707Rupee approach would still not exonerate us from thinking about expected
exchange rate changes and exchange covariance risk:- In open markets, exchange risk affects any cost of capital ...In prin-
ciple, exchange risk enters asset pricing as soon as the investor base for which
we want to value the project is part of an international market. Thus, Aus-
tralia being part of a nearly worldwide capital market, an InternationalCAPM
(i-CAPM) should be used whether the project is situated at home or abroad.
Intuitively, in an international capital market, asset prices result from the in-
teraction of portfolio decisions by people from many different countries, each
having their own currency. Exchange risk makes people disagree about ex-
pected returns and risk; for example, theaudtreasury bill is risk-free to Aus-
tralians, but not to Canadians or Japanese. This heterogeneity of perspectives
does affect asset pricing, and introduces currency risk premia into theCAPM,
in principle one for each currency area that is part of the international capital
market.
Thus, in a way things are even more complicated than your worst fears might
have been: you need expected returns onallcurrencies in the international
capital market, and covariances for your project with each of these currencies.
In addition, exposures to exchange rates are even harder to estimate than
betas. Fortunately, ... - ... but currency risk premia are smallThe literature on the forward rate
as a predictor of futures spot rates shows that, while the currency risk premium
is surely not a constant, it is small and seems to fluctuate around zero. So one
could use a shortcut, omitting the forex items in the i-CAPMformula, so that
it looks rather like the familiar domesticCAPM. Two differences remain: the
market portfolio is the world-market index rather than a domestic one, and
the market beta is from a multiple regression with all exchange rates included.
The discussion can be summed up as follows.
(i) WhichCAPMYou use a (possible simplified) i-CAPMwhen thehomecountry
is part of an international capital market; the domestic model works only for
segmented home markets.
Note, incidentally, that this holds for any investment, whether at home or
abroad.(ii) Which currencyIf home and host areboth part of the same international
market, either currency will do for valuation purposes; otherwise only the
investors’hccan be used.
This chapter addresses these issues in the following order. First we discuss the
effect of capital-market integration or segmentation on the capital-budgeting proce-
dure (Section 19.1), notably which should come first, translation fromfctohcor
discounting. The bulk of the chapter then relates to the determination of the cost