The Capital Asset Pricing Model (CAPM) was initially developed by Sharpe (1964) and Lintner (1965) which received a Nobel Prize in 1990. This model was built from the work of Harry Markowitz in 1952 where he wrote a “portfolio selection” article in which he included the analysis of the risks involved when choosing a portfolio. This model of the portfolio is also known as the “mean-variance model” (Elbannan, 2014, p.216). It mainly focuses on how investors choose portfolios based on variance and the expected returns. The framework developed by Markowitz has the assumption that investors are efficient, against risks and maximize their utility which is the reason why the portfolio selection highly depends on investors risk-return benefits function. This means that investors only choose a portfolio for a single investment which brings a return at that particular time (Sander, 2011, p.1).
International CAPM is the extension of the standard CAPM to international investments. The international CAPM mainly focus on international investments that incorporate foreign exchange risks. This means that it is the standard CAPM with the addition of the premium risk of foreign exchange. Since International CAPM is an extension of the Standard CAPM, it is obvious that it faces the same problems and criticism just like the normal CAPM because it has the same theory assumptions. However, International CAPM takes into account other variables that have an effect on the expected return on assets at an international level.
Comparison of ICAPM to CAPM and its Assumptions
According to Pastor and Stambaugh (1999, p.68), the capital asset pricing model is an appealing theory because it is persuasive and powerful in giving predictions on how to come up with the risk involved in choosing a portfolio, plus the relationship between the return expected and the risk measured. Fama and French (2004, p.25) state that besides its attractive nature the model has poor verifiable records which invalidate its practical use. Due to its simplified assumptions in the financial market world, most financial managers use this model with other supporting techniques (Mullins, 1982, p.1). Despite the heated debate on the application of the capital asset theory model, most investment companies and corporate finance organization are benefiting from the use of this technique up to an international level (Roll, 1977, p.130-133). According to a survey done on the same matter, the capital market pricing model is the most used technique by financial professionals in estimating the return to be expected (Student Accountant, 2008, p.50).
It is due to these simplified and unrealistic assumptions of the theory that several other models have been expanded which include other added factors and have relaxed the assumption used in CAPM (Tobin, 1958, p. 65). When comparing CAPM to the international CAPM, ICAPM is more useful when used practically though it has its limitations. Even though ICAPM is aimed to improve on the application of the CAPM to the real market world through the addition of other factors, it has its assumptions in order for it to be a valid theoretical model. The International CAPM assumes a risk-free rate of borrowing and lending without any limits. Another key assumption for this model is that there is the incorporation of the international capital market. Failure to this assumption (meaning that the capital market disintegrates) will result to inefficient asset pricing.
As stated earlier in the paper that ICAPM is an extension of the CAPM theory, investors are expected to be familiar with the domestic CAPM calculations in order to clearly understand the ICAPM calculations. The CAPM model which is built from the Markowitz (1959) model deals mainly with the risks and returns. The CAMP formula shows the linear relationship between the expected return on the asset and the systematic risk of return (Black, 1972, p.444; Black and Scholes 1974 p.20). This relationship is known as the security market line. In this formula, it is assumed that only systematic risk of the investor’s portfolio matters which is measured by beta (β). The expected return is equal to the risk-free rate plus the risk premium. In this model, the premium is calculated by multiplying beta and the expected return by subtracting the risk-free rate (Mullins, 1982, p.1). The security market line is illustrated graphically in figure 1 below.
E (Ri) = Rf +βi (E (Rm) – Rf )
E (Ri) is the expected return on asset i
β is market beta of asset i
Rf is the risk free rate of return
Rm is the market return
In the standard CAPM, investors are compensated for time value for money and the market risk they take. In addition, the international CAPM allows investors to be compensated for either direct or indirect foreign currency risk exposure. Foreign currency is an added variable is added to the CAPM equation to account for the sensitivity which is symbolized by beta (β), of the premium for foreign currency risk. Given the manner at which ICAPM reflects the today’s world characteristics, it is considered a superior tool of evaluation as compared to CAPM (Ejara et al, 2017, p.2; Blume 1970, p.152).
Expected return = Rfr + β(Rm – Rf) + (β*FCRPi)
Where, Rfr – domestic free rate, Rm – Rf is the premium for global market risk measured in investors’ local currency, β*FCRPi is the foreign currency risk premium.
ICAPM Practical Uses
According to Ejara et al (2017, p.2), one of the interpreted approaches is involved in the practical application of the international CAPM. The first approach is the use of global CAPM which involves the use of global index while the second approach used the global market index and the currency index. ICAPM plays a role in the global investment management mostly in the financial markets’ pricing and the estimation of the expected returns on funds borrowed or lend by the investors. The International CAPM is used in portfolio selection whereby the CAPM theory has an effect on (Banz 1981, p. 19). Application of the ICAPM will help the investors understand the currency movements in different companies globally which will be relevant in choosing assets of the same characteristics in different countries. This will enable investors to have knowledge of how the foreign currency will affect the expected return in the local currency.
