Appendix GGlobal, International, and Local CAPM
The standard capital asset pricing model (CAPM), introduced in Chapter 15, for estimating the cost of capital, does not explicitly account for foreign assets, foreign investors, or currencies. This raises the question whether such a model can provide the right cost of capital for investments in foreign currencies. If foreign-currency rates are changing, the same investment will generate different returns to investors from different countries. Take the case of a German government bond denominated in euros. From the perspective of a German or Dutch investor, this bond generates a risk-free return (assuming there is no inflation), because the euro is also the investor’s domestic currency. But the bond’s return is not risk free for investors in the United States, because the return measured in U.S. dollars will vary with the dollar-to-euro exchange rate.
As a general rule, investors from countries with different currencies are likely to disagree about an asset’s expected return and risk. In theory, this means that the standard CAPM no longer holds, and a more complex, international CAPM is required. In practice, however, we find that the CAPM-based approach as laid out in Chapter 15 is still valid for estimating the cost of capital for cross-border investments. This appendix provides further background for our recommendations and practical guidelines for estimating the cost of capital in foreign currency.
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