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International Asset Pricing with Nontradable Consumption Goods

We extend and unify existing international asset pricing models for perfect capital markets by allowing both exchange rates and inflation rates to be stochastic and investors to consume both tradable and nontradable goods. We show that country-specific demand for risky assets arises from two sources: PPP-deviationrate differential risks and nontradable-good-specific inflation-rate-differential risks. Furthermore, equilibrium asset returns can be expressed in a multi-beta linear asset pricing model with benchmark portfolios including the global market portfolio and hedge portfolios for the reference country-inflation risk, PPP deviation risks and nontradable-good-specific inflation rates. We argue that the hedge portfolios can be constructed by using portfolios of the reference-country nominal riskfree bond and individual countries’ TIPS bonds.