Premium
Arbitrage Asset Pricing under Exchange Risk
Author(s) -
IKEDA SHINSUKE
Publication year - 1991
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/j.1540-6261.1991.tb03761.x
Subject(s) - diversification (marketing strategy) , foreign exchange risk , arbitrage , economics , stochastic discount factor , portfolio , currency , financial economics , risk arbitrage , arbitrage pricing theory , capital asset pricing model , statistical arbitrage , bond , index arbitrage , econometrics , monetary economics , business , finance , marketing
This paper extends the APT to an international setting. Specifying a linear factor return‐generating model in local currency terms, we show that the usual risk‐diversification rule in the APT does not yield a riskless portfolio unless currency fluctuations obey the same factor model as asset returns. We then consider an arbitrage portfolio whose exchange risk is hedged by foreign riskless bonds. Under the resulting no‐arbitrage conditions, the expected returns are not on the same hyperplane, unlike the closed‐economy APT, unless they are adjusted by the cost of exchange risk hedging.