Theory Lecture 2

Question 1

Key challenges for global asset pricing

Answer 1

• The extent of financial globalization is large and (until recently?) increasing.
• But local country-specific factors continue to affect globally traded asset prices.

Question 2

Local country-specific factors continue to affect globally traded asset prices. Why?

Answer 2

Possible reasons:

1. National monetary policyaffects asset prices through currency risk or real exchange rate changes (relative prices of countries).
2. Capital markets segmentationresulting from various “frictions.”
3. National fiscal policy affects returns through taxes, expected taxes, or sovereign risk.

• These issues can interact with each other!

Question 3

The international asset pricing models need to confront the following observed relationships:

Answer 3

1. Equity returns depend on both domestic and global risk factors.
2. Home equity bias by local investors.
3. Comovementof returns and international capital flows.
4. Premium around the cross-listing of the firms.

Question 4

What are the main assumptions of global asset pricing

Answer 4

many assets; retain assumption that almost all assets have uncertain returns.
perfectly competitive asset markets –no “frictions” (not crucial for results).

Question 5

Basic question answered by any asset pricing model:
At what price should financial asset sell so that investors would like to hold them in their portfolio
What are the two types of models used to answer this question?

Answer 5

Traditional CAPM (Lintner 1965, Mossin1966, Sharpe 1964). capture asset risk and return –
an attractive feature.
1)Investors are concerned with the mean and variance of the return on their portfolios.
How much risk will an asset add to a portfolio that looks like the market?
2) Expected-return premiums are proportional to market betas.
-> the covariance of asset returns with the returns on the “market portfolio.”

Consumption CAPM (Breeden 1979; Merton 1973, Rubinstein 1976, Lucas 1978) how the expected asset premium is affected by the risk that comes from consumption-driven stock price volatility.

1) Investors are also consumers.
2) Premiums on assets are proportional to their “consumption betas.”
- > the covariance between an asset’s return and consumption.

(Delivers a richer set of implications for global asset markets.
We connect asset markets via economic links between countries.)

Question 6

Consumption CAPM attractive for asset pricing?

Answer 6

• CCAPM has “economic fundamentals”: Start from the basic theory of consumption
under uncertainty.
• But there is an important difference from the (macro) consumption theory
• Unlike in the (macro) consumption theory, we take the consumption as givenand
derive the uncertain return on assets.
Consumption theory does other way around: derives consumption out of the
“observed” returns.

Question 7

What are the Implications of the basic consumption CAPM?

Answer 7

Implication (in words):investors are willing to accept a lowerexpected return on an asset that provides a hedge against low consumption: paying off more in states of the world when consumption is low.

Question 8

Compare consumption CAPM and Finance CAPM

Answer 8

 The traditional CAPM was derived before consumption CAPM by Lintner1965, Mossin
1966, Sharpe 1964 assuming some explicit preferences.
 Merton (1973) derived CAPM in continuous time from intertemporal optimization of
consumers over portfolio choices and consumption.

• The traditional CAPM is attractive for empirical purposes: ௝ is estimated by
regressing j𝑡 on mt, no need to assume preferences or risk aversion.
• The traditional CAPM is a proper model for asset pricing when the marginal utility of
consumption is highly correlated with the return on the stock market (as we assumed
earlier, ᇱ ௧ାଵ ௠௧).
• But: A large nontradableasset (e.g., human capital) would decrease this correlation.
Then consumption CAPM is more appropriate.

Empirical evidence comparing two models.
1) Mankiw and Shapiro (1986) found that the standard CAPM fits asset returns better
than consumption CAPM (based on the data on aggregate consumption).
2) But the test of two version of CAPM is a test of a joint hypothesis: model itself and
its assumptions. We are not sure which of the two drives the poor performance.

Question 9

Lucas version of consumption CAPM (what did he propose)

Answer 9

Lucas (1978) proposed a “shortcut” by considering an exchange economy in which
output each period was exogenous.

In equilibrium, consumption is equal to output and itself exogenous.

While not a “solution” to joint endogeneity of consumption and AP, the model is
extremely useful to study many empirical issues.

We study the global version of the model from Lucas (1982); see treatment in Lewis
(2011).

Question 10

What is SDF?

Answer 10

SDF is the intertemporal marginal rate of substitution of consumption.

Question 11

Which are the two cases considered in Lucas version of consumption CAPM?

Answer 11

fully segmented and fully open capital markets

Question 12

Case 1: Fully segmented capital markets (financial autarky)

Answer 12

-> Without financial integration, equity prices depend on SDF derived from domestic
output.
-> Global equity prices comove only due to the exogenous correlation of the
endowments ௝௧

Question 13

Case 2: Open capital markets (full integration).

Answer 13

Integrated markets imply that prices endogenously co-move according to the
commonSDF ௧ାఛை (no subscript j!).

