International asset pricing models and currency risk: Evidence from Finland 1970–2004

In this paper we investigate whether global, local and currency risks are priced in the Finnish stock market using conditional international asset pricing models. We take the view of a US investor. The estimation is conducted using a modified version of the multivariate GARCH framework of [De Santis, G., Gérard, B., 1998. How big is the premium for currency risk? Journal of Financial Economics 49, 375–412]. For a sample period from 1970 to 2004, we find the world risk to be time-varying. While local risk is not priced for the USA, the local component is significant and time-varying for Finland. Currency risk is priced in the Finnish market, but is not time-varying using the De Santis and Gérard specification. This suggests that the linear specification for the currency risk may not be adequate for non-free floating currencies.     

Habit formation,surplus consumption and return predictability: International evidence

On an international post World War II dataset, we use an iterated GMM procedure to estimate and test the Campbell and Cochrane (1999, By force of habit: a consumption-based explanation of aggregate stock market behavior. Journal of Political Economy 107, 205–251.) habit formation model with a time-varying risk-free rate. In addition, we analyze the predictive power of the surplus consumption ratio for future stock and bond returns. We find that, although there are important cross-country differences and economically significant pricing errors, for the majority of countries in our sample the model gets empirical support in a variety of different dimensions, including reasonable estimates of risk-free rates. Further, for the majority of countries the surplus consumption ratio captures time-variation in expected returns. Together with the price-dividend ratio, the surplus consumption ratio contains significant information about future stock returns, also during the 1990s. In addition, in most countries the surplus consumption ratio is also a powerful predictor of future bond returns. Thus, the surplus consumption ratio captures time-varying expected returns in both stock and bond markets.     

International evidence on bond risk premia

This paper revisits the study of time-varying excess bond returns in international bond markets. Using newly available yield curve data from 10 different countries with independent monetary policy, I test the robustness of Cochrane and Piazzesi (2005). For most countries in my sample, I find more modest predictive power for forward rates than originally found by Cochrane and Piazzesi (2005) for the US. Their single-factor model captures well the predictability in international data, and this factor also tends to have a tent-shape in most countries of my sample. CP factors are more idiosyncratic across countries than yields or forward rates. Finally, I show that the recent financial crisis has significantly affected the predictability of excess bond returns.     

An international CAPM for partially integrated markets: Theory and empirical evidence

This article proposes a theoretical testable capital asset pricing model for partially segmented markets. We establish that if some investors do not hold all international assets because of direct and/or indirect barriers, the world market portfolio is not efficient and the traditional international CAPM must be augmented by a new factor reflecting the local risk undiversifiable internationally. We also introduce a suitable framework to test this model empirically. Using a sample of six emerging markets and three mature markets, we find that the degree of stock market integration varies through time and that most of the sample emerging markets have become more integrated in the recent years. The local risk premium for emerging markets represents the most important component of the total risk premium, but its relative importance has decreased recently. Differently, the total risk premium for developed countries is largely driven by global factors.     

CAPM for estimating the cost of equity capital: Interpreting the empirical evidence

We argue that the empirical evidence against the capital asset pricing model (CAPM) based on stock returns does not invalidate its use for estimating the cost of capital for projects in making capital budgeting decisions. Because stocks are backed not only by projects in place, but also by the options to modify current projects and undertake new ones, the expected returns on stocks need not satisfy the CAPM even when expected returns of projects do. We provide empirical support for our arguments by developing a method for estimating firms' project CAPM betas and project returns. Our findings justify the continued use of the CAPM by firms in spite of the mounting evidence against it based on the cross section of stock returns.     

