Bernard Dumas Fin 748 248 Fin 749 249 Market Equilibrium, Cost of Capital and International Acquisit - PowerPoint PPT Presentation

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Bernard Dumas Fin 748 248 Fin 749 249 Market Equilibrium, Cost of Capital and International Acquisit

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A multi-factor CAPM that recognizes a special price for currency risk ... Recall that this has been ascertained by running a regression of the USD excess ... – PowerPoint PPT presentation

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Title: Bernard Dumas Fin 748 248 Fin 749 249 Market Equilibrium, Cost of Capital and International Acquisit


1
Fall 2008
International Finance Faculty Professor Bernard
Dumas CAPM applied to currencies CAPM applied
to hedged foreign investments
2
Overview
  • 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.

3
Classic 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

4
If worldwide classic CAPM holds, it holds also
for foreign currency deposits
5
Required 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.

6
Required 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.

7
Full integration and currency risk The
International Asset Pricing Model (IAPM)
  • A multi-factor CAPM that recognizes special price
    of currency risk

8
Currency 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
9
The 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
10
Example required excess rate of return on Thalès
according to IAPM
11
Thalès in Euro units
12
Major 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

13
Required rate of return on Thalès after hedging,
according to IAPM
14
Major 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

15
Conclusion
  • 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
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