2022 ICM Part 3

International Capital Markets
and Investment Practice
Part 3
International asset pricing theories
Dr. Peter Oertmann

peter.oertmann@tum.de
This lecture is largely congruent in content with the video

recording of the 2020 lecture available on lecturio.de
Part 3: International asset pricing theories
International parity relations

Introduction into the setting of international asset pricing
Base-line International CAPM
Structure of more general IAPM’s
© 2018-2022 Peter Oertmann 2

Part 3: Positioning in the lecture
Major fields in asset management Knowledge base
Diversification Asset allocation Stylized facts on Sources of risk

global markets and return
Empirical research Models and empirical
research
Security Investment Asset pricing Portfolio

selection strategy Theories, models and construction
empirical tests
implementation Models and empirical
tests
Risk Trading and Financial Time series

management execution economics analysis
Models and empirical Models and empirical
research procedures



Starting point of international asset pricing
§ Investors throughout the world use different numeraire currencies

§ Returns on international investments are affected by exchange rate movements
– Directly, because they have to be translated from foreign to domestic
currency units (numeraire currency units)
– Indirectly, because asset prices react to shifts in exchange rates
§ Asset prices, interest rates, and foreign exchange rates are economically
interrelated in a complex manner
§ Investment analysis in the international setting requires a distinct understanding
of the links between
– Foreign exchange rates
– Interest rates
– Inflation rates
between countries (international parity relations)

Definitions
Spot exchange rate (S) Interest rate (R)

§ Rate of exchange between two • Rate of interest quoted for a certain
currencies for immediate delivery currency and in accordance with a
certain time period for
§ Amount of domestic currency
required to buy one unit of foreign borrowing/lending
currency • Interest rate differential: Difference
in interest rates between two countries
Forward exchange rate (F) Inflation rate (p)

§ Rate of exchange between two • Rate of consumer price index (CPI)
currencies set today for delivery increase over a period
at a specified date in the future
• Inflation differential: Difference in
§ Amount of domestic currency inflation rates between two countries
required at a specified date in the
future to buy one unit of foreign
currency

Some EUR exchange rates
EUR exchange rate 22-Apr-22 Min Max
USD 1,0817 1,0803 1,2264
JPY 138,83 125,55 139,61
GBP 0,83925 0,82388 0,86988
CHF 1,0336 1,0056 1,1067
TRY 15,9446 9,7942 20,0434
Data: ECB

USD/EUR exchange rate since 1985
USD price of 1 EUR

1,6
1,5
1,4
1,3
1,2
1,1
0,9
0,8
0,7
0,6
Jan-85 Jan-87 Jan-89 Jan-91 Jan-93 Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 Jan-13 Jan-15 Jan-17 Jan-19 Jan-21
Data: Bloomberg

Long-term inflation rates (1900-2016)
Data: Elroy Dimson, Paul Marsh and Mike Staunton, Credit Suisse Global Investment Returns Yearbook 2017

Inflation in the euro area since 1997
Euro area inflation rate

8
-1
Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 Jan-13 Jan-15 Jan-17 Jan-19 Jan-21
Data: ECB, Euro area indices of consumer prices (changing composition), HICP Overall index, Annual rate of
change, Eurostat, Neither seasonally nor working day adjusted

Exercise question
On 7 July 2020 the closing price of an Apple stock is 91.03 USD and 1 EUR costs
1.1200 USD, and one year later, on 7 July 2021, the closing price of an Apple stock
is 137.27 USD and 1 EUR costs 1.1883 USD. Calculate the stock return over that
one-year period denominated in EUR.

Parity relations of international finance
§ Commodity price parity (CPP)

– Linking real prices of goods
§ Purchasing power parity (PPP)
– Linking spot exchange rates and inflation rates
§ Fisher relation
– Linking interest rates and inflation rates
§ Foreign exchange expectation relation
– Linking forward exchange rates and expected spot rates
§ Interest rate parity
– Linking spot exchange rates, forward exchange rates, and interest rates

Commodity price parity
“The real price of an individual good is the same in two countries”
PtD = St × PtF
where P price of a good

S spot exchange rate (price of foreign currency)
§ Instantaneous arbitrage condition: “Law of one price”

