Inconsistency of the Capital Asset Pricing Model in a Multi‐Currency Environment

ABSTRACT The capital asset pricing model (CAPM) is a widely adopted model in asset pricing theory and portfolio construction because of its intuitive nature. One of its main conclusions is that there exists a global market portfolio that each rational investor should hold in proportion to the risk‐free asset. In this paper, we demonstrate theoretically and through an example that the CAPM cannot hold in a multi‐currency environment. This is because it produces different market risk premia depending on the investor's base currency unless each exchange rate is uncorrelated with the asset prices in the portfolio.