International Asset Pricing Chapter 4 International Asset Pricing

Introduction In this chapter we discuss: The valuation and portfolio implications of international asset pricing. International asset pricing models (ICAPM). Domestic CAPM vs. ICAPM The relation between exchange rates and asset prices.

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.

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.

Integration versus Segmentation 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. 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. Most developed markets are considered to be integrated.

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. Segmentation tends to be more apparent with emerging markets.

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.

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.

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 The set of risky assets is fixed and all assets are traded No transactions costs or taxes.

Asset Pricing Theory – The Domestic CAPM A major challenge is to determine the relevant measures of risk, as well as the size of the associated premiums. Two conclusions emerge from the domestic CAPM: Separation Theorem Risk-Pricing Relation

Separation Theorem Separation Theorem: When riskfree borrowing and lending are possible, the decision of which portfolio of risky assets to hold is separated from the decision of how much risk to assume The optimal portfolio involves a mix of the risky market portfolio and the riskfree asset In other words, investors need only two portfolios to design their investment strategies: a market index fund and the risk-free asset.

Risk-Pricing Relation The relation can be expressed as: E(Ri) = R0 + RPm x βj 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

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. Even if a company has extensive foreign operations, its international risks should not be taken into account specifically.

Asset-Pricing Models - Definitions 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.

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.

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.

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.

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.

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

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.

International CAPM (ICAPM) The ICAPM is developed under the assumption that nationals 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.

Foreign Currency Risk Premium (SRP) The foreign currency risk premium (SRP) is defined as the expected return on an investment minus the domestic currency risk-free rate.

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:

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.

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

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.

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

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 γIT -0.3 0.75

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%

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.

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.

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.

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.

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.

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.

Currency Exposure of National Bond Markets A rise in the national real interest rates leads to an appreciation of the domestic currency, because of international investment flows attracted by the higher real interest rate. Hence, domestic bond price declines would accompany domestic currency appreciation. A rise in national inflationary expectations leads to both a rise in national nominal interest rates and a depreciation of the domestic currency. Hence, domestic bond price declines would accompany domestic currency depreciation.

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.