The Price of Inflation and Foreign Exchange Risk in International Equity Markets

Cesare Robotti
Working Paper 2001-26
November 2001

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In this paper the author formulates and tests an international intertemporal capital asset pricing model in the presence of deviations from purchasing power parity (II-CAPM [PPP]). He finds evidence in favor of at least mild segmentation of international equity markets in which only global market risk appears to be priced. When using the Hansen & Jagannathan (1991, 1997) variance bounds and distance measures as testing devices, the author finds that, while all international asset pricing models are formally rejected by the data, their pricing implications are substantially different. The superior performance of the II-CAPM (PPP) is mainly attributable to significant hedging against inflation risk.

JEL classification: G12, G15

Key words: international intertemporal capital asset pricing model, purchasing power parity, hedging demands

The author thanks Pierluigi Balduzzi, Arthur Lewbel, Shijun Liu, and seminar participants at Boston College, the University of California at Irvine, and the 2000 Meetings of the Financial Management Association for useful comments. The views expressed here are the author’s and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the author’s responsibility.

Please address questions regarding content to Cesare Robotti, Financial Economist, Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street, N.E., Atlanta, Georgia 30309-4470, 404-498-8543, 404-498-8810 (fax),