§ CPP holds in absence of trade barriers for homogeneous goods (e.g. gold,
precious metals)

Purchasing power parity
... in absolute terms
“Average price levels are the same in two countries at any time”
D
åwt × PtD = St × å w Ft × PtF
goods goods
where w weight of a good

P price of a good
S spot exchange rate (price of foreign currency)
D " domestic"
F " foreign"

Purchasing power parity (cont.)
... in relative terms
“Spot exchange rates between currencies adjust to inflation differentials

between the respective countries”
Exact formula
St +1 1 + pD t .t +1
1 + st .t +1 = =
St 1 + pFt .t +1
Linear approximation
St +1 - St
st .t +1 = » pD F
t .t +1 - pt .t +1
St

Purchasing power parity (cont.)
When PPP in relative terms holds ...

§ Real returns on international assets are identical for investors from different
countries denominating returns in different currencies
§ FX rate shifts purely mirror inflation differentials and have no impact on the
valuation of assets
Empirical evidence
§ PPP is a poor explanation of short-term FX movements (explains 5-10%)
§ It takes several years before a PPP deviation is adjusted for in the FX market
… because
– Inflation is not consistently defined across countries
– Consumption baskets are different
– Changes in relative prices cause consumption substitution
– Transaction costs, taxes, and restrictions prevent arbitrage in goods markets

Exercise question
Today 0.90 EUR buy 1 USD. Economists forecast 3.0% inflation in the Eurozone
and 7.0% inflation in the US over the next year. Predict the EUR/USD exchange rate
at the end of next year assuming that PPP holds.

PPP – The Economist’s Big Mac Index
What is it?
§ Invented by The Economist in 1986 as a lighthearted guide to whether currencies
are at their “correct” level, it was never intended as a precise gauge of currency
misalignment, merely a tool to make exchange-rate theory more digestible
§ Based on the theory of purchasing-power parity (PPP), the notion that in the long
run exchange rates should move towards the rate that would equalise the prices
of a basket of goods and services around the world
§ Yet the Big Mac index has become a global standard, included in several
economic textbooks and the subject of at least 20 academic studies
Source: www.economist.com

0
1
2
3
4
5
6
7
8
Switzerland
Norway
United States
Sweden
Uruguay
Israel
Canada
Venezuela
Euro area
Source: www.economist.com
Denmark
Britain
United Arab Emirates
New Zealand
Australia
Singapore
Brazil
Argentina
Sri Lanka
Kuwait
Costa Rica
Czech Republic
Saudi Arabia
Bahrain
Chile
Thail and
China
South Korea
Nicaragua
USD price of a Big Mac as of January 2022
Honduras
Qatar
Croatia
Poland
Japan
Guatemala
Peru
© 2018-2022 Peter Oertmann

PPP – The Economist’s Big Mac Index (cont.)
Pakistan
Mexico
Colombia
Lebanon
Hungary
Vietnam
Jordan
Oman
Mol dova
Hong Kong
Phil ippines
Egypt
Taiwan
Azerbaijan
South Afri ca
India
Ukraine
Romania
Malaysia
Indonesia
Turkey
Russia
19
Exercise question
Looking at data from 2018: In the US the average price of a Big Mac in January
2018 is 5.28 USD. At the same time in China it is 20.40 Yuan which is equivalent to
3.17 USD at market exchange rates, and in Switzerland it is 6.50 Swiss francs which
is equal to 6.76 USD. Comment on the relative valuation of the three currencies in
accordance with the Big Mac index.

PPP – Long-run real equity returns from an USD perspective
Source: Elroy Dimson, Paul Marsh and Mike Staunton, Triumph of the Optimists, 2002

Fisher relation
“Fluctuations in interest rates are caused by revisions in expected

inflation, when real interest rates are very stable over time”
National
(1 + rnom ) = (1 + rreal ) × (1 + E(p))
International
F F
1 + rnom 1 + rreal 1 + E(pF)
D
= ×
1 + rnom 1 + rreal 1 + E(pD )
D

Fisher relation (cont.)
When the international Fisher relation holds ...

