HOW A SINGLE-FACTOR CAPM WORKS IN A MULTI-CURRENCY WORLD

Robert Thomson, Şule Şahin and Taryn Reddy

ASTIN Bulletin, 2016, vol. 46, issue 1, 103-139

Abstract: In this paper, a single-factor multi-currency (SFM) capital-asset pricing model (SFM-CAPM) is developed. The advantage in using a single-factor model is that it does not treat currency risks as carrying different weight from investment risks; regardless of its source, risk is measured as variance, and weighted accordingly. The aim of this paper is primarily to give actuaries a way ahead in the use of the single-factor CAPM in a multi-currency world for the purposes of the stochastic modelling of the assets and liabilities of long-term financial institutions, such as pension funds, particularly for the purposes of liability-driven investments and market-consistent valuation, and the application of the model has been designed with that intention. However, it is envisaged that the model will also be of interest to other practitioners. The paper's major original contribution to the literature is its proof that, for a single-factor CAPM to work in a multi-currency world, there is a necessary condition. The theory is applied to two major currencies and two minor currencies, namely the US dollar, the UK pound, the South African rand and the Turkish lira.

Date: 2016
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