International Asset Pricing Model Research Articles

International asset prices and portfolio choices under Bayesian learning

We calculate equilibrium asset prices and portfolio choices from a two-country OLG international asset pricing model under the assumption that investors are on a Bayesian learning path. Investors from both countries receive identical information flows, but domestic investors start off with less precise priors concerning foreign fundamentals. Learning is shown to produce first-order effects on the properties of asset prices, in the form of increased equity returns, volatility clustering, and time-varying correlations across national stock markets. Moreover, on a learning path, estimation risk generates portfolio biases similar to those observed empirically, i.e. a strong preference towards domestic securities and excessive turnover in foreign securities. These findings are robust to changes in prior beliefs, the calibration of initial information asymmetries, and the parameterization of the model. We use real GDP data for the US and Europe to calibrate the model and show that in the event of a financial liberalization during the 1970s, high excess returns, time-varying volatility, substantial home bias, and excess turnover should have been observed.

Are the East Asian markets integrated? Evidence from the ICAPM

We test a conditional international asset pricing model with both world market and domestic risk included as independent pricing factors for five East Asian markets, the US and World markets. We model second moments and risk exposures using a bi-diagonal multivariate GARCH(1,1) process. We document that this novel GARCH specification provides a significantly better fit of the return process than a standard diagonal specification. Although exposure to world market risk carries a significant premium across all markets, we find little support for the hypothesis that exposure to residual country risk is rewarded. However, residual country returns are significantly related to exchange rate changes. Hence, we find surprisingly little evidence of market segmentation in East Asia over the period 1985–1998.

Can currency risk be a source of risk premium in explaining forward premium puzzle?: Evidence from Asia-Pacific forward exchange markets

This paper studies time-varying price of risk and volatility in Asia-Pacific forward exchange markets in an attempt to see whether currency risk can be a potential source of risk premium to explain forward premium puzzle. To derive a measure of the risk premium, a conditional version of international CAPM (ICAPM) in the absence of PPP is estimated and the parameter restrictions are tested based on asset pricing theories. To incorporate time-varying feature of the risk premium into the model, not only are the second moments of asset returns allowed to change over time by utilizing a parsimonious parameterization of the asymmetric multivariate GARCH with conditionally t-distributed error process (MGARCH-t), but also the prices of risks are permitted to evolve through time based on some predetermined information variables. Estimation results indicate that the not only are currency risks priced, but also change over time. In addition, the explanatory power of the model measured by pseudo- R 2 is relatively high with an average of 38.211%, suggesting that the predicted time-varying forward risk premia are both statistically and economically significant. Finally, both forward premium and its squared are statistically significant in describing the dynamics of currency risk prices, implying the non-linearity of forward risk premium, which sheds a new light in the estimation of international asset pricing model and on the test of forward premium puzzle.

The Effects of Liberalization on Market and Currency Risk in the European Union

This paper investigates the effects of liberalization on the pricing of market and currency risk for a number of financial markets in the European Union (EU). An International Asset Pricing Model with a multivariate GARCH-in-Mean specification and time-varying prices of risk is used for the four markets with the largest market capitalization in the EU. Only one price of market risk exists and international investors are rewarded for their exposure to currency risk. The evidence shows that all prices of risk are time-varying and have been decreasing during the process of liberalization. There is also evidence that financial markets react to periods of uncertainty in the process toward the completion of liberalization. In addition, the operation of the European Monetary System has generated lower covariances. As a consequence, total risk premia have declined in the last decade.

An examination of linear factor models in country equity asset allocation strategies

We examine the out of sample performance of country equity asset allocation strategies between January 1985 and February 2000 that use conditional versions of international asset pricing models to forecast expected returns. We find that strategies that use conditional asset pricing models tend not to outperform a strategy that uses the sample mean to forecast expected returns. We find that this result is fairly robust across different levels of risk aversion, whether riskless lending is available or not, and when we impose upper bound constraints.