§ and real interest rates are stable and equal across countries, interest rate
differentials across countries are predominantly caused by differences in
expected inflation across countries
§ and real interest rates between two countries deviate, capital flows would take
advantage of these differences
Empirical evidence
§ The Fisher relation more or less holds for major currencies
§ Real interest rates vary over time
§ Real interest rates differ across countries

Foreign exchange expectation relation
“Forward exchange rates mirror expected future spot rates”

Ft = Et (St +1 )
where Ft forward exchange rate quoted at time t

for delivery at time t + 1
Et (St +1) time t + 1 spot rate expected at time t
Forward premium
“The difference between the forward and spot FX rate mirrors the
expected spot FX rate change”
Ft E(St +1)
-1 = - 1 = E(st .t +1)
St St

Foreign exchange expectation relation (cont.)
When the foreign exchange expectation relation holds ...

§ there is no reward for bearing FX risk
§ forward FX contracts can be used to hedge foreign asset positions with no costs
(except for transaction costs)
Empirical evidence
§ Forward premiums explain only a small portion of observed FX rate changes
… because
– FX rate changes systematically deviate from expected FX changes
– Taking FX exposure is rewarded with a (varying) risk premium

Interest rate parity
“The forward premium for currency exchange mirrors the interest

differential between the respective countries”
… implies that
§ the return on riskfree investment is equal across countries
§ observable interest rate differentials can be used to forecast FX rate movements
Ft 1 + rD
=
Exact formula St 1 + rF
Ft
Linear approximation Et (St +1) = - 1 » rD - rF
St

Exercise question
The spot exchange rate between two currencies is 0.80. The domestic interest rate
is 1.5% and the foreign interest rate is 3%. Calculate the forward exchange rate.

Links between monetary variables
FX rate
Purchasing St +1 - St FX expectation
power parity st .t +1 = relation
St
Inflation Forward FX rate

differential Ft
Et (st .t +1) = -1
D F
p -p St
Interest rate
International differential Interest rate
Fisher relation parity
rD - rF



Recall: Asset pricing in the closed-economy

Recall: Asset pricing in the closed-economy
Description of the setting

§ All investors face the same investment opportunity set
§ Asset returns are measured in the same currency (numeraire), the same CPI is
used to calculate real returns
§ Efficient portfolio diversification brings all investors on the same efficient frontier
§ Availability of a riskfree investment implies a clear two-fund separation: All
investors hold a combination of the riskfree asset and the unique market portfolio
§ In equilibrium, expected nominal returns are consistent with the CAPM
Portfolio choice Asset pricing restriction

Combination of riskfree asset and
market portfolio E ( Ri ) = R f + b i × ( E ( RM ) - R f )

Core problem of international asset pricing:
Heterogeneity across investors
§ PPP does not hold: Deviations from absolute and relative PPP can be observed
at almost all times between almost all countries, affecting the purchasing power of
investors differently
Reasons: Differences across countries concerning ...
– Composition of national consumption baskets (tastes)
– Relative prices of goods
– Time-evolution of relative prices
§ Investment opportunities differ across countries: Investors around the world

face different feasible sets of assets for investment
Reasons: Differences across countries concerning ...
– Restrictions
– Capital controls

Implications
Investors in different countries ...

Expected
§ evaluate real returns from the return
same internationally traded asset
differently Investor from country A
§ face different settings for portfolio Investor from country B
optimization
§ evaluate the cross-section of
internationally traded assets
differently
Risk

What makes international investors heterogeneous?
§ Set of consumption opportunities

– Goods available
– Tastes
– Prices and relative prices
– Consumer Price Index (CPI)
§ Set of investment opportunities

– Border controls
– Taxes and regulations
– Transaction costs
– Restrictions

Major classes of international asset pricing models
Utility-based equilibrium IAPM‘s Arbitrage-motivated IAPM‘s

Alternative settings Alternative settings
A Models that assume equal A Models that assume that
consumption and investment exchange rates are driven by the
opportunity sets across countries same factors as asset returns
B Models that consider differences B Models that consider factors in
across the national consumption exchange hedged asset returns
opportunity sets
C Models that assume the existence
of barriers to certain international
investments