Despite its existing limitations, it has continued to be used in the financial field more than anyone would have expected. Apart from the investment management, this model is as well applicable in the corporate finance (King, 2009, p.1). It is used in the corporate finance to define the cost of equity. It is not easy to measure the market expectations of the cost of equity since very few techniques are available (Mullins, 1982, p.1). According to Mullins (2004, p.1), the cost equity in the corporate finance is used for capital budgeting evaluation and valuations of acquisitions. It is also a component of investment evaluation. This is why financial manager use ICAPM due to the shortage of techniques for the task (Perold, 2004, p.18).
Advantages of Using ICAPM
According to Lessar (1979, p.159), the most important advantage that ICAPM has over the domestic CAPM is the ability to reduce the risk for expected returns on assets. Investment risk can be possibly reduced through international diversification since the national financial markets correlations are low. The exchange rate is, however, a limitation to international diversification but the good news is that the risk can be managed using various hedging strategies and currency derivatives as discussed later in the paper. According to an article by Ip (1991), International CAPM can help in reducing investment risk in terms of total and systematic risks. There are also other factors such as trading in the forward and future markets that help in risk reduction. He uses the empirical evidence on the monthly closing of major stock markets indices and exchange rates to calculate the local stock market returns and exchange rate changes. The table below shows the documentation of “the benefits of international diversification because of the low correlation between different stock markets” from 1985 to 1988 (Ip, 1991, p.164).
Another advantage is that the investors are paid for direct or indirect exposure to foreign currency. This is because the changes in currency have an effect on the returns either directly or indirectly. This means that ICAPM favors investors when it comes to maximizing their returns (Levy and Sarnat, 1970, p.98). When national markets are integrated, ICAPM can be used to value any security globally. A more realistic assumption added to CAPM to improve the theory to ICAPM which states that investors care more about their opportunities for investment and consumption over time serves as an advantage. This tool of portfolio selection put into consideration the future uncertainties whereby investors use the portfolios to protect themselves against risks such as the prices of goods and services.
Limitation of the International CAPM
Despite its superiority over the domestic CAPM, ICAPM has its limitations. The theory does not fully explain what should exactly be calculated when finding the asset prices. It is not specific to the additional factors and how they affect the assets prices. This aspect of ICAPM has left room for more research to be conducted in order to provide a more efficient evaluation tool (Harvey, 1991, p.111). There are three main limitations for the real world application of the international capital asset pricing model. They include segmentation, purchasing power parity and the exposure to foreign currency risk.
- Failed Capital Market Integration (Segmentation)
Segmentation is the process of dividing the market into different parts which have growth potential and are profitable to the company. One of the key assumptions of the ICAPM is that the international capital markets are integrated, failure to which the international markets will be segmented leading to pricing discrepancies on assets, which will intern result to inefficiency in asset pricing. Adler and Dumas (1983, p. 964) confirm that international market segmentation will disturb global risk allocation. Segmentation disturbs the global market because the goods markets are a capital market. However, they say that capital market can be segmented along national lines but can only be inhibited by investors which can be as a result of lack of information by the investors or discriminatory taxation. Inhabitations of the capital segmentation can also be caused by official restrictions which limit foreigners from accessing capital markets. From these restrictions that nations have to investors, nations can be defined as the segments of the international capital market. Capital market segmentation will cause investors to make higher allocations of prices on assets in specific nations. Separation also causes a breakdown of the independence of capital budgeting and financing decisions for companies. At an international level, it is hard to assume that there is the integration of the capital market because every government tries to cushion its capital and goods market from other nations (Adler and Dumas, 1983, p.965).
Segmentation of stock markets enables home country firm purchase share in foreign firms which result in an indirect exposure to foreign currency risk. Lee and Sachdera pursued a point about the calculations of value maximizing foreign acquisition which was also done by Adler and Dumas and pointed out that, the assumption that home country companies had monopoly power in their countries capital market is what produced the results.
The extent of market integration for a nation can be assessed using the Capital Asset Pricing Model as an evaluation tool. Global market integration is the determining factor for the choice of the market portfolio for use in the global index. Integration is evident when a firm’s stockholder hold diversified portfolio internationally while segmentation is when stockholders invest in the home country. According to Stulz (1994) segmentation is a challenge to investors and is perceived to be a barrier to investment. Bruner et al (2008) conducted a study on the market integration in developed and emerging markets using evidence from the domestic CAPM. They present empirical observations and guidance to beta calculations on securities in various developed and emerging markets. The findings show that emerging markets do not show any improvement in their integration level. It also revealed that in developed markets global expected returns are lower compared to the local expected return.
