CHAPTER 4CHAPTER 4 The International Asset The International Asset

PricingPricing

Lecture Agenda

• Learning Outcomes• International Market Efficiency• The Capital Asset Pricing Theory• Practical Implications

Learning Outcomes

• Explain international market integration and international market segmentation

• Discuss the impediments to international capital mobility

• Discuss the factors that favor international market integration

• Explain the extension of the domestic capital asset pricing model (CAPM) to an international context Continued to next slide

Learning Outcomes

• Describe the assumptions needed to justify the extended CAPM

• Determine whether the real exchange rate changes in a period

• Calculate the expected exchange rate and the expected domestic currency holding period return on the foreign bond.

• Calculate the end of period real exchange rate and the domestic currency ex post return on a foreign bond. Continues

Learning Outcomes

• Explain a foreign currency risk premium in terms of interest rate differentials and in terms of forward rates

• Calculate a foreign currency risk premium• Calculate the expected returns on a stock,

given its beta and currency exposure• Define currency exposure

INTERNATIONAL MARKET EFFICIENCY

• In an efficient market, any new information would be immediately and fully reflected in prices

• Financial analysts and professional investors throughout the world search for information and make the world markets close to fully efficient

• Investors must be aware that it is not easy to beat the market in any developed stock market

• Continued next

INTERNATIONAL MARKET EFFICIENCY

• This observation also suggests that theoretical asset-pricing models, based on the premise that markets are efficient, are useful guides to investment policy

• The fundamental issue of international market efficiency is often viewed in terms of international market integration or segmentation

• See page 119

INTERNATIONAL MARKET EFFICIENCY

• The debate over integration versus segmentation involves two somewhat different concepts:

• 1 – The first concept has to do with impediments to capital mobility. Are there legal restrictions or other forms of constraints that segment one national market from others?

• The second concept has to do with international asset pricing. Are similar securities priced in the same manner on different national markets.

INTERNATIONAL MARKET EFFICIENCY

• Although each national market might be efficient, numerous factors might prevent international capital flows from taking advantage of relative mispricing among countries, such as: Psychological barriers, legal restrictions, transaction cost, discriminatory taxation, political risks and foreign currency risks

• To have a meaningful discussion of market segmentation, we must introduce asset-pricing models

Asset Pricing Theory - Assumptions

• We assume investors are risk-averse wealth We assume investors are risk-averse wealth maximizers.maximizers.

• This means they will not willingly undertake fair This means they will not willingly undertake fair gamble.gamble.– A risk-averse investor prefers the risk-free situation.A risk-averse investor prefers the risk-free situation.– The investor needs a risk premium to be induced into a The investor needs a risk premium to be induced into a

risky situation.risky situation.– Evidence of this is the willingness of investors to pay Evidence of this is the willingness of investors to pay

insurance premiums to get out of risky situations.insurance premiums to get out of risky situations.• The implication of this, is that investors will only The implication of this, is that investors will only

choose portfolios that are members of the efficient choose portfolios that are members of the efficient set.set. Continued nextContinued next

Asset Pricing Theory - Assumptions

• A consensus among all investors holds, and everyone agrees about the expected return and risk of all assets

• Investors care about nominal returns in their domestic currency

• A risk free interest rate exists• There are no transaction costs or taxes

Separation Theorem

• The normative conclusion of the domestic CAPM is that every one should hold the same portfolio of risky assets, and the optimal combination of risky assets can be separated from the investor’s preferences toward risk and return. All investors should hold a combination of:

• 1- the risk free asset 2- the market portfolio

• The two key components to measure a risk have emerged from the theoretical effort are “beta”, which is a statistical measure of risk, and capital asset pricing model, which links risk (beta) to the level of required return.

• The total risk of an investment consists of two components: diversifiable and non diversifiable risk.

• Diversifiable or unsystematic risk represents the portion of an investment’s risk that can be eliminated by holding enough stocks.

Risk-Pricing Relation

• Non-diversifiable or systematic risk is external to an industry or business and is attributed to broad forces, such as war, inflation and political events.

• Beta measures non-diversifiable risk. Beta shows how the price of a security responds to market forces. The risk pricing relation of the CAPM for asset i can be written as:

• E(Ri) = Ro + βi * RPm (4.1)

• E(Ri) is the expected return on asset I

• E(Rm) is expected return on the market portfolio

• Ro 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) - Ro

• Equation 4.1 describes the risk pricing relation for all assets I so RPm and Ro are constant, where E(Ri) and βi vary depending on the asset I considered.

• There is a linear relationship between the expected return on all assets and their sensitivity to market movements.

• This straight line is usually called the security market line.

Capital Asset Pricing Model

• Using beta as the measure of Non-diversifiable risk, the CAMP is used to define the required return on a security according to the following equation:

• Rs = Rf + βs (Rm – Rf)

• Rs Return required on the investment

• Rf Return on Risk free investment

• Rm The average return on all investments

• βs The security’s beta risk

• Example: Assume a security with a beta of 1.2 is being considered at a time when risk free rate is 4 percent and the market return is expected to be 12 percent

• Rs = 4% + 1.20(12% - 4%)

= 4% + (1.20 * 8%)

= 4%+ 9.6%

= 13.6% The investor should require an 13.6% return on this investment as compensation for the non-diversifiable risk assumed

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