Utility-based international IAPM‘s
§ Group A
– Stulz (1984, 1994): Base-line International CAPM
(IntCAPM)
§ Group B
– Solnik (1974), Sercu (1980): Consumption is
limited to the home country and local inflation is more and
zero (SS-IAPM) more
– Grauer/Litzenberger/Stehle (1976), Fama/Faber complex
(1979): Consumption sets differ across countries, models
but PPP holds
– Stulz (1981), Adler/Dumas (1983): General
equilibrium international valuation model with PPP
deviations (IAPM)



Assumptions („no real differences between investors ...“)

§ No differences concerning consumption and investment opportunities across
countries
§ All investors consume the same single good (same tastes)
§ Consumption good is available in every country, freely traded across borders
and can be used for borrowing or lending
§ Real price of the consumption good is always the same in all countries: CPP
(PPP) holds all the time
§ Perfect markets, no frictions
§ No barriers to international investment
§ All investors are risk-averse, maximize end-of-period consumption
§ Consumption good is used as numeraire to calculate real returns

Base-line International CAPM (cont.)
Consequences
§ Expected real returns are the same for all investors across different countries
§ Existence of multiple countries can be ignored completely
§ All investors face the same input parameters for portfolio optimization
Optimal portfolio choice

Any investor desires a combination of ...
§ Riskfree asset
§ Portfolio of risky assets that is common to all investors across countries (world
market portfolio)

ICAPM in real terms
E(Rreal real
i ) = Rf + breal
i × (E(Rreal real
WM ) - Rf )
Cov(Rreal real
i , RWM )
where bi =
Var(Rreal
WM )
Pit Pgood, t
Rreal
i = " real asset return"
Pi, t -1 Pgood, t -1
PWMt Pgood, t
Rreal
WM = " real world market return"
PWM , t -1 Pgood, t -1

Exercise question
On 20 April 2018 the price of an Apple stock is 172.80 USD and the price of one
fresh white bread is 2.52 USD. One year before the stock price was 142.44 USD
and the bread price was 2.40 USD. Calculate the real return on Apple shares.

Does the ICAPM also hold in terms of a certain currency?
Yes, but ...

additional assumptions have to be made ...
§ Existence of a riskfree asset denominated in the country‘s currency, having a
zero world market beta
§ Inflation rate in the country is uncorrelated with nominal returns (inflation risk is
not systematic)

Derivation of the ICAPM in nominal terms

Step 1: Rewriting the Real-ICAPM taking a certain currency perspective
æ rid r d ö
Cov ç , WM ÷
æ rid ö æ rWM
d ö ç 1 + pd 1 + pd ÷
Eç ÷ d
= bi × Eç ÷ where bid = è ø
ç 1 + pd ÷ ç 1 + pd ÷ æ rWM
d ö
è ø è ø Var ç ÷
ç 1 + pd ÷
è ø
rid = Rid - Rdf asset excess return
d
rWM = RdWMi - Rdf world market excess return
pd domestic inflation rate

Derivation of the ICAPM in nominal terms

Step 2: Transformation in accordance with COV-Rules
æ 1 ö d æ d 1 ö
Eç rid × d
÷ = bi × Eç rWM × d
÷
è 1+ p ø è 1+ p ø
ì ü
ï ï
Û
æ d 1 ö
Cov ç ri , d
d æ 1 ö
÷ + E(ri ) × Eç d
d ï
ï æ d
÷ = bi × íCov ç rWM ,
1 ö
d
( )
d æ 1 öïï
÷ + E rWM × Eç ÷
d ý
$!è!#1! p"ø
+! è1 + p ø ï$!è!!#! "ø
1 +!p! è 1 + p øï
=0 ï =0 ï
by assumption ï
î by assumption ïþ
Û E(rid ) = bid × E(rWM

d
)

ICAPM in nominal terms
E(Rid ) = Rdf + bid × (E(RdWM ) - Rdf )
Characteristics
§ Appeal: Pricing model in terms of returns denominated in a certain country‘s
currency; the currency of any country can be used
§ Critical assumption: Inflation rate changes do not systematically affect the
cross-section of asset returns
§ Practicability: If the covariance between inflation rate changes and asset
returns is small, formula can be used as an approximation

0,0
0,2
0,4
0,6
0,8
1,0
1,2
1,4
1,6
1,8
2,0
MSCI EU
MSCI USA
Source: Own calculations

