Jump-Diffusion International Asset Pricing with Nontraded Consumption Goods

Abstract

We present a jump-diffusion international asset pricing model with stochastic exchange rates and inflation rates when investors consume both traded and nontraded goods. We argue that in general, the Adler-Dumas inflation rate differential may not fully capture PPP deviation risks, unless all volatilities, drift rates and jumps rates of PPP deviations/excchange rates are constant. The structure of optimal portfolios for investors from different countries reveals that country-specific demand for risky assets can arise from two sources of risks: PPP-deviation risks and nontraded-good-specific inflation-rate-differential risks. Consequently, equilibrium asset returns can be expressed in a multi-beta linear asset pricing model with a number of benchmark portfolios including hedge portfolios for PPP deviation risks and nontraded-good-specific inflation rate risks. The optimal portfolio structure further reveals that even if jump risks were added to otherwise pure diffusion assets in a no-jump world, investors' existing optimal portfolios of risky assets wouldn't change. We also note that risk premia on PPP deviation risks can be positive, zero, or even negative, that in the presence of inflation risks, hedging against exchange rate risks in isolation can sometimes make the investor's real wealth riskier than no hedging at all, and that a global investor optimally increases his consumption in both traded and nontraded goods as the price of the traded good of his own country increases.