International Finance: Putting Theory Into Practice

19.3. THE INTERNATIONALCAPM 727

19.3.3 Do Assets have a Clear Nationality?

For a better understanding of the exchange rate covariance risk of individual assets,
it is convenient to scale the covariance risk by the exchange rate variance. Consider
the following regression equation:

r ̃j=αj,s+γj ̃sCAD/USD+j,s. (19.29)

The regression coefficientγjequals cov( ̃rj,s ̃)/var( ̃s)—the asset’s exchange rate co-
variance risk, scaled by the variance of the exchange rate change. In this sense,γj
measures the relative exchange risk of assetj, or the relative exposure of assetjto
the exchange rate, in the same way beta measures the relative exposure of a stock
to market movements. We now consider the exchange rate exposure of six types of
assets: a domestic and foreign risk-free asset, a foreign exporter and importer, and
a domestic exporter and importer.

• Let us consider the domestic T-bill, asset 0. Since this return is not stochastic,
  it has zero exposure to the exchange rate.


• The next asset we consider is theusdT-bill, asset 1. The return, measured
  incad, on theusdT-bill increases by one percent if thecad/usdspot rate
  increases by one percent. This follows from

̃rusdTbill≈r∗+ ̃sCAD/USD. (19.30)

Clearly, if ̃rj=r∗+ ̃scad/usd, then, in the relative exposure regression Equa-

tion [19.29], we must haveγusdTbill= 1 (andαusdTbill=r∗). In this sense,

the exposure regression (Equation [19.29]) for the foreign T-bill will reveal a

very clear nationality for that asset. Incadterms, theusdT-bill is exposed

one-to-one to its “own” exchange rate,cad/usd.

Thus far, things are clear: the home T-bill has zero exposure and the foreign

one has a unit exposure. For stocks, however, nationality is much more blurred:

• Let asset 2 be a Canadian importer. Typically an appreciation of the usd
  relative to thecadis bad news for such Canadian firm, because its costs have
  gone up. Thus, for a Canadian importer, the relative exposure (γj) is negative.


• Let us now consider as asset 3 a Canadian producer competing againstus
  producers in theusand/or Canadian market. Typically an appreciation of
  theusdrelative to thecadis good news for such a Canadian firm, because its
  competitive position has improved. Thus, for a Canadian exporter or import-
  substituter, the relative exposure (γj) is positive.


• The next case we look at is auscorporation that competes against Canadian
  firms in theusand/or Canadian market. Holding constant theusdprice of
  the stock, a one percent appreciation of theusdadds one percent to the return
  on that stock incad. However, an appreciation of theusdsimultaneously is