Currency risk premia and uncovered interest parity in the International CAPM

Zero-investment uncovered interest parity (UIP) portfolio positions provide perfect factor-mimicking portfolios for currency risk in the International CAPM context. Their returns are the currency risk premia. Since the UIP positions on average provide low returns, the currency risk premia must be low so that currency risk appears not to be priced in an unconditional model. However, previous research has shown that UIP returns are predictable and may be quite substantial conditionally. We use this observation to generate a specific conditional version of the International CAPM. A GMM approach shows that the conditional model performs well, while the unconditional International CAPM is (marginally) rejected. The paper thus argues that previous rejections of the International CAPM stem from the fact that currency risk premia are by nature low over extended periods of time and do not provide evidence against the International CAPM.     

International day-of-the-week effects: An empirical examination of iShares

Ample evidence suggests that day-of-the-week patterns exist in US and foreign equity returns. We extend the evidence on the day-of-the-week effect in equity returns by examining the return patterns of iShares for 17 countries and Standard and Poor's Depository Receipts (SPDRs) to establish whether previously observed predictabilities in equity returns are reflected in iShares' returns. We utilize a split sample to examine return patterns and develop trading rules using the initial subsample. We then test those trading rules out of sample. Empirical results reveal that iShares exhibit day-of-the-week return patterns that can be exploited by informed traders.     

Return decomposition and the Intertemporal CAPM

The Intertemporal CAPM (ICAPM) from Merton (1973) has had a strong impact in empirical asset pricing leading to numerous multifactor models. This paper shows that the explanatory power of the ICAPM application by Campbell and Vuolteenaho (2004) relies critically on the computation of Dimson (1979) covariances (betas). If one employs the standard factor covariances (excluding lagged factors), the two-factor ICAPM has virtually no explanatory power for the average returns of the 25 size/book-to-market portfolios. More specifically, it is the covariance with the lagged innovation in one of the state variables (the value spread) that drives the explanatory power of the model. These results are inconsistent with the central economic intuition from the ICAPM. By specifying a more general version of the ICAPM, the fit of the model improves relative to the Campbell and Vuolteenaho (2004) model.     

Short-term patterns in government bond returns following market shocks: International evidence

We employ government bond portfolios from 17 countries in order to investigate the short-run reaction of investors to price shocks. Our findings indicate a uniform return reversal pattern across countries, that persists irrespective of various robustness tests such as different datasets (Datastream/J.P. Morgan), different maturity bands, and day-of-the-week effects. Simulated trading strategies based on our results suggest that this pattern can be employed to generate economically significant profits for many country portfolios. We also demonstrate that significant zero-investment profits are possible even when instead of the expensive to replicate country bond portfolios we employ directly tradable and low transactions cost instruments, such as Bond Futures Contracts.     

Macroeconomic risks and characteristic-based factor models

We show that book-to-market, size, and momentum capture cross-sectional variation in exposures to a broad set of macroeconomic factors identified in the prior literature as potentially important for pricing equities. The factors considered include innovations in economic growth expectations, inflation, the aggregate survival probability, the term structure of interest rates, and the exchange rate. Factor mimicking portfolios constructed on the basis of book-to-market, size, and momentum therefore, serve as proxy composite macroeconomic risk factors. Conditional and unconditional cross-sectional asset pricing tests indicate that most of the macroeconomic factors considered are priced. The performance of an asset pricing model based on the macroeconomic factors is comparable to the performance of the Fama and French (1993) model. However, the momentum factor is found to contain incremental information for asset pricing.     

Estimation of expected return: CAPM vs. Fama and French

Most practitioners favour a one-factor model (CAPM) when estimating expected return for an individual stock. For estimation of portfolio returns, academics recommend the Fama and French three-factor model. The main objective of this paper is to compare the performance of these two models for individual stocks. First, estimates for individual stock returns based on CAPM are obtained using different time frames, data frequencies, and indexes. It is found that 5 years of monthly data and an equal-weighted index, as opposed to the commonly recommended value-weighted index, provide the best estimate. However, performance of the model is very poor; it explains on average 3% of differences in returns. Then, estimates for individual stock returns are obtained based on the Fama and French model using 5 years of monthly data. This model, however, does not do much better; independent of the index used, it explains on average 5% of differences in returns. These results therefore bring into question the use of either model for estimation of individual expected stock returns.     

