724 CHAPTER 19. SETTING THE COST OF INTERNATIONAL CAPITAL
nonresidents.^9 All of this means that, in internationally integrated markets, the true
stock market portfolio for any country is unobservable—and, with an unobservable
national stock market portfolio, the standardCAPMis of no practical use to managers
who, for instance, want to assess the cost of capital or evaluate the performance of
their investment advisers.
19.3.2 Why Exchange Risk Pops up in the International Asset Pric-
ing Model
How can we get around this problem of an unobservable market portfolio? One
could argue that, even if we do not know what shares are held by whom, we can
still observe theworldmarket portfolio. (For conciseness, we will refer to the the
countries that allow free capital movements as “the world”, with an apology to
residents from China and other unworldly countries.) Even if we do not know what
stock is held by whom and where, we do know what stocks are listed somewhere
in the world and how many shares are outstanding at what price. Thus, the world
market portfolio contains all securities issued by all firms in the world, and it can be
obtained by constructing a value-weighted sum of all member countries’ local stock
indices.^10 As investors do hold assets from all over the world, and as the world
market portfolio is observable, a very simple approach to international asset pricing
would be to interpret the world as one huge country, and use the world market
portfolio as the benchmark in a unified-worldCAPM.
There is, however, one important reason why international asset pricing in inte-
grated capital markets cannot simply be reduced to an as-if-one-countryCAPM. Even
if international capital transactions are unrestricted and have low costs, transactions
in the commodity markets are still difficult and costly. These imperfections in the
goods market, as we saw in Chapter 3, lead to substantial deviations from relative
purchasing power parity and to real exchange risk. The (real) return on, say,ibm
common stock as realized by a German investor differs from the (real) return real-
ized by a Japanese investor on the same asset. As a result, the distributions of the
real return from a given asset depend on the nationality of the investor. This then
violates the homogeneous expectations assumption of theCAPM, which states that
all investors agree on the probability distribution of the (real) asset returns. In a
sense, the investors’ perceptions about real return distributions are segmented along
country lines because goods prices differ across countries, implying that investors
(^9) The same problem arises when one includes into the market portfolio all stocks—domestic or
foreign—that are listed on the national stock exchange(s). Investors can (and do) buy foreign assets
in foreign stock exchanges, or can (and do) buy foreign assets through mutual funds that are traded
over-the-counter; and all of these investments are missing from the menu of locally listed stocks.
(^10) A well-known proxy for such an international stock market index is the Morgan Stanley Capital
International (MSCI) index, or Datastream’s World Market Index. Both are biased towards large
firms; but small firms are held locally, mostly, so that’s not a huge problem.