- Violation of Purchasing Power Parity
One of the assumptions of the international CAPM is that there is a violation of the purchasing power parity. According to Ejara (2017, p.2), real returns have been yield from different assets when the PPP does not hold according to investors realization. This explains the risk to exchange rate exposure changes. PPP is useful in the capital market theory and the international cooperate finance. It used in the capital market finance and international corporate finance in different countries to compare the consumption opportunities. It is also used as cash flow influence generated by production. Nations can be differentiated from another by deviations from PPP as survey reveals (Adler and Dumas, 1983, p.929).
There are conditions required for PPP to hold which include:
“Sufficient conditions include homothetic preferences, commodity price parity (CPP) respect to every good included in the index; and in addition, identical tastes to guarantee that the composition of different nations indices will be identical” (Adler and Dumas, 1983, p.930).
The PPP deviations are important in international finance because they show how investors compute the real returns from their investment in a given security. Considering the conditions required for PPP to hold, the returns of two investors; one investing in a foreign country and the other from a home country with the price indices in line with the exchange rate, the real return for the two investors will be similar. The real returns will only differ if the price indices differ whereby the PPP will have been violated which represent the application of the International CAPM. Adler and Dumas (1983, p.931) clarify that the existence of the PPP does not eliminate or raise the risk of foreign currency exchange. Figure 1 below illustrates the empirical records of PPP deviations.
- Investment Exchange Rate Risk
This is the uncertainty of the value of different currencies whereby its change affects the investment value or the expected returns of the investment made by an investor. Currency risk exposure is also known as the foreign exchange risk. These risks are caused by the fluctuation in the exchange rates in different countries which cause direct or indirect effects of the expected returns to investors. It is referred to as a risk because in most cases it is known to have a negative effect on the investments i.e. losses and also the expected future cash flow of the firm may be affected (Viswanathan and Menon, 2005, p.57). However, the International CAPM allows investors to be compensated for currency risk exposure which is a factor that makes it an ideal evaluation tool for investors in portfolio selection.
Foreign exchange risks have three types of exposure namely economic, translation and the contingent exposure. Economic exposure is when the firm’s market value is affected by the currency volatility and is hard to identify where a translation is a fluctuation in the foreign exchange rate. Contingent exposure mostly affects firms which are interested in projects and investments in foreign countries (Dhanani, 2000, p.30).
ICAPM comes in handy for individuals or group of investors who invest internationally when faced by foreign exchange risk. The foreign currency exposure is also applicable for investors engaged in exporting and importing of products. Investors have to change currency in order to import products from another country; this exchange rate may differ between the home currency and the foreign currency where they want to invest. This can affect the investment value and the expected returns in general. Most contracts signed between parties are specific on how the exchange rate will affect the transactions; it can be either during the signing of the contract or according to the fluctuation of the exchange rate.
Foreign currency risk cannot be avoided or assumed in the international market; however, it can be managed in several ways despite being a limitation to the practical application of the International CAPM. This risk can be managed by using currency derivatives “such as forward and option contracts as well as currency swaps” (Makar and Huffman, 1997, pp. 73- 86). Studies conducted have shown that many firms are using the currency derivatives in managing the foreign currency risk. A study conducted by Viswanathan and Menon (2005) has confirmed this since its findings state that the use of currency derivatives positively affect a firm’s level of foreign currency risk exposure.
ICAPM is the extended and improved version of the domestic CAPM which was initially developed by Sharpe and Lintner in 1964. The international CAPM is considered superior because it has additional factors and has relaxed some assumptions from the standard CAPM. However, ICAPM has its limitations because it also has its own assumptions hence facing criticism for the same. When comparing international CAPM and the domestic CAPM the former has more advantages and favors investors as compared to the later. It is because of these additional variables to the CAPM model that makes the international CAPM attractive. Despite its attractiveness, this theoretical model has little practice because of its risk of foreign currency exposure that cannot be avoided but can be managed using currency deviation.
Adler, M. and Dumas, B. (1983). International Portfolio Choice and Corporation Finance: A Synthesis. The Journal of Finance, 38(3), p.925.
Banz, R. (1981). The Relationship between Return and Market Value of Common Stocks. Journal of Financial Economics, 9(1), pp.3-18.
Black, F. (1972). Capital Market Equilibrium with Restricted Borrowing. The Journal of Business, 45(3), p.444.
Black, F. and Scholes, M. (1974). The effects of dividend yield and dividend policy on common stock prices and returns. Journal of Financial Economics, 1(1), pp.1-22.
