Understanding the International Capital Asset Pricing Model (ICAPM)

The International Capital Asset Pricing Model (ICAPM) is an extension of the traditional Capital Asset Pricing Model (CAPM) that accounts for the additional risks associated with international investments. It incorporates factors such as exchange rate risk, political risk, and differences in market regulations to determine the expected returns on investments in foreign markets.

To illustrate the ICAPM, let’s consider an example involving two countries: the United States and Japan. Suppose an investor is considering investing in stocks from both countries and wants to evaluate the expected returns on these investments using the ICAPM framework.

1. Exchange Rate Risk:
   Exchange rate risk refers to the risk of fluctuations in exchange rates impacting the returns on investments denominated in foreign currencies. Let’s assume that the current exchange rate between the US dollar (USD) and the Japanese yen (JPY) is 1 USD = 110 JPY.
2. Political Risk:
   Political risk reflects the uncertainty associated with changes in government policies, regulations, or instability in a country. For instance, suppose there is political unrest in Japan due to upcoming elections, which could impact the stability of the Japanese stock market.
3. Market Regulations:
   Differences in market regulations between countries can affect the investment environment and investor sentiment. For example, the regulatory framework for financial markets in the US may differ from that in Japan, leading to varying levels of investor confidence and risk perceptions.

Now, let’s incorporate these factors into the ICAPM equation to calculate the expected returns on investments in US and Japanese stocks:

[ E(R_i) = R_f + β_i[E(R_m) – R_f ] + λ^x_i​σ^x + λ^p_i​σ^p + λ^r_i​σ^r ]

where:

• E(R_i) = Expected return on investment ( i )
• R_f = Risk-free rate
• β_i = Beta coefficient (systematic risk)
• E(R_m) = Expected market return
• λ^x, λ^p, λ^r= Risk premiums for exchange rate risk, political risk, and regulatory risk, respectively
• σ^x, σ^p, σ^r = Standard deviations of exchange rate risk, political risk, and regulatory risk, respectively

Assume:

• Risk-free rate = 2%
• Expected market return = 8%
• Beta coefficient :
  • US stocks = 1.2
  • Japanese stocks = 0.8
• Risk premiums
  • Exchange rate risk = 3%
  • Political risk = 2%
  • Regulatory risk = 1%
• Standard deviations :
  • US stocks = 15%
  • Japanese stocks = 12%

Now, let’s calculate the expected returns for US and Japanese stocks using the ICAPM equation:

1. Expected return for US stocks:
   [ E(R_US) = 2% + 1.2 * (8% – 2%) + 3% *15% + 2%* σ_japan + 1% *σ_japan ]
   [E(R_US) = 2% + 1.2* 6% + 0.45% + 24% + 12% = 2% + 7.2% + 0.45% + 24% + 12% = 45.65\% ]
2. Expected return for Japanese stocks:
   [ E(R_Japan) = 2% + 0.8 *(8% – 2%) + 3% * 12% + 2% * σ_US+ 1% * σ_US ]
   [ E(R_Japan) = 2% + 0.8 * 6% + 0.36% + 16% + 8% = 2% + 4.8% + 0.36% + 16% + 8% = 31.16% ]

Therefore, according to the ICAPM, the expected return for investing in US stocks is approximately 45.65%, while the expected return for investing in Japanese stocks is approximately 31.16%.

This example demonstrates how the ICAPM integrates various risk factors associated with international investments to estimate the expected returns accurately.