Teori Manajemen Keuangan

International Asset Pricing

PROGRAM STUDI MAGISTER MANAJEMEN

FAKULTAS EKONOMI DAN BISNIS
UNIVERSITAS JENDERAL SOEDIRMAN
Introduction

 In this chapter we discuss:

 Efficient market hypothesis
 Domestic CAPM vs. ICAPM
 The relation between exchange rates and asset
prices.

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Quote Convention used in this chapter
 Throughout this chapter, the direct currency
quote is utilized as:

Foreign currency :Domestic currency = S

 The investor will pay S units of domestic

currency for 1 unit of foreign currency.

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 International Market Efficiency

Efficient Market Hypothesis

 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.

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Integration versus Segmentation
 An integrated world financial market would
achieve international efficiency, in the sense that
capital flows across markets would
instantaneously take advantage of any new
information throughout the world.
 International markets are integrated if they are
efficient in the sense that securities with the same
risk characteristics have the same expected return
wherever in the world they are traded.
 Most developed markets are considered to be
integrated.
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Integration versus Segmentation
 International markets are considered to be
segmented if they are inefficient in the sense
that securities with the same risk
characteristics sell at different exchange rate
adjusted prices in different countries, thus
violating the law of one price.

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Impediments to Capital Mobility
 It is sometimes claimed that international markets
are not integrated but segmented because of
various impediments to capital mobility.
 Such impediments include:
 Psychological barriers
 Legal restrictions.
 Transaction costs.
 Discriminatory taxation.
 Political risks
 Foreign currency risks.

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Impediments to Capital Mobility
 The flow of foreign investment has grown rapidly
over the years; thus, it does not seem that the
international markets are fully segmented.
 Large corporations, as well as governments,
borrow internationally and quickly take advantage
of relative bond mispricing between countries,
thus making the bond markets more efficient.

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Asset Pricing Theory - Domestic
CAPM’s Main Assumptions
 Investors are risk averse individuals who maximize the
expected utility of their end-of-period wealth
 Investors make portfolio decisions on the basis of
mean (expected return) and variance
 Investors have identical expectations about asset returns
 Investors care about nominal returns in their domestic
currency
 Capital markets are perfect
 Borrowing and lending at the riskfree rate is possible
 No transactions costs or taxes.

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Asset Pricing Theory – The Domestic
CAPM

 Two conclusions emerge from the domestic

CAPM:
 Separation Theorem
 Risk-Pricing Relation

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Separation Theorem

 Separation Theorem: everyone should hold

the same portfolio of risky asset, and the
optimal combination of risky assets can be
separated from the investor’s preferences
toward risk and return.
 The optimal portfolio involves a mix of the risky
market portfolio and the risk-free asset

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Risk-Pricing Relation
 The relation can be expressed as:
E(Ri) = R0 + RPm × βi

 where E(Ri) is the expected return on asset i

 R0 is the risk-free interest rate
 βi is the sensitivity of asset i to market movements
 RPm is the market risk premium equal to E(Rm) - R0

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Risk-Pricing Relation

 In an international context, the domestic

CAPM implies that all domestic securities
would be priced in line with their risk
relative to the domestic market.

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Asset Returns and Exchange rate movements
 Assume S is the direct exchange rate between the
two countries
 Return from time 0 to time 1 shows that the DC
rate of return on an foreign investment
R=(V1-V0)/V0
That is
R=RFC + s + (s × RFC)
RFC =(V1FC-V0FC)/V0FC, the FC rate of return on the investment
s =(S1-S0)/S0, the percentage exchange rate movement

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Asset Returns and Exchange rate movements
 The expected return on an unhedged
foreign investment is:
E(R) = E(RFC) + E(s)

 where E(R) is the expected domestic-currency

return on the investment, E(RFC) is the expected
foreign-currency investment return, and E(s) is
the expected percentage currency movement.

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Asset-Pricing Models - Definitions

 The expected return on a hedged foreign

investment is:
E(R) = E(RFC) + (F – S0)/S0

where E(R) is the expected domestic-currency return on the

hedged investment,
E(RFC) is the expected foreign-currency investment return
F is the forward rate
S0 is the spot exchange rate.

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Domestic CAPM: A Reminder

 Two conclusions emerge from the CAPM:

 The normative conclusion where the optimal
investment strategy for any investor is a
combination of two portfolios: the market
portfolio and the risk-free asset.
 The descriptive conclusion is an equilibrium
risk-pricing expression where the expected return
on an asset i is the sum of the risk-free rate plus a
market risk premium:
E(Ri) = R0 + i  RPM
where i is the domestic market exposure of the
asset and RPM is the domestic-market risk
premium.
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The CAPM Extended to an International
Context
 The extended CAPM is similar to the
domestic CAPM, but the world market
portfolio replaces the domestic market
portfolio.

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The CAPM extended to an International
Context (continued)
 The domestic CAPM extension can be justified
only with the addition of 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.

