International Asset Pricing

Summaries

International Market Efficiency: Integration vs segmentation

Segmentation: Capital cannot flow freely => mispricing => abnormal gain for some people

1)      Psychological barriers

2)      Legal Restrictions

3)      Transaction costs

4)      Discriminatory taxation

5)      Political risks

6)      Foreign Currency risk

Under CAPM, all investors will hold some combination of market portfolio and risk-free assets (Separation Theorem)

With additional assumptions,

1)      investors in the world have the same consumption basket

2)      purchasing power parity holds

we have the extended CAPM,

E(Rp) = R_rf_domestic + Beta x premium using market capitalization-weighted portfolio in the work

Expected return of unhedged investment:

E(R_DC) = E(R_FC) + (E(S_t) – S_0)/S_0

Expected return of hedged investment

E(R_DC) = E(R_FC) + (F – S_0)/S_0

Real exchange rate = spot rate (DC/FC) * FC purchasing power / DC purchasing power

(just like find the “barter exchange rate”)

Change of real exchange rate = change of spot rate + difference in inflation (FC-DC)

Foreign Currency Risk Premium (FCRP)

= (E(S) – S0)/S0 – interest rate differential(DC-FC) 

If IRP holds, = (E(S)-F)/S0

This means that if it is unhedged, there is a premium (e.g. E(S) is larger than F, then domestic currency depreciates more, so the return is higher). If it is hedged premium will be zero.

Risk premium can be assumed to be zero in long run. (So the change of exchange rate is determined solely on interest differential).