CHAPTER 2

INTERNATIONAL ASSET
PRICING
 CONTENTS
1. International Market efficiency
2. International pricing models
3. The relation between exchange rates and asset
prices
1. International market efficiency
In an efficient market, any new information would be immediately and fully
reflected in prices.
Example:
A new balance of payments statistic of one country would immediately be used
by foreign exchange traders to buy or sell a currency until the foreign exchange
rate reached a level considered consistent with the new information.
Why some individual markets across the world are quite efficient?
 The intense competition among professional security analysts and managers.
 The number of foreign investors and securities firms using their own
financial analysis techniques has increased.
 The degree of regulation of the market.
Why some individual markets in developing countries are inefficient?
 Psychological barriers: Unfamiliarity with foreign markets, language, sources of
information.
 Legal restrictions: Institutional investors are often constrained in their foreign
investments.
 Transaction costs: The costs of foreign investment can be high and greater
than for domestic investment: the cost of access to source of information, management
fees,...
 Discriminatory taxation: Foreign investment might be more heavily taxed than
domestic investment.
 Foreign currency risks: Foreign investments bear the risk of local market
movements and unexpected changes in the foreign exchange rate
2. Asset-Pricing Theory
2.1 The Domestic Capital Asset Pricing Model (Domestic CAMP)
The value of an asset depends on its discounted anticipated cash flows adjusted for
risk.
Example: the value of a risk-free bill is equal to the repayment value of the bill
discounted at the risk-free interest rate.
A goverment bond has nominal value is 100 mil VND. This bond has coupon interest
rate of 10%/year, payment at the end of each year, the maturity date is ten years later
from now. Calculate the present value of this bond with discount risk – free interest
rate of 7%/year?
Market equilibrium requires that the expected return be equal to the risk-free rate plus risk
premiums to reward the various sources of risk borne by the investor.
The expected return = the risk-free rate + risk premiums

E(Ri) = R0 + βi x RPm
E(Ri): expected return on asset i
R0: risk- free interest rate
βi : is the sensitivity of asset i to market movements. (covariance of stock to the market).
RPm is the market risk premium equal to E(Rm) - R0
E(Rm): expected return on market portflolio
 If a stock is riskier than the market, βi > 1
 If a stock has a lower risk than the market, βi < 1
 If the price variance of a stock is adverse to the price variance of the market,
βi = 0
How we apply CAMP in stock trading
Today, the trading price of stock A is 50 USD, dividend of stock A is 30% of nominal
value (par value) each year (unchanged in the the following years). Beta of stock A is 1.5,
risk-free interest rate is 4%/year and the expected return on market porfolio is 10%/year.
a/ Calculate the expected return of stock A
The expected return of stock A based on CAMP
= 4% + 1.5 (10% - 4%) = 13%/year
b/ If the nominal value (par value) of stock A is 10 USD. The price of stock A at the end
of 4th year is 70 USD. Do we buy stock A based on CAMP model?
How we calculate β of a specific stock
An investor is looking to calculate the beta of Apple (AAPL) as compared to the
SPDR S&P 500 ETF Trust (SPY). Based on recent five-year data, the correlation
between AAPL and SPY is 0.83. AAPL has a standard deviation of returns of
23.42% and SPY has a standard deviation of returns of 32.21%.
How we calculate β of one specific stock
Use Excel Function
βVNM = Slope (change of VNM, change of VNI Index)
βVNM = Covariance.P (change of VNM, change of VNI Index) /Var.P (change of VNI Index)
3. The Domestic CAPM Extended in the International Context (ICAMP)
3.1 The relation between the real and nominal exchange rates
We have 2 ways to express the relation between the real and nominal exchange rate:
X = S * (PFC / PDC)
Where
X is the real exchange rate (direct quote FC:DC)
S is the nominal exchange rate (direct quote FC:DC)
PFC is the foreign country price level
PDC is the domestic country price level
 x = s + IFC - IDC = s - (IDC - IFC)
Where
x and s are the percentage movement in the real and nominal exchange rates.
IDC and IFC are the inflation rates in the domestic and foreign countries.
If purchasing power parity holds, the real exchange rate is constant (x = 0%), and the
nominal exchange rate movement FC:DC is equal to the inflation rate differential
(domestic inflation minus foreign inflation) or the interest rate differenctial (domestics
interest rate – foreign interest rate)
Example 1:
An investor in his home (domestic) country considers investing in the securities
of a foreign country. The direct exchange rate between the two countries is
currently two domestic currency (DC) units for one foreign currency (FC) unit.
The price level of the typical consumption basket in domestic country relative to
the price level of the typical consumption basket in foreign country is also 2 to 1.
Identify the real Exchange rate?
