What is the International Fixed Asset Pricing Model (CAPM)?
The International Asset Valuation Model (ICAPM) is a financial model that extends the concept of the Capital Asset Valuation Model (CAPM) to international investments. The CAPM’s standard pricing model is used to help determine the return investors need 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 currency risks (usually with the addition of a currency risk premium) when dealing with multiple currencies.
Key points to remember
- The International Asset Valuation Model (CAPM) is a financial model that applies the traditional principle of CAPM 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 time they hold investments and the risk they take in holding investments.
- The international CAPM extends beyond the standard CAPM by compensating investors for their exposure to foreign currencies.
Understand the International Fixed Asset Pricing Model (CAPM)
The CAPM is a method of calculating the risks and expected returns of investment. Economist and Memorial Nobel Laureate William Sharpe developed the model in 1990.The model states that the return on investment should equal its cost of capital and that the only way to get a higher return is to take more risk. Investors can use CAPM to assess the attractiveness of potential investments. There are several different versions of CAPM, of which the international CAPM is just one.
International CAPM vs Standard CAPM
To calculate the expected return on an asset given its risk in the standard CAPM, use the following equation:
ra=rF+??a(rm–rF)or:rF=risk free rate??a=security betarm=expected market return
CAPM is based on the central idea that investors should be compensated in two ways: the time value of money and risk. In the above formula, the time value of money is represented by the risk-free value (rF) rate; this compensates investors for locking their money into any investment over time (as opposed to keeping it in a more accessible and liquid form).
The risk-free rate is usually the yield on government bonds such as 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 returns of the asset to the market over time and to 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 a market risk, investors are also rewarded for their direct and indirect exposure to foreign currencies. ICAPM allows investors to take into account the sensitivity to changes in foreign currencies when investors hold an asset.
ICAPM arose out of some of the issues investors faced with the CAPM, including the assumptions of no transaction costs, taxes, the ability to borrow and lend at the risk-free rate, and investors being averse. at risk. Many of them don’t apply to real world scenarios.