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The CAPM extended to an International
Context (continued)
 With direct rates, the real exchange rate is
the nominal exchange rate times the ratio of
the foreign price level to the domestic price
level.
X = S  (PFC/PDC)

 where X is the real exchange rate

 S is the nominal exchange rate
 PFC is the foreign country price level.
 PDC is the domestic country price level
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 We can rewrite the mentioned equation in
terms of percentage changes over a time
period (1 year)
x=s+ IFC-IDC = s – (IDC-IFC)

Where x and s are percentage movement in the

real and nominal exchange rates
If PPP holds, the real exchange rate is constant,
and the nominal exchange rate is equal to the
inflation rate differential
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The CAPM extended to an International
Context (continued)
 The real exchange rate changes in a period
if the foreign exchange appreciation during
the period does not equal the inflation
differential between the two countries
during the period.

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 International CAPM (ICAPM)
 Real foreign currency risk
the risk that real prices of consumption goods might
not be identical in every country
 Foreign currency risk premiums
The foreign currency risk premium (SRP) is defined
as the expected return on an investment minus the
domestic currency risk-free rate.

SRP  E[( S1  S 0 ) / S 0 ]  (rDC  rFC )

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Foreign Currency Risk Premium (SRP) -
Example
 The one-year risk-free interest rates are 6 percent
in DC and 3 percent in FC. The expected
exchange rate appreciation of FC is 4 percent.
What is the foreign currency risk premium?
 Solution:
SRP  E[( S1  S 0 ) / S 0 ]  (rDC  rFC )
SRP  4%  (6%  3%)
SRP  1%

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International CAPM (ICAPM)

 The ICAPM is developed under the

assumption that investors of a country care
about returns and risks measured in their
home currency.
 All assumptions of CAPM still hold.
 In the ICAPM, as in the domestic CAPM, all
investors determine their demand for each
asset by a mean-variance optimization using
their domestic currency as base currency.
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ICAPM Conclusions

 Two conclusions emerge from the ICAPM.

 One conclusion is normative and indicate
what should be the optimal investment
strategy of investors.
 The other conclusion is descriptive and
indicate what should be the equilibrium
risk-pricing relation for all assets.

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ICAPM: Normative Conclusion

 The normative conclusion is that 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 personalized hedge portfolio used to reduce
purchasing power risks. This is usually
assumed to be the home risk-free rate
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 ICAPM: Risk-Pricing Relation
 The risk-pricing expression for the ICAPM is that
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(Ri) = R0 + iw  RPw + i1  SRP1 +…+ ik  SRPk
where  is the world market exposure of the asset
and the ’s are the currency exposures, or
sensitivities, of the asset returns to the various
exchange rates (1 to k). RPw is the world market
risk premium and SRPk are the currency risk
premiums.
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ICAPM: Risk-Pricing Conclusion

 With one foreign currency, the asset pricing

equation of the ICAPM simplifies to:
E(Ri) = R0 + iw x RPw + i x SRPFC

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ICAPM: Example
Assume you are a U.S. investor who is considering
investments in the German (stock A) and Italian (stock B)
markets. The world market risk premium is 6 percent. The
currency risk premium on the Italian lira is 1.75 percent,
and the currency risk premium on the euro is 1.5 percent.
The interest rate on one-year risk-free bonds is 4.25 percent
in the United States. In addition you are provided with the
following information:
Stock A B
β 1 1.5
γ€ 1 -1
γIT -0.3 0.75

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Example - Solution
Use
E(Ri) = R0 + iw  RPw + i1  SRP1 +…+ ik  SRPk

E(RA) = 0.0425 + 1(0.06) + 1(0.015) -0.3(0.0175)

= 11.225%

E(RB) = 0.0425 + 1.5(0.06) - 1(0.015) + 0.75(0.0175)

= 13.0625%

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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.

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Practical Implications
 Individual companies
 National stock markets

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Currency Exposure of Individual Companies

 Could be estimated historically by regressing

the company’s stock returns and currency
returns.
 The exchange rate exposure for an individual
firm depends on the currency structure of its
exports, imports, investments and financing.
 For example, if there is a foreign currency
appreciation — the importer is hurt and the
exporter is helped.

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Currency Exposure of National Stock Markets

 The influence of exchange rate movements

on domestic economic activity may explain
the relation between exchange rate
movements and stock returns.

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Exhibit 4.2: The J-Curve Effect

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Tests of the ICAPM
 Empirical researchers have explored several
questions:
 Is currency risk priced?
 Is domestic market risk priced beyond global
market risk (segmentation)?
 Are other firms’ attributes priced beyond global
market risk?

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Tests of the ICAPM (continued)
 A summary of current research tends to
support the conclusion that assets are priced
in an integrated global financial market.
 The evidence is sufficiently strong to justify
using the ICAPM as an anchor in
structuring global portfolios.
 However, the evidence can be somewhat
different for emerging smaller markets, in
which constraints are still serious.

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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.

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 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.

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