Title: Bernard Dumas Fin 748 248 Fin 749 249 Market Equilibrium, Cost of Capital and International Acquisit
1Fall 2008
International Finance Faculty Professor Bernard
Dumas CAPM applied to currencies CAPM applied
to hedged foreign investments
2Overview
- Classic worldwide CAPM
- Required rate of return on currencies
- Required rate of return on equities after hedging
- National currency points of view
- A multi-factor CAPM that recognizes a special
price for currency risk - Note table numbers refer to the numbering in the
class note that has been distributed. The same
numbering is used across several lectures.
3Classic worldwide CAPM applied to currencies and
other assets
- Note It is harder to imagine a world financial
market that would be segmented, where currencies
would be priced by pure, classic, domestic CAPM
4If worldwide classic CAPM holds, it holds also
for foreign currency deposits
5Required returns after hedging
- If Thalès obeys the worldwide, classic CAPM and
if a currency deposit denominated in Euros obeys
the worldwide, classic CAPM, - a combination of these two assets must as well.
- From the USD point of view, the exposure of a
Thalès share to the Euro is equal to 0.391 (as in
earlier lecture). - Recall that this has been ascertained by running
a regression of the USD excess rate of return of
Thalès on the USD excess rate of return of a
deposit denominated in Euros. The slope
coefficient of that regression was found to be
equal to 0.391.
6Required return after hedging
- The net excess rate of return from this
combination is equal to - the excess rate of return on Thalès (0.232 see
Table 3) - minus 0.391 times the excess rate of return on a
deposit (loan) denominated in Euros (0.012 see
Table 4). - The result is equal to 0.228.
- Note Another way to obtain the same result is to
calculate the ? of Thalès hedged. It is equal to - the ? of Thalès before hedging (0.870 see Table
3) - minus 0.391 times the ? of a currency deposit
denominated in Euros (0.046 see Table 4). - The result is 0.853.
- This value of this ? times the world premium
(0.267 per month) is equal to 0.228.
7Full integration and currency risk The
International Asset Pricing Model (IAPM)
- A multi-factor CAPM that recognizes special price
of currency risk
8Currency risk why it should receive a special
price. The International APM
European investors
American investors
Same universe of securities
The world investor population
Etc.
Japanese investors
9The way to compute real rates of return on an
Argentine security
Peso rate of return
USD rate of return for the same security
Translation
using the future exchange rate relative to the
present one
Deflate by the USA price index in USD
Real rate of return from the point of view of a
US investor
difference arising from PPP deviations
10Example required excess rate of return on Thalès
according to IAPM
11Thalès in Euro units
12Major advantage of IAPM handling of currencies
- Neat separation
- Quantities of risk measured by
- Joint ? against market and
- Joint ? against currencies
- Currency risk is priced by average excess return
on currencies - If these are kept the same, going from one
currency unit to another - Almost leaves risk premium unchanged
- So, it is just a matter of replacing intercept
(riskless rate) - If CAPM holds when expressed in units of one
currency, it also holds in units of another
13Required rate of return on Thalès after hedging,
according to IAPM
14Major advantage of IAPM handling of currencies
(2)
- The required returns on securities after hedging
- and after hedging also the market portfolio
- is simply given by the classic CAPM
15Conclusion
- The risk of a foreign-currency deposit/exposure
can be priced against the world (or domestic)
market by the classic CAPM - Premium is then just based on beta of the foreign
currency against the world market, just like for
any other asset - The price of world market risk is simply applied
to currency assets - The international CAPM (different from classic
CAPM) recognizes a special, separate price for
currency risk because investors of different
countries have different points of view. - In that CAPM, the required returns after hedging,
and after hedging also the market portfolio, is
simply given by the classic CAPM