Theory of international asset pricing

Abstract

The global environment is characterized by several factors that are distinct from a purely domestic setting. It is necessary to identifying these differences before translating the pricing concepts introduced in the previous chapter into an international context. Most important, different countries have different commercial and monetary policies. Barriers to the movements of goods, labor, and capital are the results of national commercial policies. National monetary policies introduce different currencies. Therefore, exchange rate risk and barriers to capital flows are the two major aspects of international financial theory. These aspects of the global environment will be referred to as differences in consumption and investment opportunity sets throughout this chapter. Closely related is the stylized fact that the purchasing power parity is grossly violated. Hence, people from different countries have different appreciations for real returns. This chapter presents the classical approaches to extend domestic asset pricing models to a global context. As a by-product, international asset pricing models provide the benchmark returns for tests of capital market integration. Finally, in an international context, there is evidence that the correlation of consumption across countries is extremely low, whereas it should be equal to unity in complete and integrated markets. This ‘consumption home bias’ is related to the ‘equity home bias’, the observation that domestic investors hold too few foreign assets relative to what standard results of international portfolio theory suggest.KeywordsRisky AssetPurchase Power ParityCapital Asset Price ModelAsset Price ModelPrice ConditionThese keywords were added by machine and not by the authors. This process is experimental and the keywords may be updated as the learning algorithm improves.