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LOS d: Justify the extension of the domestic CAPM to an international context (the extended CAPM), and discuss the assumptions needed to make the extension.

Which of the following assumptions is NOT needed to justify the extended capital asset pricing model?

A)	The rate of inflation must be identical throughout the world.

B)	World markets are integrated (i.e. no segmentation).

C)	Investors throughout the world have identical consumption baskets.

The rate of inflation need not be identical throughout the world. In a world where identical consumption baskets exist and where purchasing power parity holds exactly at any point in time, exchange rate changes would mirror inflation differences between any two countries.

Which of the following assumptions is needed to justify the extended capital asset pricing model (CAPM)? Investors throughout the world have:

A)	identical consumption baskets.

B)	similar consumption baskets.

C)	nearly-identical consumption baskets.

Investors throughout the world need to have identical consumption baskets to justify the extended CAPM.

Which of the following assumptions is needed to justify the extended capital asset pricing model (CAPM)? Purchasing power parity (PPP) holds:

A)	approximately at any point in time.

B)	approximately over extended periods of time.

C)	exactly at any point in time.

The extended CAPM assumes that PPP holds exactly at any point in time.

Some market participants have argued that, under certain circumstances, the domestic capital asset pricing model (CAPM) can be extended to the international environment. When using the domestic CAPM in the international environment, the model is referred to as the:

When using the domestic CAPM in an international setting, the model is referred to as the extended CAPM.

Which of the following assumptions is required in order to extend the domestic capital asset pricing model (CAPM) to an international setting?

A)	All countries have identifiable consumption baskets.

B)	Purchasing power parity holds at all times.

C)	Exchange rate risk is perfectly hedged.

Extending the CAPM to an international setting requires two additional assumptions: (1) purchasing power parity holds at all times, and (2) all investors have identical (not identifiable) consumption baskets.

Suppose the assumptions underlying the extended capital asset pricing model (CAPM) hold. Which of the following would be most accurate in an extended CAPM world?

A)	Exchange rate changes could be perfectly hedged in the forward market.

B)	All investors would hold the same "uniform risk-free asset."

C)	Exchange rate changes would mirror inflation differences.

If the extended CAPM assumptions hold, the exchange rate changes would be purely a function of inflation differences.