Pricing Capital Assets in an International Setting: an Introduction

This paper shows how differences across countries of 1) inflation rates, 2) consumption baskets of investors, and 3) investment opportunity sets of investors matter when one applies capital asset pricing models in an international setting. In particular, the fact that countries differ is shown to affect the portfolio held by investors, the equilibrium expected returns of risky assets, and the financial policies of firms. * Capital asset pricing models play a central role in finance theory.1 For instance, they provide the basis for finding appropriate discount rates in capital budgeting problems. When one tries to extend such models to an international setting, however, one is confronted with several important problems. First, whereas most basic capital asset pricing models use the simplifying assumption that returns are denominated in a numeraire good whose price is fixed, such an assumption makes little sense when one has to choose a portfolio in a world in which inflation rates are stochastic and differ across countries. Second, in deriving capital asset pricing models, one generally assumes that investors have identical tastes with respect to commodities and consume identical baskets of goods. While this may be a reasonable approximation in a single country, it is not very useful in an international setting since investors based in different countries consume locally produced, nontraded goods, and, probably, differing proportions of internationally traded goods. Because the relative prices of traded and nontraded goods fluctuate significantly, real returns on any particular asset depend upon which investor's perspective is taken. Third, capital asset pricing models generally assume that all investors have the same investment opportunity set-that is, that any distribution of returns feasible for one investor is feasible for all investors. In an international setting, taxes, transactions costs, and holding costs differ across securities and across investors. Furthermore, some investors are restricted from buying some securities. This paper shows how differences across countries of 1) inflation rates, 2) consumption baskets of investors, and 3) investment opportunity sets of investors matter when one applies capital asset pricing models in an international setting. In particular, the paper shows how the fact that countries differ affects the portfolio held by investors, the equilibrium expected returns, and the financial policies of firms. Many results presented in this paper are already known. The main contribution of this paper is a systematic and unified examination of the implications of what the author believes to be the 3 most important differences among countries for application of capital asset pricing models in an international setting.2 The purpose of this paper is to discuss problems that one encounters when applying capital asset pricing models, rather than to derive international asset pricing models under the most general assumptions. Throughout the paper, references are provided to more general derivations of the results presented, when such references are available, and otherwise directions are provided for SECTION 1: