International Capital Asset Pricing Model Research Articles

Inflation Risk and International Asset Returns

We show that inflation risk is priced in international asset returns. We analyze inflation risk in a framework that encompasses the International Capital Asset Pricing Model (ICAPM) of Adler and Dumas (1983). In contrast to the extant empirical literature on the ICAPM, 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 1975-1998 and find evidence of statistically and economically significant prices of inflation risk (in addition to priced nominal exchange rate risk). Our results imply a rejection of the restrictions imposed by the ICAPM. In an extension of our analysis to 2003, we show that even after the termination of nominal exchange rate fluctuations in the euro area in 1999, differences in inflation rates across countries entail non-trivial real exchange rate risk premia.

An Exact Bayes Test of Asset Pricing Models with Application to International Markets*

This paper develops and implements an exact finite‐sample test of asset pricing models with time‐varying risk premia using posterior probabilities. The strength of our approach is that it allows multiple conditional asset pricing specifications, both nested and nonnested, to be tested and compared simultaneously. We apply our procedure to international equity markets by testing and comparing the international Capital Asset Pricing Model (ICAPM) and conditional ICAPM versions of Fama and French (1998). The empirical evidence suggests that the best performing model is the ICAPM with the value premium constructed based on global earnings‐to‐price ratio.

The Geography of International Portfolio Flows, International Capm and the Role of Monetary Policy Frameworks

Using bilateral data on international equity and bond flows, we find that (i) the prediction of the International Capital Asset Pricing Model is partially met and that global equity markets might be more integrated than global bond markets, and (ii) asset allocators engage in trend-chasing activities, particularly in bond markets. Moreover, over the turbulent 1998-2001 period characterized by an equity bubble and the subsequent burst, we find evidence that investors preferred portfolio assets of countries where the central bank gave relative importance to money. As for EMU, once controlling for diversification benefits and the elimination of the exchange rate risk, we show that cross-border portfolio flows among euro-area countries have increased due to the catalyst effect of EMU. Countries’ shares in the world market portfolio, home bias, initial degree of misallocation across countries, past returns, diversification benefits, and EMU can explain 35-40 percent of the total variation in equity and bond asset flows.

The Geography of International Portfolio Flows, International CAPM and the Role of Monetary Policy Frameworks

The Geography of International Portfolio Flows, International CAPM and the Role of Monetary Policy Frameworks

Financial Market Design and the Equity Premium: Electronic versus Floor Trading

ABSTRACTWe assemble the announcement and actual introduction dates of electronic trading by the leading exchanges of 120 countries to examine the impact of automation, controlling for risk factors and economic conditions. Dividend growth models and international CAPM suggest a significant decline in the equity premium, especially in emerging markets. Consistent with this reduction in the equity premium in the long run, there is a positive short‐term price reaction to the switch. Further analysis of trading turnover supports the notion that electronic trading enhances the liquidity and informativeness of stock markets, leading to a reduction in the cost of capital.

Governance, Stock Market Risks and Appraisal Ratios

The purpose of this paper is to examine the effect of governance environments upon stock market risks and Appraisal ratios for developed and emerging stock markets over the time period January 1995 to December 2002. Using an augmented international capital asset pricing model (ICAPM) model and allowing for the control of risk factors, we find that governance environments have a significant influence on the total and idiosyncratic risks of stock markets, and subsequently their Appraisal ratios. The results have policy implications for government policy setters as improvements to governance environments may reduce the cost of capital. The results also have implications for active portfolio managers with investments in emerging markets.

SHORT- AND LONG-TERM EFFECTS OF THE 9/11 EVENT: THE INTERNATIONAL EVIDENCE

This paper analyzes the short- and long-term effects of the September 11, 2001 terrorist attacks on a comprehensive sample of stock market indices from 33 industrial and emerging economies. From a finance-theoretic point of view, we employ the international capital asset pricing model (ICAPM) to analyze the incidence of the 9/11 event. Consistent with expectations, we document statistically negative short-term stock market reactions to the 9/11 event for 28 countries. More importantly, we find increases in the level of systematic risk for 10 stock markets which attest to the presence of negative permanent effects emanating for the 9/11 event. However, a great many capital markets (including the US, Canada, Japan, China, Russia, and the largest European economies) did not experience statistically significant increases in systematic risk in the post-9/11 period. The decisiveness of the evidence clearly points in the direction of resilience and flexibility of the world capital markets.

