Local, Global and International CAPM

Modern financial markets are internationally integrated to the point that an international CAPM is conceptually superior to the traditional “local” CAPM, which in principle is appropriate only for a segmented financial market. Moreover, an international CAPM that includes currency risk is conceptually superior to one that ignores it. However, to a practitioner who wants to use a risk-return model to estimate a discount rate for a valuation analysis, the local CAPM is easier to apply than an international CAPM, and an international CAPM that ignores currency risk (termed a global CAPM) is easier to apply than one that includes it.

Because the effort needed to apply each model varies, it is relevant for practitioners to know how much difference the model choice makes in discount rate estimates. This empirical study shows that the model choice tends to make a small difference for some countries and a large difference for others. Therefore, practitioners in some countries can apply an easier model and estimate discount rates that tend to reasonably approximate those of an international CAPM that includes currency risk. Practitioners in countries where model choice makes a substantial difference should beware that applying an easier model may result in substantial errors in discount rate estimates for valuation.

To estimate a discount rate for a valuation analysis, some textbooks (Sercu, 2009; Solnik and McLeavey, 2009) and articles (Stulz, 1995a,b; Stulz, 1999) say that an international risk-return model is more appropriate than the traditional (“local”) CAPM, even for most emerging markets (Stulz, 1999). The argument is that world financial markets are now sufficiently integrated, and investors are sufficiently internationally-diversified, to justify an international model, whereas the local CAPM applies only in the passé setting of segmented financial markets and no international diversification.

However, financial information services continue to offer beta estimates (e.g., Value Line and brokerage research reports) and market risk premium estimates (e.g., Duff and Phelps, Damodaran) for only the local CAPM and not the input estimates for international risk-return models. Therefore, it is important to know how much difference an international model makes in discount rate estimates, to understand whether the model is worth the additional effort necessary to estimate the inputs.

This study investigates empirical differences between discount rate estimates of the following three risk-return models: (1) the traditional local CAPM; (2) the global CAPM (GCAPM), where the only risk factor is the global market index; and (3) an international CAPM (ICAPM) with two risk factors, the global market index and a wealth-weighted foreign currency

The full article is published in the current edition of the Journal of Investment Management.

WP Dipl.-Kfm. Santiago Ruiz de Vargas (CVA), Munich, is partner of Noerr LLP, board member of NOERR AG WPG StBG and co-head of the Advisory Services division of the Noerr Group.