Risk and International Parity Conditions: A Synthesis from Consumption Based Models

Built on a consumption-based capital asset pricing model, this paper presents a coherent theoretical framework from which the main international parity conditions are derived. These conditions represent market equilibria characterized by the equality of gross returns after adjustment for risk premia. The spectrum of assets treated is broadened to include equity markets. The parity conditions obtained from the model are then used to characterize the relationships for the pricing of risks encountered in international finance. Only two fundamental types of aggregate risk matter when pricing any asset: equity risk and foreign exchange rate risk. The relative riskiness of an asset can then be approximately measured by a linear combination of equity and foreign exchange risk premia. [F30, G12]