The Impact of Macroeconomic and Financial Variables on Market Risk: Evidence from International Equity Returns

Using a GARCH approach, we estimate a time–varying two–factor international asset pricing model for the weekly equity index returns of 16 OECD countries. We find significant time–variation in the exposure (beta) of country equity index returns to the world market index and in the risk–adjusted excess returns (alpha). We then explain these world market betas and alphas using a number of country–specific macroeconomic and financial variables with a panel approach. We find that several variables including imports, exports, inflation, market capitalisation, dividend yields and price–to–book ratios significantly affect a country’s exposure to world market risk. Similar conclusions are obtained by using lagged explanatory variables, and thus these variables may be useful as predictors of world market risks. Several variables also significantly impact the risk–adjusted excess returns over this time period. Our results are robust to a number of alternative specifications. We further discuss some economic hypotheses that may explain these relationships.

Tests of international asset pricing model with and without a riskless asset

This paper investigates the unconditional mean-variance efficiency of the Morgan Stanley Capital International (MSCI) world index in the context of the Sharpe- Lintner CAPM where there exists a universal riskless asset and the Black's zero-beta CAPM in the absence of a riskless asset. Using data from 16 OECD countries and Hong Kong over the period from 1980 to 1997, various tests under alternative distributional specifications are performed. The results show that overall the mean-variance efficiency of the MSCI world index cannot be rejected, regardless of the existence of the riskless asset.

Explaining exchange rate risk in world stock markets: A panel approach

Using a GARCH approach, we estimate a time-varying two-factor international asset pricing model for weekly equity index returns of 16 OECD countries. A trade-weighted basket of exchange rates and the MSCI world market index are used as risk factors. We find significant currency risk exposures in country equity index returns. We then explain these currency betas using several country-specific macroeconomic variables with a panel approach. We find that imports, exports, credit ratings, and tax revenues significantly affect currency risks in a way that is consistent with some economic hypotheses. Similar conclusions are obtained by using lagged explanatory variables, and thus these macroeconomic variables may be useful as predictors of currency risk exposures. Our results are robust to a number of alternative specifications.

The world price of exchange risk in the Pacific Basin equity markets

This paper investigates whether the foreign exchange risk is priced in the Pacific Basin equity markets. The test was performed in the conditional version which allows the world prices of market risk and exchange risk to vary over time. Being parsimonious, a principal component analysis is taken on these Pacific Basin interest rates to extract the common exchange rate factors. The results show that the international asset pricing model with exchange risk premia is better than the international asset pricing model without exchange risk premia to describe the Pacific Basin stock returns. This implies the world prices of exchange risk are present in the Pacific Basin equity markets.

Firm Characteristics and the Impact of Emerging Market Liberalizations

We provide a firm level analysis of the impact of capital market liberalization in 18 emerging markets. We find a larger increase in returns during liberalization and a larger decrease in returns after liberalization than previously found using indexes. While slightly more than half of the firms had higher returns during liberalization, a significant majority of firms have lower returns and lower dividend yields subsequently. These changes in returns suggest that liberalization lowers firms? cost of equity as predicted by models of international asset pricing. We also find that emerging market firms have increased exposure to the world market and decreased exposure to the home market following liberalization. On average, the Fama and French factors and momentum are not significantly affected by liberalization. We also find that the impact of liberalization varies significantly and to a large degree predictably across firms. During liberalization, smaller firms, high book-to-market value firms, low local beta firms, low foreign exchange beta firms, and non-manufacturing firms have increased returns. After liberalization, firms with higher local market betas, and firms with lower foreign exchange betas have decreased returns. Firms which are cross- listed have significantly larger changes in returns than other firms, suggesting that cross- listing has an additional diversifying impact.

Pricing of Foreign Exchange Risk from a German Investor's Perspective

We investigate the pricing of exchange risk using two international asset pricing model (IAPM) specifications: one model with a single currency index beside the world market factor (CI-IAPM) and a second employing three exchange risk variables to mirror the Triad regions (“Triad”-IAPM). For the total period we find significant exchange risk premia for both models. Sub-period and moving-window results are mixed and indicate pronounced time-variation. However, contrary to the CI-IAPM, the “Triad”-IAPM provide evidence on systematic exchange risk in more recent time. Consequently, the “Triad”-IAPM helps to gain a more differentiated picture on the pricing of exchange risk compared to most IAPMs which use only a single currency index.

