16/12/2019 Introduction to International CAPM

TRADING SKILLS & ESSENTIALS RISK MANAGEMENT

Introduction to International CAPM

BY KRISTINA ZUCCHI, CFA | Updated Jun 10, 2019

Investing in any asset has risks that can be minimized by using financial tools to determine
expected returns. The capital asset pricing model (CAPM) is one of these tools. This model
calculates the required rate of return for an asset using the expected return on both the
market and a risk-free asset, and the asset's correlation or sensitivity to the market.

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Some of the problems inherent in the model are its assumptions, which include: no
transaction costs, no taxes, investors who can borrow and lend at the risk-free rate and
investors who are rational and risk averse. Obviously these assumptions are not fully
applicable to real-world investing. Despite this, CAPM is useful as one of several tools in
estimating the return expected on an investment. 

The unrealistic assumptions of CAPM have led to the creation of several expanded models
that include additional factors and the relaxing of several assumptions used in
CAPM. International CAPM (ICAPM) uses the same inputs as the CAPM but also takes into
account other variables that influence the return on assets on a global basis. As a result,

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ICAPM is far more useful than CAPM in practice. However, despite relaxing some
assumptions, ICAPM does have limitations that impact its practicality. 

Understanding ICAPM Calculations

Since ICAPM introduces additional variables or factors to the CAPM model, investors first
need to understand CAPM's calculations. CAPM simply states investors want to be
compensated for:

1. The time value of money, which they expect to be more than the risk-free rate and
2. Taking market risk so they require a premium over the return of the market, less the risk-
free rate, times the correlation with the market.

ICAPM expands on CAPM by further saying that in addition to getting compensated for the
time value of money and the premium for taking market risk, investors need to be paid for
direct and indirect exposure to foreign currency. ICAPM allows investors to add currency
effects to CAPM to account for the sensitivity to changes in foreign currency when investors
hold an asset. This sensitivity accounts for changes in a currency that directly and indirectly
affects profitability and, thus, returns. 

For example, if a company domiciled in the United States buys parts from China and the U.S.
dollar strengthens relative the yuan, then the costs of those imports goes down. This indirect
currency exposure impacts the profitability of a company and the returns generated by the
investment. To determine these effects, investors need to calculate the difference between
the expected future spot exchange rate and the forward rate and divide that difference by
today's spot rate, the result of which is the foreign currency risk premium (FCRP). Then,
multiply that by the sensitivity of the domestic currency returns to changes in foreign
currencies. ICAPM provides investors with a way of calculating expected returns in local
currency terms by accounting for variables as stated below:

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Expected Return = RFR + β(Rm − Rf ) + β(FCRP)

where:
RFR = Domestic risk-free rate
β = Beta
Rm = Expected return of market
Rf = Risk-free rate
Rm − Rf = Premium for global market risk measured
in local currency
FCRP = Foreign currency risk premium

Assumptions
While ICAPM improves upon the unrealistic assumptions of CAPM, several assumptions are
still required for the theoretical model to be valid. The most important assumption is that
international capital markets are integrated. If this assumption fails and international
markets are segmented, then there will be pricing discrepancies among assets with similar
risk profiles but in different currencies. As a result, segmented markets will cause investors
to make higher allocations to specific assets in specific countries, resulting in inefficient
asset pricing. ICAPM also assumes unlimited lending and borrowing at the risk-free rate.

Practical Uses
ICAPM's usefulness in stock selection and portfolio management is only as good as
understanding the assumptions as stated above. Despite these limitations, portfolio
selection can be influenced by the model. Understanding the impact of currency movements
on a particular company's operations and profits will help investors choose among two
assets with similar characteristics in different countries. 

For example, if an investor in the U.S. wants to calculate the expected return from holding
asset A and compare that to the expected return from holding asset B, he needs to
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determine the inputs for the last two components of the model, which are to determine the
direct currency impact and the indirect currency impact. The first two variables in the
equation will be the same for both assets. Therefore, the practical usefulness of the ICAPM is
in understanding how one currency affects a company in the foreign country and how
translating it to the investor's local currency will impact the return on the asset.

For example: An investor is deciding to invest in one of the following assets:  

Company A: Japanese company that derives all of its profits and input costs in yen
Company B: Japanese company that derives all its profits in U.S. dollars but has input
costs in yen

Both assets have similar betas, or sensitivity to changes in world market portfolio. In a
macroeconomic environment where the U.S. dollar is weakening relative to the yen, an
investor will determine that the profits for company B would decline, as it would cost more
U.S. dollars to buy the products. As such, the required return would increase for company B,
relative to company A, to offset the additional currency risk. 

The Bottom Line

ICAPM is one of several models used to determine the required return on an asset. Used in
conjunction with other financial tools, it can assist investors in selecting assets that will meet
their required rate of return. ICAPM, like CAPM, makes several assumptions, including that
global markets are integrated and efficient. If this assumption fails, then stock selection is
critical; allocating more resources toward investments in countries that have a currency
advantage should result in alpha. Currency advantages tend to disappear quickly as
exploited market inefficiencies close, but the fact that these inefficiencies occur argues that
active portfolio management is key to providing superior returns over the market portfolio.

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Related Terms
International Capital Asset Pricing Model (CAPM)
The international capital asset pricing model (CAPM) is a financial model that extends the concept of
the CAPM to international investments. more

Country Risk Premium (CRP) Definition

Country Risk Premium (CRP) is the additional return or premium demanded by investors to
compensate them for the higher risk of investing overseas. more

Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model is a model that describes the relationship between risk and expected
return, helping in the pricing of risky securities. more

International Beta
International beta (often known as "global beta") is a measure of the systematic risk or volatility of a
stock or portfolio in relation to a global market, rather than a domestic market. more

How the Consumption Capital Asset Pricing Model Works

The consumption capital asset pricing model is an extension of the capital asset pricing model that
focuses on a consumption beta instead of a market beta. more

Understanding Arbitrage Pricing Theory

Arbitrage pricing theory is a pricing model that predicts a return using the relationship between an
expected return and macroeconomic factors. more

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