Some of the problems inherent in the model are its assumptions, which include: no transaction costs; no taxes; investors can borrow and lend at the risk-free rate; and investors are rational and risk averse. Obviously these assumptions are not fully applicable to real-world investing. Despite this, CAPM is useful as one of several tools in estimating the return expected on an investment.

The unrealistic assumptions of CAPM have led to the creation of several expanded models that include additional factors and the relaxing of several assumptions used in CAPM. International CAPM (ICAPM) uses the same inputs as the CAPM but also takes into account other variables that influence the return on assets on a global basis. As a result, ICAPM is far more useful than CAPM in practice. However, despite relaxing some assumptions, ICAPM does have limitations that impact its practicality.

**Understanding ICAPM Calculations**

Since ICAPM introduces additional variables or factors to the CAPM model, investors first need to understand CAPM's calculations. CAPM simply states investors want to be compensated for:

- The time value of money, which they expect to be more than the risk-free rate and;
- Taking market risk so they require a premium over the return of the market, less the risk-free rate, times the correlation with the market.

For example, if a company domiciled in the United States buys parts from China and the U.S. dollar strengthens relative the Chinese Yuan, then the costs of those imports goes down. This indirect currency exposure impacts the profitability of a company and the returns generated by the investment. To determine these effects, investors need to calculate the difference between the expected future spot exchange rate and the forward rate, and divide that difference by today's spot rate, the result of which is the foreign currency risk premium (FCRP). Then, multiply that by the sensitivity of the domestic currency returns to changes in foreign currencies. ICAPM provides investors with a way of calculating expected returns in local currency terms by accounting for variables as stated below:

Expected Return= RFR+B(Rm-Rf)+(Bi*FCRPi) |

where: RFR = domestic risk free rate Rm-Rf = premium for global market risk measured in investor's local currency Bi*FCRPi= foreign currency risk premium |

**Assumptions**

While ICAPM improves upon the unrealistic assumptions of CAPM, several assumptions are still required for the theoretical model to be valid. The most important assumption is that international capital markets are integrated. If this assumption fails and international markets are segmented, then there will be pricing discrepancies among assets with similar risk profiles but in different currencies. As a result, segmented markets will cause investors to make higher allocations to specific assets in specific countries, resulting in inefficient asset pricing. ICAPM also assumes unlimited lending and borrowing at the risk-free rate.

**Practical Uses**

ICAPM's usefulness in stock selection and portfolio management is only as good as understanding the assumptions as stated above. Despite these limitations, portfolio selection can be influenced by the model. Understanding the impact of currency movements on a particular company's operations and profits will help investors choose among two assets with similar characteristics in different countries.

For example: An investor is deciding to invest in one of the following assets:

- Company A: Japanese company that derives all of its profits and input costs in Yen
- Company B: Japanese company that derives all its profits in U.S. dollars but has input costs in Yen

**The Bottom Line**

ICAPM is one of several models used to determine the required return on an asset. Used in conjunction with other financial tools, it can assist investors in selecting assets that will meet their required rate of return. ICAPM, like CAPM, makes several assumptions, including that global markets are integrated and efficient. If this assumption fails, then stock selection is critical; allocating more resources toward investments in countries that have a currency advantage should result in alpha. Currency advantages tend to disappear quickly as exploited market inefficiencies close, but the fact that these inefficiencies occur argues that active portfolio management is key to providing superior returns over the market portfolio.