Essays on International Risk-Return Trade-Off Relations

Abstract

This dissertation consists of two essays on the international risk-return trade-off relations. The first essay is titled “The Role of the US Market on International Risk-Return Trade-Off Relations” and the second essay is titled “The Role of Investor Sentiment on International Risk-Return Trade-Off Relations”. In our first essay, we study the intertemporal risk-return trade-off relations based on returns from 18 international markets. Our main contribution is that we find the US market plays an important role affecting the international risk-return trade-off. We present striking new empirical evidence that the inclusion of US market variables significantly changes the estimated risk-return trade-off relationship in international markets. The estimated risk aversion coefficient switches from mostly negative to mostly positive after the inclusion of these US market variables even when the conditional variance model specification remains the same. Our results are consistent with the state variable interpretation of the US market variables in the sense of Merton’s Intertemporal CAPM. Our collective findings confirm and extend the recent literature that find an important role of US market return in predicting international stock returns. In our context of the risk-return trade-off relationship, we find that the contemporaneous state variables are more significant than the lagged ones, suggesting that the importance of US market variables are more likely driven by expected changes in investment opportunity set rather than the slow diffusion of information. In our second essay, we investigate the role of domestic investor sentiment on the risk-return trade-off relation in the international markets context. We extend the study of Yu and Yuan (2011) by including 16 international stock markets with longer sample period than prior international studies. Our main contribution is that we find the significant roles of the US market returns and risk-free rates as we examine the local investor sentiment impacts on the home country’s risk-return relation. After we include the US market returns and risk free rates, we identify a two-regime sentiment pattern in most of the international markets: a low sentiment regime and a high sentiment regime. In the low sentiment period during which sentiment traders have small impact, the risk-return relation is largely robust positive in many international markets. Meanwhile, in the high sentiment period with more noise traders involved in the market, this positive trade-off is undermined. We also find that to some extent, US sentiment spreads to other countries, co-existing with local sentiment. However, the US sentiment effect is less significant and influential than the home sentiment effect. Our findings suggest that the local sentiment effect dominates and effectively subsumes the US sentiment effect.