Jump-Diffusion International Asset Pricing with Nontraded Consumption Goods

We present a jump-diffusion international asset pricing model with stochastic exchange rates and inflation rates when investors consume both traded and nontraded goods. We argue that in general, the Adler-Duma inflation rate differential may not capture PPP deviation risks, unless all volatilities, drift rates and jumps rates for price levels, exchange rates and asset returns are constant, and there are no PPP deviation jumps. Our model suggests that country-specific demand for risky assets arises from two sources: PPP-deviation risks and nontraded-good-specific inflationrate-differential risks. Furthermore, equilibrium asset returns can be expressed in a multi-beta linear asset pricing model with a number of benchmark portfolios including hedge portfolios for PPP deviation risks and nontraded-good-specific inflation rate risks. We show that all of these hedge portfolios may be constructed by using portfolios of the reference-country nominal riskfree bond and individual countries’ TIPS bonds. We note that in the presence of inflation risks, hedging against exchange rate risks in isolation can actually make the investor’s real wealth riskier than no hedging at all. We also show that global investors optimally increase their consumption in both traded nontraded goods as the prices of traded goods of their own countries increase. ∗I thank Mark Loewenstein for many insightful comments and suggestions.