We had a recent discussion on this subject that boiled down to (quoted form another author im to lazy to look up) " Extended CAPM has 2 big assumptions: Same basket of goods aross countries (homogenous) Purch Power Parity holds @ any time International DOES NOT REQUIRE THESE ASSUMPTIONS Under ICAPM, all investors hold combo of THEIR countries RF asset and the WORLD market portfolio. It uses domestic/local sensitivities (lambda) to sensitize foreign currency risk premiums. " Can someone illustrate the different formulas side by side? I have been researching this and for some lame reason cant put it together and the CFAI indexes are kind of weak on this subject. 11 More Days!!
ICAPM and Extended CAPM both have the same basic formula: E ® = Risk Free rate (domestic) + Beta (world market risk premium) + Gamma (Spot rate risk premium) The beta is also a world beta, by the way. We use extended CAPM when either: - Real exchange rates are constant - PPP holds - Real interest rates are constant In this case the SRP=0, so we can omit it from the formula. If those criteria don’t hold, then we use ICAPM. We can work out the SRP by either: a) SRP = E(S) - F / S0 Remember we can work out E(S) from PPP and F from IRP (see econ) b) Via a linear approximation… SRP = (expected % change in exchange rate) - (Interest rate of variable currency - Int rate of fixed currency) Hope that helps!
extended CAPM is simply the domestic CAPM, however investors hold international market portfolio. Because of the 2 assumptions mentioned above, PPP and same consumption basket, and IF investors are only interested in real returns, exchange rate movements don’t matter - they’re inflation adjusted based on PPP and we said we’re only interested in real returns. however these two assumptions don’t hold well, thus one must mitigate against exchange rate movements, hence the ICAPM. if you want the forumla’s, get the domestic CAPM formula (i think) and ICAPM forumla, you can see the differences.
Question on : Gamma (Spot rate risk premium) Is SRP = FCRP (foreign currency risk premium)? Isn’t the formula: F-S/S - (domestic i rate - foreign i rate) = FCRP