Barriers to International Investment, Exchange Rate Risk and World CAPM

Abstract

Due to a mis-interpretation of mathematics, a vintage world CAPM that assumes barriers to international investment exist in the form of prohibitive taxes, is found to come up with wrong results. Security market lines for long and short international holdings are shown not to be parallel to that for holding domestic assets, as opposed to the claim by the original study. This result would have far-reaching empirical implications. In addition, based on recent empirical studies, the model is extended to incorporate forward hedging of exchange rate risk. The hedging might be a better approach than simply assuming away the risk.