Local risk factors in emerging markets: Are they separately priced?

We provide new evidence on the pricing of local risk factors in emerging stock markets. We investigate whether there is a significant local currency premium together with a domestic market risk premium in equity returns within a partial integration asset pricing model. Given previous evidence on currency risk, we conduct empirical tests in a conditional setting with time-varying prices of risk. Our main results support the hypothesis of a significant exchange risk premium related to the local currency risk. Exchange rate and domestic market risks are priced separately for our sample of seven emerging markets. The empirical evidence also suggests that although statistically significant, local currency risk is on average smaller than domestic market risk but it increases substantially during crises periods, when it can be almost as large as market risk. Disentangling these two factors is thus important in tests of international asset pricing for emerging markets.     

Understanding Housing Market Volatility

The Campbell–Shiller present value formula implies a factor structure for the price–rent ratio of housing market. Using a dynamic factor model, we decompose the price–rent ratios of 23 major housing markets into a national factor and independent local factors, and we link these factors to the economic fundamentals of the housing markets. We find that a large fraction of housing market volatility is local and that the national factor has become more important than local factors in driving housing market volatility since 1999, consistent with the findings in Del Negro and Otrok (2007). The local volatilities mostly are due to time variations of idiosyncratic housing market risk premia, not local growth. At the aggregate level, the growth and interest rate factors jointly account for less than half of the total variation in the price–rent ratio. The rest is due to the aggregate housing market risk premium and a pricing error. We find evidence that the pricing error is related to money illusion, especially at the onset of the recent housing market bubble. The rapid rise in housing prices prior to the 2008 financial crisis was accompanied by both a large increase in the pricing error and a large decrease in the housing market risk premium.     

The Risk‐Return Relation in International Stock Markets

We investigate the risk‐return relation in international stock markets using realized variance constructed from MSCI (Morgan Stanley Capital International) daily stock price indices. In contrast with the capital asset pricing model, realized variance by itself provides negligible information about future excess stock market returns; however, we uncover a positive and significant risk‐return tradeoff in many countries after controlling for the (U.S.) consumption‐wealth ratio. U.S. realized variance is also significantly related to future international stock market returns; more importantly, it always subsumes the information content of its local counterparts. Our results indicate that stock market variance is an important determinant of the equity premium.     

Asset pricing in China's domestic stock markets: Is there a logic?

China's stock markets have grown rapidly since their inception and have become an increasingly important emerging market for international investors. However, there are few systematic studies on how asset prices are formed in Chinese domestic equity markets; popular financial media even depict the market as irrational. In this paper, we study the asset pricing mechanism in the nascent Chinese stock markets, with the objective of identifying variables that capture the cross-sectional variation in average stock returns. We focus on the effects of various market imperfections in China. We find that while the market risk (beta) is not priced, there is a significantly negative relationship between firm-specific risk and expected returns. Chinese investors are willing to pay a significant premium for more liquid stocks or for dividend-paying stocks. Furthermore, investors value local A-shares more if there are offshore counterparts (e.g., B- and H-shares) for foreigners, implying that a Chinese firm with a foreign shareholder base has a lower cost of capital, ceteris paribus. Lastly, as with U.S. and other mature markets, firm size and the book-to-market ratio are systematically related to stock returns. Given market imperfections, stocks are priced rather rationally in China, despite the widespread perception to the contrary.     

The Equity Market Risk Premium and the Valuation of Overseas Investments

There is little agreement among academics or practitioners about how to measure the size of the equity market risk premium, particularly when it relates to investments in emerging markets. Using monthly equity returns for 22 developed and 24 emerging markets covering the period 1976–2006, the authors find that developed capital markets have experienced significant increases in their degree of integration with the U.S. and world market indexes, while emerging markets remain at least partly segmented from those of the U.S. and the world. For countries that are reasonably well integrated into global capital markets, the authors suggest using the U.S.—based equity market risk premium. But when valuing investments in emerging markets, they recommend use of the Capital Asset Pricing Model adjusted for political risk and a measure of co‐movement between the foreign and U.S. stock markets. The authors also remind readers that the equity market risk premium is supposed to be a forward‐looking measure, and that the common practice of inferring the future from the past can be misleading, particularly in the case of rapidly developing emerging markets.     

An International Asset Pricing Model with Time-Varying Hedging Risk

This paper employs a two-factor international equilibrium asset pricing model to examine the pricing relationships among the world's five largest equity markets. In addition to the traditional market factor premium, a hedging factor premium is included as the second factor to explain the relationship between risks and returns in the international stock markets. Moreover, a GARCH parameterization is adopted to characterize the general dynamics of the conditional second moments. The results suggest that the additional hedging risk premium is needed to explain rates of return on international equities. Furthermore, the restriction that the coefficient on the hedge-portfolio covariance is one smaller than the coefficient on the market-portfolio covariance can not be rejected. This suggests that the intertemporal asset pricing model proposed by Campbell (1993) can be used to explain the returns on the five largest stock market indices.     