An Evaluation of International Asset Pricing Models

This paper assesses the ability of international asset pricing models to explain the cross-sectional variation in expected returns. All the models considered seem to capture national market returns fairly well. However, global portfolios, sorted on earnings-price ratio and market value, pose a special challenge. We find that an unconditional international CAPM cannot explain the cross-sectional variation in these portfolio returns. Interestingly, a conditional international asset pricing model that includes foreign exchange risk factors is able to explain a large part of the variation in average returns. Our empirical work suggests that this model has the same explanatory ability as an international three-factor model, where zero-cost portfolios based on earnings-price ratios and market values are used in addition to the world market portfolio. Importantly, the loadings associated with the zero-cost portfolios are driven out by the characteristics themselves, indicating a misspecification.

The Price of Inflation and Foreign Exchange Risk in International Equity Markets

This paper uses minimum-variance (MV) admissible kernels to estimate risk premia associated with inflation and foreign exchange risk and to test multi-beta models. Estimating risk premia using MV kernels is appealing because it avoids the need to: i) identify all relevant sources of risk; ii) assume a linear factor model for asset returns. Testing multi-beta models in terms of restricted minimum-variance kernels has the advantage that: i) the candidate kernel has the smallest volatility; ii) test statistics are easy to interpret in terms of Sharpe ratios. I find that only global market risk is significant both conditionally and unconditionally as indicated by the high positive and significant relative Sharpe ratio. When using the Hansen & Jagannathan (1991, 1997) variance bounds and distance measures as testing devices, I find that, while all international asset pricing models are formally rejected by the data, their pricing implications are significantly different. The international intertemporal CAPM in presence of deviations from Purchasing Power Parity (PPP) outperforms all the other asset pricing models.

Specification Test of International Asset Pricing Models

The benchmark model for domestic asset pricing is the Sharpe-Lintner CAPM, which claims that the asset returns are determined by their covariances with the return on the (domestic) market portfolio. But since the late 1970's, the major developed countries have gradually rescinded capital controls and opened the domestic market to international investors. As the global risk factors become more influential, is the local benchmark the right benchmark for asset pricing? This study tries to answer this question by evaluating and comparing several domestic and international asset pricing models. The set of models includes the Sharpe-Lintner CAPM, the International single-beta CAPM (with and without exchange risk), the Fama-French three-factor model (1993), and the International Fama-French multi-factor model (1998). These models are tested on several common sets of assets, which are comprised of size and B/M portfolios both within and across individual countries. (When the investors are constrained to the local market or a fund manager wants to construct a country fund, it is useful to know how local factors and global factors affect asset returns in the single national market. But if the investors have access to foreign markets or the fund manager wants to diversify globally, it is more relevant to price portfolios from different countries.) I use the Hansen-Jagannathan (1997) distance measure (hereafter HJ-distance) to test and compare various models. In addition, this article explores the relation between the Fama-French empirical factors and the business cycle variables, and how exchange risks affect individual portfolio returns. The asset pricing models are mainly required to price the B/M spread in returns, because the size effect is absent from all countries. The asset pricing test results show that the models with constant risk prices fail to price the cross-sectional returns. By allowing the risk prices to fluctuate with business cycle variables, the local Fama-French factor models and the conditional international models are able to pass the HJ-distance test within US and UK. Since the business cycle variables are highly correlated across countries, it suggests the importance of common world risks in local asset pricing. The market integration hypothesis (with the uniform risk prices across countries) is not rejected in cross-country asset pricing, when risk prices are scaled by global industrial production. The conditioning business cycle variables greatly improve the performance of each model, and they are always significantly priced (together with the global market risk when cross-country). Both the value premiums as in Fama and French (1993, 1998) and the exchange risks are priced in unconditional models. However, these factors either are never priced or lose their significance in the presence of industrial production.

