A model of international asset pricing under imperfect commodity arbitrage

Abstract

This paper examines the effect of imperfect international commodity arbitrage (i.e., violation of the law of one price), modeled as the existence of non-traded goods, on the structure of purchasing power risk, optimal portfolio rules of the risk-averse investors and the equilibrium yield relationship among assets. The major results of the paper include: (i) There are two separate sources of purchasing power risk, i.e., relative price risk and inflation risk; relative price risk is specific to the country in which the investor resides. (ii) In a world of n countries, investors may hold n + 1 hedge portfolios as vehicles to hedge against purchasing power risk; facing different relative prices, investors residing in different countries display divergent portfolio behavior. (iii) In equilibrium, investors are compensated in terms of excess return for bearing not only the systematic world market risk but also the systematic inflation and relative price risks.