Introduction

The Sharpe–Lintner Capital Asset Pricing Model (CAPM), which is based upon mutual fund theorems applied to a single domestic capital market, suggests that with homogeneous expectations and opportunity sets, all investors will hold identical portfolios of risky assets. Aggregation of investors' portfolios to get a market equilibrium implies that all individuals will choose their portfolios from two funds: the market portfolio of risky assets and the risk free asset, or a zero beta portfolio if there is no riskless asset.

The CAPM cannot be extended into an international CAPM by simply extending the opportunity set to include the world market portfolio, since the international capital markets differ from the domestic capital markets in certain important aspects, such as different currency areas, different socio–economic systems, taxes and barriers to capital flows. Several international capital market models have been developed to capture these complexities of the international capital markets. Most of these models treat exchange risk as the prime factor making international capital market equilibrium different from domestic equilibrium.

For instance, Grauer, Litzenberger and Stehle (1976) assume that exchange risk is due to different stochastic national inflation rates, while on the other hand Solnik (1974), Sercu (1980) and Adler and Dumas (1983) assume that exchange risk stems from differences in consumption baskets between investors of different origin.