Definition of the international financial asset pricing model (CAPM)
What is the International Capital Asset Pricing Model (CAPM)?
The International Financial Asset Pricing Model (ICAPM) is a financial model that extends the concept of the Financial Asset Pricing Model (CAPM) to international investments. The standard CAPM pricing model is used to help determine the return investors need for a given level of risk. When considering investments in an international context, the international version of the CAPM model is used to incorporate currency risks (usually with the addition of a currency risk premium) when dealing with multiple currencies .
Key points to remember
- The International Financial Asset Pricing Model (CAPM) is a financial model that applies the traditional CAPM principle to international investments.
- The international CAPM helps determine the return sought by investors for a given level of risk, including foreign risks associated with different currencies.
- CAPM was formed on the premise that investors should be compensated for the length of time they hold investments and the risk they assume in holding investments.
- The international CAPM extends beyond the standard CAPM by compensating investors for their exposure to foreign currencies.
Understanding the International Capital Asset Pricing Model (CAPM)
CAPM is a method of calculating the risks and anticipated returns of investments. Economist and Nobel laureate William Sharpe developed the model in 1990.Inasmuch asThe model indicates that the return on investment should be equal to its cost of capital and that the only way to get a higher return is to take on more risk. Investors can use CAPM to assess the attractiveness of potential investments. There are several different versions of the CAPM, of which the international CAPM is only 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:
ra=rF+βa(rm−rF)or:rF=risk free rateβa=security betarm=expected market returnInasmuch as
CAPM is based on the central idea that investors should 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; it compensates investors for locking up their money in any investment over time (instead of keeping it in a more accessible liquid form).
The risk-free rate is usually 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 take on more risk. This is calculated by taking a measure of risk (beta) that compares the asset’s returns to the market over time and the market premium (rm -rF), which is the market return minus the risk-free rate.
In the international CAPM, in addition to being compensated for the time value of money and the premium for deciding to take market risk, investors are also rewarded for their direct and indirect exposure to foreign currencies. The ICAPM allows investors to take into account sensitivity to foreign currency variations when holding an asset.
ICAPM was born out of some of the issues investors had with CAPM, including the assumptions of no transaction fees, no taxes, the ability to borrow and lend at the risk-free rate, and the investor risk aversion. Many of them don’t apply to real-world scenarios.