Appendix G  829
from PPP between currencies are typically reduced to half their value within 
three to five years.2 In other words, exchange rates do adjust for differences in 
inflation between countries, although not immediately and perfectly.
For investors and companies able to invest outside their home markets 
without restrictions, we recommend using the global CAPM to estimate the 
cost of capital for foreign as well as domestic investments. Effectively, this 
means applying the approach described in Chapter 15. Although the alter-
native, international CAPM (discussed next), may be theoretically superior, 
it is far more complex and does not lead to materially different results in 
practice.
International CAPM
If PPP does not hold, real returns from foreign assets are no longer free from 
currency risk, because changes in exchange rates are not offset by differences 
in inflation. The greater the correlation between the return on a foreign asset 
and the relevant currency rate, the higher the risk for an investor. Take, for 
example, a Dutch company whose stock returns, measured in euros, tend to 
be higher when the euro appreciates against the U.S. dollar and vice versa (for 
instance, because the company imports components from the United States 
and sells end products in Europe). The stock’s returns will be riskier for an 
American investor than for a European investor, because the exchange rate 
tends to amplify the returns when translated into U.S. dollars. The absence of 
PPP means that disparities between dollar and euro inflation will not offset 
this difference in returns when measured in real terms.
To hold foreign assets, rational investors will require some compensation 
in the form of a higher expected return for an asset, depending on its exposure 
to currency risk. As a result, what matters for an asset’s expected return is no 
longer only the asset’s beta versus the global market portfolio (as in case of 
the global CAPM). The international CAPM captures the additional return re-
quirements by also including asset betas versus currency exchange rates. For 
example, in a world consisting of three countries, each with its own currency, 
the international CAPM would define the expected return on asset j in a given 
home currency as follows:3
E r
r
E r
r
j
f
j G
G
f
j A
A
j B
B
( )
(
)
,
,
,
=
+
−

+
+
β
β
β
CRP
CRP 
(G.1)
2 For an overview, see A. M. Taylor and M. P. Taylor, “The Purchasing Power Parity Debate,” Journal of 
Economic Perspectives 18, no. 4 (Fall 2004): 135–158.
3 This is a simplified version of the Solnik-Sercu international CAPM; see, for example, P. Sercu, Inter-
national Finance (Princeton, NJ: Princeton University Press, 2009), chap. 19; and S. Armitage, The Cost of 
Capital (Cambridge: Cambridge University Press, 2005), chap. 11.

830  Appendix G
where 
r
j
r
j
j
f
j G
=
=
=
return for asset
risk-free rate
beta of asset
versus g
β ,
lobal market portfolio
beta of asset
versus currency
G
j
j A
j B
β
β
,
,
,
=
rate
CRP
CRP
risk premium for currency
X
X
A B
A
B
A
B
,
,
,
=
The currency risk premiums are defined as follows:
CRPn
n
n
n
E X
F
X
=
−
(
)
1
1
0

(G.2)
where X
n
nt = exchange rate of homecurrency expressed in units of
currency
at time where
forward rate for
1 of home currency expre
t
n
A B
F
t
n
=
=
=
,
1
ssed in
units of currency n
Although theoretically correct, the international CAPM is probably too 
cumbersome for practical use. In particular, it is not clear how many of 
the world’s currencies to include in estimating the cost of capital. Even 
taking only a handful of leading global currencies would require that you 
estimate as many currency risk premiums. Further, in addition to an as-
set’s market beta, you would need to estimate its beta versus each of these 
currencies.
Another reason not to use the international CAPM is that empirical re-
search has shown that the currency risk premiums are typically too small to 
matter when estimating a cost of capital.4 According to recent research that 
compared cost of capital estimates from a global and an international CAPM 
for large U.S. companies, differences are probably less than half a percentage 
point.5 As we can see from Equations G.1 and G.2, the international CAPM 
simplifies to the global CAPM when currency risk premiums are negligible. 
In other words, PPP apparently holds sufficiently well for the global CAPM 
to lead to the same cost of capital as the international CAPM. Expressed 
either way, this evidence reinforces our recommendation to use the global 
CAPM.
4 Sercu, International Finance, chap. 19.
5 See W. Dolde, C. Giaccotto, D. Mishra, and T. O’Brien, “Should Managers Estimate Cost of Equity Us-
ing a Two-Factor International CAPM?” Managerial Finance 38, no. 8 (2012): 708–728; and D. Mishra and 
T. O’Brien, “A Comparison of Cost of Equity Estimates of Local and Global CAPMs,” Financial Review 
36, no. 4 (2001): 27–48.