X = S * (PFC / PDC) = 2 * (1/2) =1
A year later the inflation rate has been 3 percent in domestic country and 1
percent in foreign country. The foreign currency has appreciated and the
exchange rate (direct quote FC:DC) is now 2.04.
What is the new real exchange rate?
The new exchange rate : X = S x (PFC/PDC) = 2.04 x (1.01/2.06) = 1
The real exchange rate remains constant because the foreign exchange
appreciation of 2 percent is equal to the inflation differential between the two
countries.
Example 2:
An investor in her home (domestic) country would like to expand her portfolio to
include one-year bonds in foreign countries. The expected inflation rate in the
domestic country is 3% and the expected inflation rate in one of the foreign
countries is 1%.
Inflation rates are totally predictable over the next year. The exchange rate
between the two countries is currently two DC units for one FC unit. The price
level of the typical consumption basket in the domestic country relative to the
price level of the typical consumption basket in the foreign country is also 2 to 1.
The real exchange rate is 1 to 1.
The one-year interest rate is 5% in the domestic country and 3% in the foreign
country. The investor expects the real exchange rate to remain constant over time.
1.What are the expected exchange rate and the expected return on the foreign
bond in domestic currency?
2. A year later the inflation rates have indeed been 3 percent in DC and 1 percent
in FC. The foreign exchange rate has been very volatile over the year, and the
foreign currency has depreciated with an end-of-year exchange rate of 1.80.
What are the real exchange rate at the end of the year and the expected post
return on the foreign bond?
3.How would you qualify the risk–return characteristics of this investment?
1/ The current nominal exchange rate FC/DC = 2
Because the investor expect the real exchange rate is constant. So the nominal
exchange rate movement FC:DC equal to the interest rate differential.
=>The expected exchange rate after 1 year = 2 * (1 + IDC –IFC) = 2.04
=>The expected return on foreign bond in domestic currency
= (1+3%) * (2.04/2) – 1 = 5.06%
1/ The current nominal exchange rate FC/DC = 2
Because the investor expect the real exchange rate is constant. So the nominal
exchange rate movement FC:DC equal to the interest rate differential.
=>The expected exchange rate after 1 year = 2 * (1 + IDC –IFC) = 2.04
=>The expected return on foreign bond in domestic currency
= 1*(1+3%) * (2.04/2) – 1 = 5.06%
2/ The real exchange rate after 1 year = nominal exchange rate x (PFC/PDC)
= 1.8 * (1.01/2.06) = 0.88
Post return of foreign bond in domestic currency = 1.03 * (1.8/2) - 1 = -7.3%
3/ This investment had an expected return similar to that of the domestic (5.06%
≈ 5%) risk-free rate, but it carried a lot of foreign currency risk.
3.2 Foreign Currency Risk Premiums
The risk premium on any investment is simply equal to its expected return in
excess of the domestic risk-free rate.
Someone investing in a foreign currency will exchange the domestic currency
(e.g., U.S. dollar) for the foreign currency (e.g., Swiss franc) and invest it at the
foreign risk-free interest rate.
So the expected domestic currency return on the foreign currency investment is
equal to the foreign risk-free rate plus the expected percentage movement in the
exchange rate.
Example 3:
The one-year domestic country risk-free rate of return is 5 percent, and the one-
year foreign country rate is 3 percent. The current exchange rate is 2 DC units for
1 FC unit. What is the current level of the forward exchange rate that is implied
by these data?
Solution
The investor could invest 2 DC units at the local risk-free rate of r DC = 5 percent
and would get 2 × (1 + rDC) or 2.1 DC units in a year. Alternately, the investor could combine
three operations:
 Exchange those 2 DC units at the spot exchange rate S for 2/S = 1 FC unit.
 Invest this FC unit at the foreign country rate of r FC = 3 percent and get 1.03 FC units in a
year.
 Sell forward today the proceeds of 1 + r FC = 1.03 units of FC received in a year at the
forward exchange rate of F.
In a year, the investor will therefore receive, with certainty, an amount of DC units equal to:
(2/S) * F * (1 + rFC) or F * 1.03
This combination should yield the same result as the first alternative because both are
riskless in domestic currency and involve the same investment. Otherwise, an
arbitrage will take place. Hence, F × 1.03 = 2.1 and F = 2.039
Foreign Currency Risk Premiums
The foreign currency risk premium is equal to the expected movement in the
exchange rate minus the interest rate differential (domestic risk free rate minus
foreign risk-free rate)
SRP =[E(S1) - F]/S0 - (rDC - rFC)
SRP: the foreign currency risk premium
E(S1): Expected exchange rate in future
F: Forward exchange rate
S0: spot exchange rate (current exchange rate)
rDC: Interest rate of domestics currency
rFC: interest rate of foreign currency