Blume, M. (1970). Portfolio Theory: A Step toward Its Practical Application. The Journal of Business, 43(2), p.152.
Bruner, R., Li, W., Kritzman, M., Myrgren, S. and Page, S. (2008). Market integration in developed and emerging markets: Evidence from the CAPM. Emerging Markets Review, 9(2), pp.89-103.
Dhanani, A. (2000). Risky Business: Financial Management. [online] Fasb.org. Available at: https://www.fasb.org/st/ [Accessed 22 Aug. 2018].
Ejara, D., Krapl, A., Obrien, T. and Ruizdevargas, S. (2017). Estimating Cost of Equity: Global CAPM Versus International CAPM Around the World. [online] Finance.business.uconn.edu. Available at: https://finance.business.uconn.edu/wp-content/uploads/sites/723/2014/08/Estimating-Cost-of-Equity.pdf [Accessed 22 Aug. 2018].
Elbannan, M. (2014). The Capital Asset Pricing Model: An Overview of the Theory. International Journal of Economics and Finance, [online] 7(1), pp.216 – 226. Available at: http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.662.4335&rep=rep1&type=pdf [Accessed 16 Aug. 2018].
Fama, E. and FRENCH, K. (1996). Multifactor Explanations of Asset Pricing Anomalies. The Journal of Finance, 51(1), pp.55-84.
Fama, E. and French, K. (2004). The Capital Asset Pricing Model: Theory and Evidence. SSRN Electronic Journal, [online] 18(3), pp.25 – 46. Available at: http://www-personal.umich.edu/~kathrynd/JEP.FamaandFrench.pdf [Accessed 17 Aug. 2018].
Harvey, C. (1991). The World Price of Covariance Risk. The Journal of Finance, 46(1), p.111.
Ip, Y. (1991). International Diversification and Exchange Rate Risk. [online] Actuaries.org. Available at: http://www.actuaries.org/AFIR/colloquia/Brighton/Ip.pdf [Accessed 23 Aug. 2018].
King, M. (2009). The Cost of Equity for Global Banks: A CAPM Perspective From 1990 to 2009. 9th ed.
Lesser, D. (1976). World, Country and Industry Relationship in Equity Returns: Implications for Risk Reduction Through International Diversification. Financial Analyst Journal, 32.
Levy, H. and Sarnat, M. (1970). International Diversification of Investment Porfolio. American Economic Review, 60, pp.97 – 103.
Lintner, J. (1965). The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets. The Review of Economics and Statistics, 47(1), p.13.
Makar, S. and Huffman, S. (1997). Foreign Currency Risk Management Practices In U.S. Multinationals. Journal of Applied Business Research (JABR), 13(2), p.73.
Markowitz, H. (1959). Portfolio Selection. Journal of finance, 7(1), pp.77-99.
Mullins, D. (1982). Does the Capital Asset Pricing Model Work?. [online] Harvard Business Review. Available at: https://hbr.org/1982/01/does-the-capital-asset-pricing-model-work [Accessed 17 Aug. 2018].
Perold, A. (2004). The Capital Asset Pricing Model. Journal of Economic Perspectives, 18(3), pp.3-24.
Pástor, Ľ. and Stambaugh, R. (1999). Costs of Equity Capital and Model Mispricing. The Journal of Finance, 54(1), pp.67-121.
Roll, R. (1977). A critique of the asset pricing theory’s tests Part I: On past and potential testability of the theory. Journal of Financial Economics, 4(2), pp.129-176.
Sander, M. (2011). The Capital Asset Pricing Model. [online] Pure.au.dk. Available at: http://pure.au.dk/portal/files/36147960/Bachelor_thesis.pdf [Accessed 17 Aug. 2018].
Sharpe, W. (1964). Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk. The Journal of Finance, 19(3), p.425.
Student Accountant (2008). CAPM: Theory Advantages and Disadvantages. [online] Chinaacc.com. Available at: http://www.chinaacc.com/upload/html/2013/06/27/lixingcunbf36c81a62904f90a4a8790a05e26785.pdf [Accessed 17 Aug. 2018].
Stulz, R. (1994). International Portfolio Choice and Asset Pricing: An Integrative Survey. [online] Papers.ssrn.com. Available at: https://papers.ssrn.com/abstract=226966 [Accessed 22 Aug. 2018].
Tobin, J. (1958). Liquidity Preference as Behavior Towards Risk. The Review of Economic Studies, 25(2), p.65.
Viswanathan, K. and Menon, S. (2005). Foreign Currencys Risks Management Practices in U.S Multinationals. Journal of International Business and Law, 4(1), pp.57 – 67.