Diversification and Asset Valuation in an International Capital Market

This paper analyzes the structure of an international capital market characterized by differing consumption patterns across boundaries and by uncertainty on the exchange rates, the national inflation rates and the commodity and security prices. The crucial assumption is that, independently of their nationality, investors share the same beliefs about the stochastic processes that generate the random variables. Thus the paper is compatible with a divergence, across boundaries, of the relative spot commodity prices but not with differing beliefs about how these relative prices will adjust through time. At the micro-level, the paper indicates the separation properties of portfolio allocation in an international setting. At the macro or valuation level, it expresses the risk-return tradeoff in nominal term and it shows that, in real terms, the standard CAPM still holds. The paper ends up by analyzing the factors that affect the discount rate on a forward exchange contract.