formally illustrated in Arouri (2003). First consider the following International Asset Pricing
Model (Solnik, 1974):
E (Ri/ Ω t-1 )-
^
r = COV (Ri, R, / Ω t-1 )
f VAR (R, / Ω t-1 )
[E ( R, / Ω t—1 )- r, ]
(1)
E(Ri /Ωt—1 )-r, = δt—1COV(Ri,R,/Ωr—1 )
Where δT-1
[E (R, / Ω t—1 )-r, ]
VAR (R, / Ω t-1 )
is the time-varying price of market covariance risk.
Therefore, the risk premium is expressed as the product of the price of risk δt-1 and the actual
riskCOV(Ri,Rw/Ωt-1 ). Besides, according to the ‘separation theorem’, investors derive
optimum portfolios by combining the market portfolio and the risk free rate (Black, 1972).
Let I be the internationally diversified portfolio. We thus have:
RI =θt-1*Rw,t+(1-θt-1)R,t
(2)
According to (2), the returns of the international portfolio can be decomposed into the risk-
free rate and the market portfolio. The exact decomposition of returns depends onθt -1 , which
represents the investor’s preference for international investment. The latter is a positive
function of the expected domestic risk, and a negative function of the expected global
portfolio risk. It can be expressed as:
θ = VAR (Ri/ Ω t -J
t-1 VAR (R,. / Ω t-1 )
(3)
Excess returns of the international portfolio can thus be given by:
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