Question 14

What are the insights Lucas 1982 model for global asset pricing:

Answer 14

• Insights from Lucas 1982 model for global asset pricing:
Without financial integration, SDF is determined by domestic output; excess returns will
be priced according to their covariance with local factors Potentially J local factors!
With fully integrated equity markets, SDF is driven by global output; returns are priced
by the covariance with a common global factor.
• These international asset pricing relationships were typically considered in the
liter

Question 15

Tests of world CAPM

Answer 15

1. Cross-country equity returns at an aggregate market-index level.
2. International equity pricing at the firm level.
3. Measuring relative importance of global, local, country risks.

Question 16

How is the World CAPM set up?

Answer 16

Solnik‘74 JET introduced a “practical” international equity pricing model.
 The World CAPMis similar to the standard finance CAPM but the world market portfolio replaces
the domestic market: 𝑅௜௧ −𝑅௙௞௧ =𝛾௜(𝑅௪௧ −𝑅௙௪௧), where
- the returns 𝑅ȉ are in local currency and 𝑋௪ are market-cap weighted averages;
- the 𝛾௜ is the international systematic risk of security 𝑖.

Question 17

Unconditional and conditional tests

Answer 17

• Unconditionaltests (like Solnik‘74 and Stehle‘77 tests of World CAPM) assume that
expected returns and risk are constant over time.
• In conditionaltests they are allowed to vary in some specified way
 The variances of returns relate to some instrumental variables or market prices of risk
(e.g., Chan, Karolyi, Stulz‘92 JFE; Ferson& Harvey ‘93 RFS);
 Constrain the behavior of the market prices of risk (e.g., Harvey ‘91 JF) and include FX risk
(Dumas & Solnik‘95 JF).
• This distinction turns out to be important for test results.

Question 18

Cross-country equity returns at an aggregate market-index level test results

Answer 18

Key results:
 Poor power of unconditional tests (FTR false H0 too often).
 FX risks are priced

Question 19

International equity pricing at the firm level

Answer 19

Summary of this work: Local factors are important for explaining cross-sectional expected returns.
 Significant unexplained intercept (alpha) remains and st.errors are often large.
Significant local factors + Low correlation across markets implies scope for international diversification

Question 20

Tests 3: Relative importanceof global, local, country risks.

Answer 20

HR find that
1. Country FE ௞௧ explained 24% of return variation in industry indices;
Industry FE ௜௧ explained only 5% of variation in countryindices.
2. Country effects are more volatile and more important in explaining cross country
correlations of returns.
Country diversification is more important than industry diversification

All the versions of models with local factors significantly dominate the world-only
factor models.
“Local” country effects are important even conditional on industry effects (HR
model)

Question 21

As globalization progresses. What happens?

Answer 21

 correlations of cross-country returns increase (Longin& Solnik‘95 JIMF);
 firms “internationalization” by cross-listing abroad increases their betas on that market and
decreases beta on their own market (see Karolyi ‘05 Rev Fin for survey).

Question 22

Empirical literature on international CAPM found

Answer 22

Int’l equity returns depend on more than a single (world) factor.
Additional localrisk factors are empirically important.
• We need models that account for these findings!
• And preferably between the two extremes of closed economy (SDF is local) and fully
integrated markets (common global SDF).
• Models with country-specific idiosyncratic risk and behavioral and informational
asymmetries.

Question 23

Evidence from conditional tests of the basic World CAPM rejects the exclusive explanatory role of a single global factor.

Answer 23

Equity returns depend on bothglobal and domestic risk factors.
FX risk is priced in country indices.
Country effects seem to matter more than industry effects

Question 24

Describe the models which extend the basic model to incorporate local factors.

Answer 24

1. Differences in real (inflation-adjusted) returnto investors across countries due to
   deviations from the Purchasing Power Parity (Adler&Dumas‘83 JF).
   Evidence:
   Recall Dumas and Solnik1995 JF: FX risks arepriced.
   But otherlocal factors still important. PPP deviations and FX risk is a partial explanation.
2. Government restrictionson access to local capital markets; segmentation of global
   capital markets.
   Evidence:
   There is time-varying integration (Bekaert& Harvey ’95).
   Global and local factors become present in returns of emerging markets after fin market
   liberalizations (surveys Bekaert& Harvey ’03 J EmpFin; Henry ’07 JEL).
    Bekaert, Harvey, Lumsdaine’02 JFE liberalizations better dated by return reactions
   than official dates.
   This explanation is not adequate for asset returns in advanced economies.
3. Informational differences across capital markets.
   Evidence:
   Model of Brennan & Cao ‘97 is designed for explaining capital flows but it has AP
   implications.
   Model of Dumas et al. ’16: Returns have a home and foreign consumption factors,
   with higher home beta.