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Arbitrage Asset Pricing under Exchange Risk



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    • School of Business Administration, Kobe University, Rokkodai, Nada, Kobe 657, Japan. This is a thorough revision of ISER Discussion Paper No. 193, 1989, which was written while I was at the Institute of Social and Economic Research, Osaka University. I am grateful to Professors Akihiro Amano, Fumio Dei, Jonathan Eaton, Yoshiyasu Ono, René M. Stulz (Managing Editor of this Journal), an anonymous referee, and especially Charles Yuji Horioka for helpful comments. I also thank Kenjiro Hirayama, Toshio Serita, Yasuhiko Tanigawa, Yoshiro Tsutsui, and other members of the Monetary Economics Workshop for fruitful discussions. All errors are the sole responsibility of the author.


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.

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