Abstract
It is elementary that in a world of certain exchange rates, the factor risk premia of different economies must be identical. Using standard arbitrage arguments, this paper demonstrates that when exchange rates become uncertain, the factor risk premia not only must be different, but more importantly, risk premia (of different economies) associated with the same underlying factor must differ by a particular amount. There are three immediate implications of this result: (1) the slopes of the CAPM (capital- asset-pricing-model) lines in different economies must be different, (2) no factor risk, including exchange-rate risk, can have a zero price in more than one economy, and (3) when making cost-of- capital comparisons, simply adjusting for differences in riskfree rates and comparing risk premia is not sufficient; one must also take into account these arbitrage-determined differences between the factor risk premia.
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