On the stability of long-run relationships between emerging and US stock markets

While most studies have found no cointegration between emerging and US stock markets, some recent studies do find a long-run relationship exists between these markets. In view of these mixed findings, this study examines the stability of long-run relationships between a number of emerging stock markets and the US stock market using recursive cointegration analysis. The results show that no long-run relationship exists between emerging markets and the US market over most of the sample period throughout 1997. However, we do find clear evidence of cointegration in response to the recent global emerging market crisis in 1997–1998. We conclude that significant crisis events can change the degree of cointegration between international stock markets and, therefore, need to be taken into account in studies of long-run relationships between international stock markets.     

Consumption baskets and currency choice in international borrowing

We propose a novel explanation for the empirically low prevalence of external borrowing in local currency in emerging market economies, a phenomenon sometimes referred to as the original sin of international finance. We study the endogenous currency denomination of an emerging economy's assets and liabilities within the context of a dynamic stochastic general equilibrium (DSGE) model with portfolio choice featuring non-tradable goods and nominal rigidities. We find that these features lower the correlation between the local currency and domestic lenders' consumption. They thus reduce the risk premium demanded by domestic lenders on local currency debt, and can therefore help explain the low willingness of foreigners to lend in local currency.     

Tail risk contagion between international financial markets during COVID-19 pandemic

In this paper, we combine the time-varying financial network model and FARM-selection approach to analyze the tail risk contagion between international financial market during the COVID-19 epidemic. Since the tail risk acts as a global transmission channel, we use the sample of 19 international financial markets to explore the contagion of tail risk during the epidemic. We find that the COVID-19 epidemic increases the number of contagion channels in the international financial system. The clustering level of the financial system has a significant growth during the COVID-19 pandemic, and the number of risk drivers is also larger than risk takers. The key financial market of each international financial network is related to the epidemic country. We also consider the tail risk contagion in local financial markets and find that the COVID-19 pandemic has an important influence on the tail risk contagions in local network systems     

International Housing Markets and the U.S. Subprime Crisis

We propose a novel decomposition approach to study the degree of co-movement of international housing markets while distinguishing among different economic drivers. We find that the housing market variability for an average country was mainly driven by the common housing risk premium components during the years leading up to the 2007–08 subprime financial crisis. A decrease in the common housing risk premium was followed by a housing boom and economic expansion in the United States prior to the crisis. Our findings add to the understanding of the role of common risk factors across international housing markets before the crisis.     

The evolution of pay premiums for managerial attributes

This paper proposes and estimates an interactive fixed effects model of executive compensation, which allows for time-variant pay premiums for unobserved manager attributes. We find that two managerial traits can explain executive compensation over time: talent and conservatism. The market premium for talent is higher in bull markets, as the higher marginal productivity of human capital during these periods increases the demand and thus the price for talents. Such pay premium is concentrated among top talented managers, who earn a premium about five times that of median talented managers. The pay premium for conservatism is linked to the equity market risk premium, with conservatism being discounted (compensated) during the low (high) risk premium periods. We show that risk-taking managers are rewarded during the early period of our sample. However, after the periods characterized by higher risk premium, such as the financial crisis, conservatism becomes a more desirable trait.     

Empirical Evidence of the Existence of Investable Premiums in Emerging Market Investable Stocks

This paper shows that portfolios of more investable securities bear a premium when compared to portfolios of less investable stocks, reflecting compensation for local risk factors. The investable premium is overwhelmingly priced across 3,782 companies traded in 29 emerging markets from 1988 to 2006. The investable premium impacts stock returns at least as much as other fundamental premiums such as size, value, momentum, and loads on political, economic, and financial risk factors. The impact of the investable premium on emerging stocks returns has increased in strength, implying that foreign ownership has greater influence on local markets in recent years.     

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. Consistent with models of international asset pricing, we find that firms’ stock returns increase during liberalization and that a majority of firms have lower mean returns and lower dividend yields after liberalization. We also find that emerging market firms have increased exposure to the world market and decreased exposure to the home market following liberalization. These changes in returns and exposures support the predictions of theoretical international asset pricing models. We also test and find support for the importance of size, local risk, foreign exchange risk, and cross-listing status in explaining the cross-section of changes in returns.     