Can Investor Sentiment Be a Channel of Contagion During the 1997 Asian Crisis? Evidence from Closed-End Country Funds

This paper tests whether changes in investor sentiment can be a channel of contagion during the 1997 Asian crisis using data from US based closed-end country funds (CECFs) and the corresponding net asset values (NAVs). Specifically, I examine whether there are any incremental conditional mean and asymmetric volatility spillovers between domestic NAV and overseas CECF markets during the crisis after controlling for the shocks from economic fundamentals. The empirical results based on the tests of international CAPM in the absence purchasing power parity with multivariate GARCH-in-mean approach show that before the crisis local NAV investor sentiment is more important than US market sentiment in determining CECF returns, while US market sentiment is more important than CECF investor sentiment in determining NAV returns. During the crisis, the intensity of mean spillover from NAV to CECF has decreased, but it has increased significantly for the mean spillover from CECF to NAV, suggesting that the changes in foreign investor sentiment in particular the sentiment from US CECF investors played the major role in determining local NAV returns and therefore can be the potential cause of the 1997 Asian crisis. After the crisis, both the mean spillovers from NAV to CECF and from CECF to NAV have shifted back to their pre-crisis levels, but the mean spillovers from both US and foreign exchange markets have become more important for CECFs. Finally, there is a unidirectional relationship of asymmetric volatility shocks between CECF and its NAV where the direction of the shocks runs from NAV to CECF, and this relationship strengthens during the crisis. This finding implies that the trading behavior of local NAV investors is the major source of asymmetric volatility shocks to the corresponding CECF traded in the US, and the impact of these shocks increases significantly during the crisis.

Differences in the price of risk and the resulting response to shocks: an analysis of Asian markets

In this study, a conditional version of the international CAPM for Asian markets is tested using a parsimonious generalized autoregressive conditional heteroskedasticity (GARCH) model in which the risk premia, betas and correlations vary through time. The results show that unlike the static CAPM, the time-varying CAPM prices market risk. Cross-country correlations increase toward the Asian crisis in mid 1997. The price of covariance risk appears to be higher for emerging markets than the industrialized markets The impulse response functions of the time-varying price of covariance variables from the VAR model estimations show that movements in the price of covariance risk belonging to the U.S. or an Asian emerging market can be contagious with varying degrees of strength in the region.

The World Price of Inflation Risk

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.

Intégration financière et diversification internationale des portefeuilles

Financial Integration and International Portfolio Diversification. This article examines the impact of financial integration on the gains expected from international diversification of portfolios. For this purpose, we develop an asymmetric extension of the GARCH multivariate model and test a conditional version of the ICAPM (International Capital Asset Pricing Model). Our results give backing to the assumption of integration of stock markets in the G-7 countries. Examination of the dynamics of gains from diversification shows that they are significant for all markets but vary considerably over time and space . In particular, we find that, except for France and the United Kingdom, these gains showed only a slight tendency to decline. A more interesting conclusion is that in recent years these gains have once more risen above their averages for the period as a whole.

The Polish stock market : risk and risk premia

This paper analyzes issues related to the pricing of equity in an Eastern European emerging capital market, the Warsaw Stock Exchange (WSE), with the purpose of estimating the CAPM, and the return-risk relationship, using the domestic and the international asset-pricing model. The empirical evidence from a sample of 221 Polish firms listed on the Warsaw Stock Exchange indicates that there exists a (sign-) conditional relationship between beta and return when the domestic CAPM is tested. The international CAPM did not perform well in the early days of the transition but since 2000 the Polish stock market seems well integrated. Most likely the local market has been segmented during the early period. The cross-sectional stock returns are positively related to the downside risk variable measured by the semi-deviation from the mean, and the total risk. However, the crosssectional stock returns are also positively related to the unsystematic risk, and negatively related to other downside risk measures. In addition, firm size is found to be positively related to the cross-sectional stock returns, while the book-to-market ratio is found to have no explanatory power as regards the returns. (original abstract)

Currency risk in emerging equity markets

The paper develops an international capital asset-pricing model (ICAPM), which includes foreign currency risk, and examines the impact of capital market liberalisation on the pricing of risks. It applies the model to data from Pacific Basin financial markets and finds substantial evidence that not only currency risk is priced in both pre- and post-liberalisation periods, but the model is superior to one which does not include currency risk. This evidence suggests that an international capital asset-pricing model, which omits currency risk, will be misspecified. Furthermore, the results imply that since currency risk is priced and investors are compensated for bearing such risk they should not be discouraged by more flexible exchange rate regimes from investing in emerging markets.

