The international CAPM when expected returns are time-varying

This paper derives a dynamic version of the international CAPM that nests the standard CAPM, the international CAPM and the dynamic CAPM. A theoretical foundation for empirical risk factors often used in international asset pricing, including dividend yields, forward premia and, especially, exchange-rate indices is presented. Empirically, the model performs quite well in explaining average foreign-exchange and stock market returns in the US, Japan, Germany and the UK. However, while derived in a theoretical sound fashion, these factors are proportional to covariances with the world market portfolio. Hence, for practical purpose, the model does not perform better than the standard CAPM. Both models fail to predict average returns on portfolios of high book-to-market stocks across countries. (C) 2004 Elsevier Ltd. All rights reserved.