MSCI CH
MSCI UK
MSCI JP
MSCI AUS
MSCI CANADA
MSCI CHINA
MSCI INDIA
MSCI BRAZIL
MSCI RUSSIA
MSCI ASIA
© 2018-2022 Peter Oertmann

MSCI EASTERN
EUROPE
MSCI LATIN
AMERICA
Private Equity
Beta relative to MSCI World Market Index (2006-2010, EUR)
(LPX-Index)
Infrastructure (NMX
Index)
46
The model does not adequately fit to reality, because

§ Investors in different countries do not have the same preferences
§ Transportation costs, taxes, tariffs, etc. cause differences in the structure of
relative prices across countries
§ Prices change differently over time across countries
Þ No reason for PPP to hold!

PPP – „OK“ in the long run, but disturbed over the short term!
Source: Elroy Dimson, Paul Marsh and Mike Staunton, Triumph of the Optimists, 2002



Structure of more general IAPM‘s
More general setting: Existence of PPP deviations!

§ Consumption opportunity sets change differently across countries
§ Investors face exchange rate risk due to unforeseen deviations from PPP
§ Shifts in PPP change the risk-return perception of an internationally traded asset
differently for investors from different countries
General assumptions
§ Investors in any country are willing to hedge against unanticipated changes in
the price of their specific consumption basket
§ Investors hedge their consumption by their investment portfolio

Structure of more general IAPM‘s (cont.)
10% 10%
5%
15%
40% 20%
“Hedging”
Investor Consumption
Home country

Structure of more general IAPM‘s (cont.)
Implications of the more general setting

§ Hedging property of an internationally traded asset with respect to consumption
depends on which country‘s perspective is taken
§ Investors in different countries have different expected returns for the same
internationally traded asset
§ Investors in different countries hold different investment portfolios
Challenges for IAPM‘s

§ Portfolio choice in a world with consumption hedging
§ Market clearing and equilibrium pricing across heterogeneous investors

Model of Solnik 1974
Assumptions
§ Differences in the consumption opportunities across countries: Single
consumption good in each country
§ No local inflation: FX rate shifts mirror pure deviations from PPP
§ Segmentation of product markets, no international trade in goods
§ Exchange rate shifts are uncorrelated to stock returns
§ In each country a riskfree bond exists
§ Investment opportunities are the same across countries:
– Domestic riskfree bond
– Domestic common stocks
– Foreign riskfree bonds
– Foreign common stocks

Model of Solnik 1974 (cont.)
Portfolio choice of every investor in the world
1. World market portfolio hedged against FX risk

– International stock positions are hedged by going short in local riskfree
bonds (zero-investment)
– Fund representing pure market risk
2. Portfolio of riskfree bonds of all countries (FX risk hedge fund)
– Weighting in accordance with FX rate speculation
– Fund representing pure FX risk
3. Riskfree bond of the home country

Model of Solnik 1974 (cont.)
Asset pricing restriction

!
E(R id ) = R df + b id! × (E(R !WM ) - R f )
where Rd return denominate d in domestic currency
R! return denominate d in local currency of the country
Critical assumption
§ World stock investments do not carry any FX risk and, hence, no potential for
hedging FX risk
§ Protection against FX risk is attainable solely by foreign currency bond
investments

Model of Adler and Dumas 1983
Most important assumptions

§ Differences across country-specific consumption baskets
§ Stochastic inflation in each country
„New“ Implications
§ Domestic bond investments are not save in real terms
§ Correlations between returns on internationally traded assets and domestic
inflation affects the real return of an investment

Model of Adler and Dumas 1983 (cont.)
Portfolio choice of every investor in the world
1. Universal world market portfolio of risky assets

– Same weighting of internationally traded risky assets irrespective of the
residence country of the investor
2. Individual inflation hedge portfolio
– Individual weighting of assets such that the nominal return of the portfolio
is most highly correlated with the inflation rate in the residence country of
the investor

Crucial insights
§ Expected return of an asset depends on its usefulness to hedge PPP risk rather
than on its world market risk alone
§ In equilibrium, expected returns must be consistent with the assets‘ hedging
potential in each country as well as the investors‘ willingness to pay for hedging
in each country

