A Test of the International CAPM Using Optimal Instruments

Abstract

The international CAPM (ICAPM) extends the classical CAPM by adding exchange rate risks as priced factors. In the literature, both conditional and unconditional tests confirm the significance of exchange rate risk. However, typical conditional tests of the ICAPM include few instruments with mixed levels of return forecastability. In contrast, investors nowadays use complex trading models that incorporate many variables. Previous conditional tests of the ICAPM might underrepresent the investors' information sets, which could lead to inconclusive results about the model's rejectability. This paper takes a different approach by selecting a set of instruments that maximizes the predictability of asset returns in order to optimally represent investors' information. In contrast to past findings, I find that exchange rate risk is not priced when using the optimized set of instruments. Specifically, the use of instruments that maximize the predictive power of the second moments of asset returns decreases the significance of the exchange rate risk premium.