Performance of Currency Trading Strategies in Developed and Emerging Markets: Some Striking Differences

Expanding the currency investment universe makes a lot of sense from a diversification point of view. Nevertheless, 60% of the total foreign exchange turnover is still only traded in three currency pairs (USD/EUR, USD/JPY and USD/GBP). The share of trading in local currencies in emerging markets is only around 5%. This can be explained by the fact that some currency managers fear investing in emerging market currencies. Many believe that political risk is the most dominant driver in these markets and that traditional investment rules do not work. In this paper, I apply four technical trading strategies for the developed market currencies and for the most traded emerging market currencies. The empirical results show some striking differences. They suggest that trend-following rules work better for emerging market currencies, while carry trading strategies perform better across developed market currencies. Nevertheless, it seems that conventional techniques could be successfully applied to both developed and emerging market currencies. I conclude that currency managers should not be afraid to diversify into emerging market currencies. They should, however, adjust their trading style accordingly.     

Value-at-risk and the cross section of emerging market hedge fund returns

This paper examines the cross-sectional relationship between downside risk (Value at Risk) and expected returns in a sample of 1370 emerging market hedge funds (EMHF). We find that downside risk significantly drives expected returns for these funds, particularly before the global financial crisis, commanding an annual risk premium of over 12%. While EMHF differ from their advanced market counterparts in risk/return patterns, we show that the global financial crisis of 2008 has caused a structural shift in that pattern. Finally, we show that the risk premium associated with downside risk is predictable by the global financial cycle, even after we control for emerging market systematic risk factors.     

全球股票市场间风险传染的测度、监管及预警

近年来,伴随金融一体化程度的加深,全球各股票市场间风险传染的动态复杂性加剧,其准确测度、高效监管及实时预警已成为优先事项。本研究选取全球21个代表性股票市场作为分析样本,首先基于广义向量自回归模型的滚动估计准确测度其间风险动态传染的高维网络序列,进一步借由矩阵值因子模型来稳健收缩上述序列,以探究其潜在动态核心结构,从而实现高效监管。最后,通过向量自回归模型的预测功能实现对全球股票市场间风险传染的实时预警。研究表明,全球股票市场间风险传染具有时变性,其监管与预警可通过少数与地理区域高度相关的风险区域间的动态传染关系及内部的市场构成来刻画。与此同时,我们发现中国内地等新兴市场的重要地位逐渐凸显。本文研究结论可为有效防范与化解金融风险提供有益参考。     

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

We 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.     

INTERNATIONAL INVESTORS' EXPOSURE TO RISK IN EMERGING MARKETS

We examine the empirical differences in emerging market betas (β's) taken across four major currencies (U.S. dollar, British sterling, Japanese yen, and German mark) where the β's are either mean-variance or mean-lower partial moment β's. The mean variance β's are found to be statistically similar to lower partial moment β's in most cases, which suggests they are robust to nonnormality in the data. The difference between the two β's has become less significant in recent years as emerging markets have become more stable. Furthermore, evidence is presented that β's obtained from both risk measures and calculated from returns denominated in different currencies have the same ordinal association. This shows the primacy of local risk over foreign exchange risk. We conclude that international investors can continue to use the mean-variance β in assessing risk in emerging markets, although investors should not give it a conventional equilibrium interpretation.     

Short-term determinants of the idiosyncratic sovereign risk premium: A regime-dependent analysis for European credit default swaps

This study investigates the dynamics of the sovereign CDS term premium, i.e. difference between 10Y and 5Y CDS spreads. It can be regarded a forward-looking measure of idiosyncratic sovereign default risk as perceived by financial markets. For some European countries this premium featured distinct nonstationary and heteroskedastic pattern during the last years. Using a Markov-switching unobserved component model, we decompose the daily CDS term premium of five European countries into two unobserved components of statistically different nature and link them in a vector autoregression to various daily observed financial market variables. We find that such decomposition is vital for understanding the short-term dynamics of this premium. The strongest impacts can be attributed to CDS market liquidity, local stock returns, and overall risk aversion. By contrast, the impact of shocks from the sovereign bond market is rather muted. Therefore, the CDS market microstructure effect and investor sentiment play the main roles in sovereign risk evaluation in real time. Moreover, we also find that the CDS term premium response to shocks is regime-dependent and can be ten times stronger during periods of high volatility.     

International asset pricing under segmentation and PPP deviations

We analyze the impact of both purchasing power parity (PPP) deviations and market segmentation on asset pricing and investor's portfolio holdings. The freely traded securities command a world market risk premium and an inflation risk premium. The securities that can be held by only a subset of investors command two additional premiums: a conditional market risk premium and a segflation risk premium. Our model is empirically supported with important implications for tests of international asset pricing.