U.S. Investors' Emerging Market Equity Portfolios: A Security-Level Analysis

We analyze a unique data set and uncover a remarkable result that casts a new light on the home bias phenomenon. The data are comprehensive, security-level holdings of emerging market equities by U.S. investors. We document that at a point in time U.S. portfolios are tilted towards firms that are large, have fewer restrictions on foreign ownership, or are cross-listed on a U.S. exchange. The size of the cross-listing effect is striking. In contrast to the well-documented under-weighting of foreign stocks, emerging market equities that are cross-listed on a U.S. exchange are incorporated into U.S. portfolios at full international CAPM weights. Our results suggest that information asymmetries play an important role in equity home bias and that the benefits of international risk sharing are limited to select firms.

Tests of an International Capital Asset Pricing Model with Stocks and Government Bonds and Regime Switching Prices of Risk and Intercepts

The paper tests a conditional multivariate International Capital Asset Pricing Model for US, Japanese and European stocks and government bonds, covering the period 1993-2001. Time variation in the prices of market and currency risk is modelled by means of synchronous regime switching. The paper also explores the statistical significance and time variation of asset specific intercept terms, again using synchronous regime switching. The prices of risk are found to be highly time varying. The price of market risk is statistically significant, and the international CAPM risk premia are validated, although currency risk premia are not statistically significant. However, the intercept terms are typically large and significant, implying an overall rejection of the international CAPM, and suggesting that additional, unidentified pricing factors contribute to return expectations.

Estimation of an International Capital Asset Pricing Model with Stocks and Government Bonds

The paper investigates whether US, Japanese and European stock and government bond return indices are jointly priced within a conditional multivariate form of the international Capital asset Pricing Model during the period 1993-2001. It also explores the time variation of the price of market risk within this framework, allowing for a structural change in the prices of market and currency risk. The corresponding conditional optimal portfolio weights are compared with the observed market capitalization weights of the assets. The agreement is found to be better for the stock markets than for the bond markets. Finally, out-of-sample performance of the conditional optimal portfolio is measured relative to the market portfolio of stocks and bonds.

Keeping Up with the Joneses and the Home Bias

Abstract We argue that when individuals care about their consumption relative to that of their neighbours, a home bias emerges, that is investors overweight domestic stocks in their portfolios. Domestic stocks are preferred because they also serve the objective of mimicking the economic fortunes and welfare of the investor's neighbours, countrymen, and social reference group. We also demonstrate that globalization mitigates the home bias, and derive a modified international CAPM.

Home Bias in European Countries within a Bayesian Framework

The home bias is defined as the tendency of the investors to invest a larger proportion of their wealth in domestic equities than what would be optimal based on the meanvariance principle. There are several explanations for this observed home bias, e.g., barriers to foreign investments and information asymmetry. From a Bayesian viewpoint the level of the investors' prior mistrust in a certain asset-pricing model may explain the home bias, despite the fact that statistical tests fail in rejecting the model. The purpose is to analyze how fragile the investors' prior confidence in ICAPM (International Capital Asset Pricing Model) must be to cause home bias in European equity markets. We use a Bayesian approach to estimate the predictive distribution of the asset returns for each European country under different prior scenarios. The investors' optimal portfolio weights are constructed from the moments of this predictive distribution. The result shows that there is a strong home bias in most countries, which cannot be explained by any degree of disbelief in the ICAPM. The losses due to the holdings of inefficient portfolios by pension funds are assessed via certainty equivalent calculations. Italian pension funds suffer more than the funds of the other countries from the home bias while UK and the Netherlands experience very small losses.

Global Risk Factors and the Cost of Capital

Analysis of 3,300 stocks from nine industrialized countries over the 1980–99 period indicates that whether the capital asset pricing model or some form of international CAPM is used makes little difference in the cost-of-capital estimate for most companies in most countries. The international CAPM yielded an estimate of the cost of equity capital that was significantly different from that of the domestic CAPM in only 4–5 percent of the sample companies. For the vast majority of companies, the domestic market factor is an adequate benchmark against which to measure an individual company's exposure to both global market and currency risk factors.

The International CAPM when Expected Returns are Time Varying

This paper derives a dynamic version of Adler and Dumas' (1983) international CAPM when expected returns are time-varying. In addition to the international CAPM factors, intertemporal hedging of future stock returns and future real exchange-rate changes are also priced factors. The model nests several different CAPMs as special cases. The model is estimated using the data on the equity and foreign exchange returns for the United States, Japan, Germany and the United Kingdom. The restrictions of the nested models are tested. While real exchange risk and intertemporal hedging of future stock return play some role, stock market risk remains the most important factor affecting the excess returns.