Global risks and cost of Capital

Question 1

Two assumptions to use the domestic CAPM re-written in terms of the world CAPM

Answer 1

• investors throughout the world have identical consumption baskets
• Real prices of consumption goods are identical in every country, that is, PPP holds

Question 2

Asset i Beta in country j is Bij
Country j’s beta with the world is Bjw
What is asset i’s beta with the world?

Answer 2

Biw= Bij*Bjw

Question 3

What do The world beta and Capm assumptions imply, are they realistic, what happens in reality?

Answer 3

• they imply that exchange rates mirror the inflation differential between any pair of countries
  In reality:
• consumption preferences differ across countries
• deviation from PPP is the major source of exchange rate variations

Question 4

Explain The ICAPM

Answer 4

• investors determine their demands for each assets by a mean-variance optimization using their home currency as base currency
• investors hold a combination of two portfolios:
  -» a risky portfolio common to all investors
  –»a personalized hedge portfolio to reduce purchasing power risks (under no-inflation risks it reduces to the national risk-free asset)

Question 5

Explain the ICAPM of Solnik

Answer 5

regular capm world plus a series of sigma i,k and cp i,k.
Sigma i,k: the sensitivities of asset i to currencies from 1 to k
cp i,k: the risk premiums on currencies 1 to k (changes in exchange rates)

Question 6

What’s the intuition behind currency premiums

Answer 6

• currency risks cannot be eliminated by simple diversification since they generally apply to all assets
• world market portfolio may be sensitive to currency risks depending on the composition of its assets

Question 7

When do traditional CAPM work in the ICAPM model?

Answer 7

• if an asset is uncorrelated with various exchange rates or is optimally hedges against currency risk, the sigmas are 0
• this implies that asset return is only a function of the world market risk and the traditional CAPM applies

Question 8

Describe the two factor model of ICAPM

Answer 8

• if exchange rates are taken separately, then there are as many exchange rate risks as there are currencies
• they can be combined into a basket, then there will be two factors: world market portfolio and exchange rate basket

Question 9

What are the problems with ICAPM

Answer 9

• market and currency risks are unstable over time
• market imperfections are much more severe at the international than domestic lvl
• the definition of world market portfolio is very complicated

Question 10

Go see the APT model slide, too complicated to write here

Question 11

Each national market is quite efficient, but..

Answer 11

• how efficient is the global market?
• can active allocation among countries consistently outperform the world market index?

Question 12

Fundamental issues with international market efficiency

Answer 12

• integration or segmentation of global markets
• in an integrated international market prices of all assets reflect their relative investment values

Question 13

The ICAPM and IAPT imply that the world is perfectly integrated, what if it’s not?

Answer 13

Then prices of assets in a given country will depend on their sensitivity not only to the world risk factors but also to the domestic market risk

Question 14

Impediments to capital mobility

Answer 14

• psychological mobility
• legal restrictions
• transaction costs
• discriminatory taxation
• political risks

Question 15

Name 3 examples of psychological barriers

Answer 15

all examples:
-geographic (distance reduces info)
- economic (no economic links hurt info)
- cultural and ethnical
- industrial
- political

Question 16

what defines integration

Answer 16

• two countries are integrated if:
• access to both capital markets of the countries is unrestricted
• two assets belonging to the two countries have the same risk then they have the same expected return

Question 17

If two countries are not integrated, what are they?

Answer 17

Partially or fully segmented

Question 18

Are integrated markets often correlated?

Answer 18

Yes, but one does not IMPLY the other, no proof of causal link

Question 19

A country is thought to be relatively integrated if

Answer 19

• ratio of market cap to GDP is high
• the proportion of exports and imports to GDP is high

Question 20

a country is relatively less integrated if

Answer 20

-ratio market cap to gdp is low
-ratio exports and imports to gdp is low

Question 21

Go read and study slide 28-29 by yourself, too complicated for a flashcard

Question 22

conclusions of the chapter

Answer 22

• domestic asset pricing models do not work in global framework
• world market integration is not perfect
• degree of integration varies from country to country
• in semi-integrated markets, asset returns can be driven by world, country, currency and possibly industry risk factors