Global Investment Analysis: The International Capital Asset Pricing Model

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Introduction  

The Capital Asset Pricing Model (CAPM) was initially developed by Sharpe (1964) and Lintner (1965) which received a Nobel Prize in 1990. This model was built from the work of Harry Markowitz in 1952 where he wrote a “portfolio selection” article in which he included the analysis of the risks involved when choosing a portfolio. This model of the portfolio is also known as the “mean-variance model” (Elbannan, 2014, p.216). It mainly focuses on how investors choose portfolios based on variance and the expected returns. The framework developed by Markowitz has the assumption that investors are efficient, against risks and maximize their utility which is the reason why the portfolio selection highly depends on investors risk-return benefits function. This means that investors only choose a portfolio for a single investment which brings a return at that particular time (Sander, 2011, p.1).

International CAPM is the extension of the standard CAPM to international investments. The international CAPM mainly focus on international investments that incorporate foreign exchange risks. This means that it is the standard CAPM    with the addition of the premium risk of foreign exchange. Since International CAPM is an extension of the Standard CAPM, it is obvious that it faces the same problems and criticism just like the normal CAPM because it has the same theory assumptions. However, International CAPM takes into account other variables that have an effect on the expected return on assets at an international level.

Comparison of ICAPM to CAPM and its Assumptions

According to Pastor and Stambaugh (1999, p.68), the capital asset pricing model is an appealing theory because it is persuasive and powerful in giving predictions on how to come up with the risk involved in choosing a portfolio, plus the relationship between the return expected and the risk measured. Fama and French (2004, p.25) state that besides its attractive nature the model has poor verifiable records which invalidate its practical use. Due to its simplified assumptions in the financial market world, most financial managers use this model with other supporting techniques (Mullins, 1982, p.1). Despite the heated debate on the application of the capital asset theory model, most investment companies and corporate finance organization are benefiting from the use of this technique up to an international level (Roll, 1977, p.130-133). According to a survey done on the same matter, the capital market pricing model is the most used technique by financial professionals in estimating the return to be expected (Student Accountant, 2008, p.50).

It is due to these simplified and unrealistic assumptions of the theory that several other models have been expanded which include other added factors and have relaxed the assumption used in CAPM (Tobin, 1958, p. 65). When comparing CAPM to the international CAPM, ICAPM is more useful when used practically though it has its limitations. Even though ICAPM is aimed to improve on the application of the CAPM to the real market world through the addition of other factors, it has its assumptions in order for it to be a valid theoretical model. The International CAPM assumes a risk-free rate of borrowing and lending without any limits. Another key assumption for this model is that there is the incorporation of the international capital market. Failure to this assumption (meaning that the capital market disintegrates) will result to inefficient asset pricing.

ICAPM calculations

As stated earlier in the paper that ICAPM is an extension of the CAPM theory, investors are expected to be familiar with the domestic CAPM calculations in order to clearly understand the ICAPM calculations. The CAPM model which is built from the Markowitz (1959) model deals mainly with the risks and returns. The CAMP formula shows the linear relationship between the expected return on the asset and the systematic risk of return (Black, 1972, p.444; Black and Scholes 1974 p.20). This relationship is known as the security market line. In this formula, it is assumed that only systematic risk of the investor’s portfolio matters which is measured by beta (β). The expected return is equal to the risk-free rate plus the risk premium. In this model, the premium is calculated by multiplying beta and the expected return by subtracting the risk-free rate (Mullins, 1982, p.1). The security market line is illustrated graphically in figure 1 below.

E (Ri) = Rf +βi (E (Rm) – Rf )

E (Ri) is the expected return on asset i

β is market beta of asset i

Rf is the risk free rate of return

Rm is the market return

In the standard CAPM, investors are compensated for time value for money and the market risk they take. In addition, the international CAPM allows investors to be compensated for either direct or indirect foreign currency risk exposure. Foreign currency is an added variable is added to the CAPM equation to account for the sensitivity which is symbolized by beta (β), of the premium for foreign currency risk. Given the manner at which ICAPM reflects the today’s world characteristics, it is considered a superior tool of evaluation as compared to CAPM (Ejara et al, 2017, p.2; Blume 1970, p.152).

Expected return = Rfr + β(Rm – Rf) + (β*FCRPi)

Where, Rfr – domestic free rate, Rm – Rf  is the premium for global market risk measured in investors’ local currency, β*FCRPi is the foreign currency risk premium.

ICAPM Practical Uses

According to Ejara et al (2017, p.2), one of the interpreted approaches is involved in the practical application of the international CAPM. The first approach is the use of global CAPM which involves the use of global index while the second approach used the global market index and the currency index.  ICAPM plays a role in the global investment management mostly in the financial markets’ pricing and the estimation of the expected returns on funds borrowed or lend by the investors. The International CAPM is used in portfolio selection whereby the CAPM theory has an effect on (Banz 1981, p. 19). Application of the ICAPM will help the investors understand the currency movements in different companies globally which will be relevant in choosing assets of the same characteristics in different countries. This will enable investors to have knowledge of how the foreign currency will affect the expected return in the local currency.

Despite its existing limitations, it has continued to be used in the financial field more than anyone would have expected. Apart from the investment management, this model is as well applicable in the corporate finance (King, 2009, p.1). It is used in the corporate finance to define the cost of equity. It is not easy to measure the market expectations of the cost of equity since very few techniques are available .............


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