Asset pricing restriction
L
E(R ) = R + l WM × Cov(R ,R
d
i
d
f
d
i
d
WM ) + å l pj × Cov(R id , p j )
j=1
where l WM premium for covariance with the world market

l pj premium for covariance with the jth country' s inflation
Characteristics
§ Multi-beta pricing model
§ World market risk as well as inflation risk are priced

Overview
Portfolio Choice in different IAPM’s
Stulz (1984) Solnik (1974) Adler/Dumas (1983)
Riskfree asset Riskfree asset of home Universal world market

country portfolio
World market portfolio World market portfolio Individual inflation

FX hedged hedge portfolio
Portfolio of riskfree
bonds of all countries

Part 3: Selected references
Global Asset Allocation, Chapter 2
Adler, M. and B. Dumas (1983), International portfolio choice and corporation finance: A synthesis, The
Journal of Finance
Dimson, E., P. Marsh, and M. Staunton (2002): Triumph of the Optimists, Princeton University Press
Solnik, B. (1974), An equilibrium model of the international capital market, Journal of Economic Theory
Stulz, R. M. (1981), A model of international asset pricing, Journal of Financial Economics
Stulz, R. M. (1984), Pricing capital assets in an international setting: An introduction, Journal of International
Business Studies
Stulz, R. M. (1994), International portfolio choice and asset pricing: An integrative survey, in: Jarrow et al.
(Hrsg.): Finance, Handbooks in Economic Research and Management Science

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International Capital Markets

and Investment Practice

Dr. Peter Oertmann

This lecture is largely congruent in content with the video

International parity relations

© 2018-2022 Peter Oertmann 2

Major fields in asset management Knowledge base

Diversification Asset allocation Stylized facts on Sources of risk

Security Investment Asset pricing Portfolio

Risk Trading and Financial Time series

© 2018-2022 Peter Oertmann 3

International parity relations

© 2018-2022 Peter Oertmann 4

§ Investors throughout the world use different numeraire currencies

© 2018-2022 Peter Oertmann 5

Spot exchange rate (S) Interest rate (R)

Forward exchange rate (F) Inflation rate (p)

© 2018-2022 Peter Oertmann 6

EUR exchange rate 22-Apr-22 Min Max

USD 1,0817 1,0803 1,2264

JPY 138,83 125,55 139,61

GBP 0,83925 0,82388 0,86988

CHF 1,0336 1,0056 1,1067

TRY 15,9446 9,7942 20,0434

© 2018-2022 Peter Oertmann 7

USD price of 1 EUR

© 2018-2022 Peter Oertmann 8

© 2018-2022 Peter Oertmann 9

Euro area inflation rate

© 2018-2022 Peter Oertmann 10

© 2018-2022 Peter Oertmann 11

§ Commodity price parity (CPP)

© 2018-2022 Peter Oertmann 12

“The real price of an individual good is the same in two countries”

where P price of a good

§ Instantaneous arbitrage condition: “Law of one price”

© 2018-2022 Peter Oertmann 13

... in absolute terms

where w weight of a good

© 2018-2022 Peter Oertmann 14

... in relative terms

“Spot exchange rates between currencies adjust to inflation differentials

© 2018-2022 Peter Oertmann 15

When PPP in relative terms holds ...

© 2018-2022 Peter Oertmann 16

© 2018-2022 Peter Oertmann 17

© 2018-2022 Peter Oertmann 18

© 2018-2022 Peter Oertmann

© 2018-2022 Peter Oertmann 20

© 2018-2022 Peter Oertmann 21

“Fluctuations in interest rates are caused by revisions in expected

© 2018-2022 Peter Oertmann 22

When the international Fisher relation holds ...

© 2018-2022 Peter Oertmann 23

“Forward exchange rates mirror expected future spot rates”

where Ft forward exchange rate quoted at time t

© 2018-2022 Peter Oertmann 24

When the foreign exchange expectation relation holds ...

© 2018-2022 Peter Oertmann 25

“The forward premium for currency exchange mirrors the interest

© 2018-2022 Peter Oertmann 26

© 2018-2022 Peter Oertmann 27

Inflation Forward FX rate