An International Asset Pricing Model with Tradable and Nontradable Goods When Both Inflation and Exchange Rates Are Stochastic

We extend and unify existing international asset pricing models for perfect capital markets by allowing both exchange rates and inflation rates to be stochastic and investors to consume both tradable and nontradable goods. We argue that in the presence of stochastic inflation and exchange rates, the Adler-Dumas’ [1983] inflation-rate differential risks can be related neither to PPP deviation risks nor to international asset pricing. We show that each investor holds five funds consisting of three global funds and two country specific funds. As a result, countryspecific demand for risky assets emerges from two sources: PPP-deviation-rate differential risks and nontradable-good-specific inflation-rate-differential risks. In particular, in a single good global economy, the reference country-specific demand depends on the global average PPP deviation risks, not on the Adler-Dumas’ [1983] inflation-rate differential risks. Further we show that equilibrium asset returns can be expressed in a multi-beta linear asset pricing model where betas are determined by covariances with reference country-inflation risks, PPP deviation risks and nontradable-good-specific inflation rates.