International Capital Asset Pricing Model (ICAPM)

Summaries

International CAPM

1)      Since investors are risk-averse, they will hedge all portfolio against exchange rate risk

2)      For the same reason, they will only borrow/lend domestic risk free asset (without exchange rate risk)

3)      Assumptions of extended CAPM are not necessarily those of ICAPM

The separation theorem of ICAPM is the same as extended CAPM with the world risky assets hedged against exchange rate risk.

ICAPM risk-pricing relationship

E(R) = R_rf + Beta x MRP + sum(gamma x FCRPi)

ICAPM already assumed the investors hedged the asset against exchange rate risk, so only FCRP matters because those predictable by interest rate differential have already been hedged.

*** For gammas, all are LC exposures, except the one related to the domestic currency which we have to add 1 to become domestic currency exposure because this includes how the effect on the profit by currency rate change and also the conversion gain to domestic currency.

Currency Exposures

Local Currency Exposure (firm’s exchange rate exposure): change of return of foreign company for every 1% change of exchange rate. (positive, zero, negative correlation)

Domestic Currency Exposure: change of return in domestic value for every 1% change of the exchange rate (this is due to currency itself and the growth of foreign company)

So, Domestic Currency Exposure = LC exposure + 1

This is the gamma