What it means
The standard CAPM says that the expected return on an asset equals the risk-free rate plus a premium for how strongly the asset moves with the overall market. It was designed with a single domestic market in mind.
When investors can buy shares in many countries, the relevant market is the whole world, not one country. International CAPM therefore uses a global market index as the benchmark and measures each asset's beta, or sensitivity, against it.
The second addition is currency risk. Exchange rates move, and an investor who earns returns in one currency but lives in another is exposed to the difference.
Some versions of the model add one or more currency risk premiums, each multiplied by the asset's exposure to that currency. Under the full version, the required return depends on three things: the risk-free rate in the investor's home currency, the asset's sensitivity to the world market, and its sensitivity to currency movements.
The result is a required return that can be higher or lower than a domestic CAPM would suggest. A multinational company can use the model to set the hurdle rate for a project in a foreign country.
Rather than using only the risk of the local market, it considers how the project's returns relate to global markets and what currency exposure arises. The model has limits.
Betas and currency premiums must be estimated from past data and can be unstable, and markets may be only partly integrated, so the assumptions should be tested and the results treated as a guide and not a precise answer.
In practice
Real-world examples.
Example
A US manufacturer evaluates a factory in Brazil. The finance team uses international CAPM to set the required return, including a currency premium, and then compares it with the project's expected returns.
Example
A global fund manager compares shares in Japan, Germany and Canada. She measures each against a world index and adjusts for currency exposure so that the required returns are comparable. The comparison shows which shares offer enough extra return for their global risk.
Example
A utilities group planning an overseas acquisition asks its advisers for a discount rate. The advisers build it from the world market premium and the target's beta, and then add a currency adjustment for the local exchange rate. They show the board a range of rates so that the effect of the assumptions is visible.
Formula
Calculation
Expected return = Risk-free rate + Beta to world market x World market risk premium + Sum of (currency exposure x currency risk premium)
An investor in dollar terms assumes a risk-free rate of 3% and a world market risk premium of 5%. A foreign company has a world beta of 1.2 and an exposure of 0.3 to a currency with a risk premium of 2%. The market component is 1.2 x 5% = 6%, and the currency component is 0.3 x 2% = 0.6%. The expected return is 3% + 6% + 0.6% = 9.6%, compared with 3% + 6% = 9.0% if currency risk were ignored.Case study
Seen in the real world.
Atlas Machinery is an illustrative, fictional company that was weighing a $50,000,000 plant in a foreign country. Its previous approach was to apply its home-market cost of equity of 9% to every project, whatever the country.
The finance team used international CAPM instead. The project's beta to the world market was 1.4, the world premium was 5%, and the currency exposure added a further 0.8%, so the required return was 3% + 7% + 0.8% = 10.8%.
At 10.8%, the plant's projected return of 10% no longer cleared the hurdle, and the board postponed the investment. The fictional example's illustrative lesson is that a single home-market discount rate can hide the real risk of overseas projects.
Watch out
Common mistakes.
- Applying the home-country cost of capital to every foreign investment, which ignores differences in global market risk and currency exposure.
- Counting the same risk twice by adding a country risk premium on top of a world beta that already reflects it.
- Treating estimated betas and premiums as exact, when they change over time and depend on the data period chosen, so a sensitivity check using a range of values is wise.
Questions
People also ask.
How is international CAPM different from the standard CAPM?
It benchmarks risk against a world market portfolio instead of a domestic one, and it can add premiums for currency risk.
Does international CAPM assume markets are integrated?
Yes, it assumes investors can hold assets worldwide, and if markets are partly segmented, the results need adjusting.
Which currency should the risk-free rate be in?
It should be in the currency of the cash flows being discounted, so that the rate and the forecast are consistent. Mixing a dollar rate with local-currency cash flows is a common source of error.
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