Exchange Risk: a Capital Asset Pricing Model Framework

It should not be surprising that in times of international monetary instability, there is renewed interest in the definition and analysis of exchange risk. One analytical framework that seems particularly suited to the analysis of the problem of exchange risk is the well-known Capital Asset Pricing Model (CAPM). CAPM is a two parameter, single period model focusing on the expected return of an asset and the asset’s riskiness. Risk is measured by the variance of the asset’s rate of return over time measured by ex-post data. Generalizing this framework to handle assets denominated in different currencies (with an added element of risk due to the presence of foreign exchange and so the possibility of devaluation) appeared to be a straightforward extension of the CAPM in its domestic context. This view was advanced by Grubel who pointed out that the models of portfolio balance developed by Markowitz and Tobin explain the real world phenomenon of diversified asset holdings elegantly and properly. However, their analysis has not yet been applied explicitly to the explanation of long-term asset holdings that include claims denominated in foreign currency.[5] The purpose of this paper is to present the development of the treatment of exchange risk in the CAPM framework in such a way as to be a useful introduction to the theory, as well as to provide some insight into the questions the theory must address and the problems it poses. The assumptions and basic conclusions of CAPM are available from various books and articles written by the theory’s codevelopers. An abridged treatment is provided here for the reader’s convenience. The assumptions underlying portfolio theory are: