (measured in local currency) to a change in the value of the local currency.  The currency exposure of a foreign investment is the sensitivity of the stock price (measured in the investor’s domestic currency) to a change in the value of the foreign currency.  It is equal to one plus the local currency exposure of the asset. (equation 4.15)

19. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 4 - 19 Estimating Currency Exposures  A zero correlation between stock returns and exchange rate movements would mean no systematic reaction to exchange rate adjustments.  A negative correlation would mean that the local stock price would benefit from a depreciation of the local currency.  A positive correlation would mean that the local stock price would drop in reaction to a depreciation of the local currency.  Example of page 140.

20. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 4 - 20 Exhibit 4.2: The J-Curve Effect