Characterizing World Market Integration Through Time

International asset pricing models suggest that barriers to portfolio flows and availability of market substitutes affect the degree and time variation of world market integration. We construct diversification portfolios for eight emerging markets over the period 1976-2000, use GARCH-M methodology to estimate the Errunza-Losq model and empirically assess the time variation in market integration. Our results suggest that although local risk is the most relevant factor in explaining time-variation of emerging market returns, global risk is also conditionally priced for some countries. Further, there are substantial cross-market differences in the degree of integration. We find evidence of a significant increase in the degree of integration during the last decade. Our results suggest the impropriety of directly using correlations of marketwide index returns as a measure of market integration. Finally, financial market development, macroeconomic development and financial liberalization policies play important roles in integrating emerging markets.

The Effects of Liberalisation on Market and Currency Risk in the European Union

This paper investigates the effects of liberalisation on the pricing of market and currency risk for a number of financial markets in the European Union (EU). An International Asset Pricing Model with a multivariate GARCH‐in‐Mean specification and time‐varying prices of risk is used for the four markets with the largest capitalisation in the EU. Only one price of market risk exists and international investors are rewarded for their exposure to currency risk. The evidence shows that all prices of risk are time‐varying and have been decreasing during the process of liberalisation. There is also evidence that markets react to period of uncertainty in the process toward the completion of liberalisation. In addition, the operation of the European Monetary System has generated lower covariances. As a consequence, total risk premia have declined in the last decade.

Sources of Capital Market Segmentation: Empirical Evidence from Finland

AbstractBecause Finland has experienced profound economic changes and financial deregulation since the mid‐1980s, we use it as a laboratory to explore issues related to time‐varying global equity market integration. Using a Finnish perspective, we construct two different portfolios of Finnish firms and a conditional one‐factor international asset pricing model. We examine whether the segmentation varies over time and across assets. We use time‐series variables for changing market integration (lagged foreign equity ownership, difference between Finnish and German short‐term interest rates, and a portfolio‐specific liquidity measure) and crosssectional variables (size and book‐to‐market ratios and industry sector) to show variation in integration.

MARKET SEGMENTATION AND INTERNATIONAL ASSET PRICES: EVIDENCE FROM THE LISTING OF WORLD EQUITY BENCHMARK SHARES

AbstractThis article provides an empirical analysis of the announcement effect of the listing of the seventeen World Equity Benchmark Shares (WEBS) on the returns of the corresponding market index returns and closed‐end country fund premiums. I find that the announcement of the listing of the WEBS resulted in a positive market price reaction for the market indexes. Furthermore, there was a significant decline in premiums for closed‐end country funds. The findings are consistent with models of international asset pricing under market segmentation and they illustrate that the listing of internationally tradable securities is an effective mechanism for integrating international capital markets.JEL classification: G14, G15

Are Financial Assets Priced Locally or Globally?

We review the international finance literature to assess the extent to which international factors affect financial asset demands and prices. International asset-pricing models with mean-variance investors predict that an asset's risk premium depends on its covariance with the world market portfolio and, possibly, with exchange rate changes. The existing empirical evidence shows that a country's risk premium depends on its covariance with the world market portfolio and that there is some evidence that exchange rate risk affects expected returns. However, the theoretical asset-pricing literature relying on mean-variance optimizing investors fails in explaining the portfolio holdings of investors, equity flows, and the time-varying properties of correlations across countries. The home bias has the effect of increasing local influences on asset prices, while equity flows and cross-country correlations increase global influences on asset prices.

The Impact of Macroeconomic and Financial Variables on Market Risk: Evidence from International Equity Returns

Using a GARCH approach, we estimate a time-varying two-factor international asset pricing model for the weekly equity index returns of 16 OECD countries. We find significant time-variation in the exposure (beta) of country equity index returns to the world market index and in the risk-adjusted excess returns (alpha). We then explain these world market betas and alphas using a number of country-specific macroeconomic and financial variables with a panel approach. We find that several variables including imports, exports, inflation, market capitalization, dividend yields and price-to-book ratios significantly affect a country's exposure to world market risk. Similar conclusions are obtained by using lagged explanatory variables, and thus these variables may be useful as predictors of world market risks. Several variables also significantly impact the risk-adjusted excess returns over this time period. Our results are robust to a number of alternative specifications. We further discuss some economic hypotheses that may explain these relationships.