The World Price of Inflation Risk

Abstract

We show that inflation risk is priced in international asset returns. We analyze the price of inflation risk in a framework that includes the International Capital Asset Pricing Model (ICAPM) as a special case. In contrast to the literature, we relax the assumption that inflation rates are constant. We estimate and test a conditional version of the model for the G5 countries (France, Germany, Japan, the U.K., and the U.S.) over the period 1975-2003. We find evidence of statistically significant prices of inflation risk (in addition to priced nominal exchange rate risk). We demonstrate that inflation risk premia are an economically important component of international asset returns. Our results can be interpreted as a rejection of the ICAPM. Moreover, we show that even after the termination of nominal exchange rate fluctuations in the euro area after 1999, differences in inflation rates across countries entail non-trivial real exchange rate risk premia.

Keywords: International asset pricing, Inflation risk, Exchange rate risk

JEL Classification: C32, F30, G12