International Capital Asset Pricing Model (CAPM)

What Is the International Capital Asset Pricing Model (CAPM)?

The international capital asset pricing model (ICAPM) is a financial model that extends the concept of the capital asset pricing model (CAPM) to international investments. The standard CAPM pricing model is used to help determine the return investors require for a given level of risk. When looking at investments in an international setting, the international version of the CAPM model is used to incorporate foreign exchange risks (typically with the addition of a foreign currency risk premium) when dealing with several currencies.

Understanding the International Capital Asset Pricing Model (CAPM)

CAPM is a method for calculating anticipated investment risks and returns. Economist and Nobel Memorial Prize winner William Sharpe developed the model in 1990. The model conveys that the return on investment should equal its cost of capital and that the only way to earn a higher return is by taking on more risk. Investors can use CAPM to evaluate the attractiveness of potential investments. There are several different versions of CAPM, of which international CAPM is just one.

International CAPM vs. Standard CAPM

To calculate the expected return of an asset given its risk in the standard CAPM, use the following equation:

r ‾ a = r f + β a ( r m − r f ) where: r f = risk-free rate β a = beta of the security r m = expected market return \begin{aligned} &\overline{r}_a = r_f + \beta_a ( r_m - r_f) \\ &\textbf{where:} \\ &r_f = \text{risk-free rate} \\ &\beta_a = \text{beta of the security} \\ &r_m = \text{expected market return} \\ \end{aligned} ra=rf+βa(rm−rf)where:rf=risk-free rateβa=beta of the securityrm=expected market return

CAPM rests on the central idea that investors need to be compensated in two ways: the time value of money and risk. In the formula above, the time value of money is represented by the risk-free (rf) rate; this compensates investors for tying up their money in any investment over time (in contrast with keeping it in a more accessible, liquid form).

The risk-free rate is generally the yield on government bonds like US Treasuries. The other half of the CAPM formula represents risk, calculating the amount of compensation an investor needs to assume more risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over time and to the market premium (rm - rf), which is the return of the market less the risk-free rate.

In the international CAPM, in addition to getting compensated for the time value of money and the premium for deciding to take on market risk, investors are also rewarded for direct and indirect exposure to foreign currency. The ICAPM allows investors to account for the sensitivity to changes in foreign currency when investors hold an asset.

The ICAPM grew out of some of the troubles investors were running into with CAPM, including assumptions of no transaction costs, no taxes, the ability to borrow and lend at the risk-free rate, and investors being risk-averse. Many of these do not apply to real-world scenarios.