World Market Risk, Country-Specific Risk and Expected Returns in International Stock Markets

Abstract

This paper determines whether the world market risk, country-specific total risk, and country-specific idiosyncratic risk are priced in an international capital asset pricing model (ICAPM). The paper also tests if the price of risk associated with each factor is common across countries. Portfolio-level analyses, country-level cross-sectional regressions, stacked time-series, and pooled panel regressions indicate that the world market risk is not, but country-specific total and idiosyncratic risks are significantly priced in an ICAPM framework with partial integration. In addition, the prices of total and idiosyncratic risks are significantly different across 37 countries considered in the paper. This result is robust to different methods for estimating risk measures, different investment horizons, and after controlling for the countries’ aggregate dividend yield, earnings-to-price ratios, inflation risk, aggregate volatility risk, and past return characteristics. The main findings turn out to be insensitive to the choice of one-factor versus multifactor models used to estimate systematic and idiosyncratic risk measures.