The conditional CAPM does not explain asset-pricing anomalies

Recent studies suggest that the conditional CAPM holds, period by period, and that time-variation in risk and expected returns can explain why the unconditional CAPM fails. In contrast, we argue that variation in betas and the equity premium would have to be implausibly large to explain important asset-pricing anomalies like momentum and the value premium. We also provide a simple new test of the conditional CAPM using direct estimates of conditional alphas and betas from short-window regressions, avoiding the need to specify conditioning information. The tests show that the conditional CAPM performs nearly as poorly as the unconditional CAPM, consistent with our analytical results.     

International equity portfolio allocations and transaction costs

In spite of the critical role of transaction cost, there are not many papers that explicitly examine its influence on international equity portfolio allocation decisions. Using bilateral cross-country equity portfolio investment data and three direct measures of transaction costs for 36 countries, we provide evidence that markets where transaction costs are lower attract greater equity portfolio investments. The results imply that future research on international equity portfolio diversification cannot afford to ignore the role of transaction costs, and policy makers, especially in emerging markets, will have to reduce transaction costs to attract higher levels of foreign equity portfolio investments.     

International portfolio diversification benefits: Cross-country evidence from a local perspective

We investigate how the benefits of international portfolio diversification differ across countries from the perspective of a local investor. We find that the benefits of investing abroad are largest for investors in developing countries, including when controlling for currency effects. Most of the benefits are obtained from investing outside the region of the home country. These global diversification benefits remain large when controlling for short-sales constraints in developing stock markets. The gains from international portfolio diversification appear to be largest for countries with high country risk. In addition to this cross-sectional evidence, we also provide evidence that diversification benefits vary over time as country risk changes. We find that diversification benefits have decreased for most countries in our sample over the past two decades.     

Market price of risk specifications for affine models: Theory and evidence

We extend the standard specification of the market price of risk for affine yield models, and apply it to U.S. Treasury data. Our specification often provides better fit, sometimes with very high statistical significance. The improved fit comes from the time-series rather than cross-sectional features of the yield curve. We derive conditions under which our specification does not admit arbitrage opportunities. The extension has extremely strong statistical significance for affine yield models with multiple square-root type variables. Although we focus on affine yield models, our specification can be used with other asset pricing models as well.     

International diversification with securitized real estate and the veiling glare from currency risk

This paper analyzes diversification benefits from international securitized real estate in a mixed-asset context. We apply regression-based mean-variance efficiency tests, conditional on currency-unhedged and fully hedged portfolios to account for systematic foreign exchange movements. From the perspective of a US investor, it is shown that, first, international diversification is superior to a US mixed-asset portfolio, second, adding international real estate to an already internationally diversified stock and bond portfolio results in a further significant improvement of the risk-return trade-off and, third, considering unhedged international assets could lead to biased asset allocation decisions not realizing the true diversification benefits from international assets.     

CAPM and APT-like models with risk measures

The paper deals with optimal portfolio choice problems when risk levels are given by coherent risk measures, expectation bounded risk measures or general deviations. Both static and dynamic pricing models may be involved. Unbounded problems are characterized by new notions such as (strong) compatibility between prices and risks. Surprisingly, the lack of bounded optimal risk and/or return levels arises for important pricing models (Black and Scholes) and risk measures (VaR, CVaR, absolute deviation, etc.). Bounded problems present a Market Price of Risk and generate a pair of benchmarks. From these benchmarks we introduce APT and CAPM-like analyses, in the sense that the level of correlation between every available security and some economic factors explains the security expected return. The risk level non correlated with these factors has no influence on any return, despite the fact that we are dealing with risk functions beyond the standard deviation.     

Using the credit spread as an option-risk factor: Size and value effects in CAPM

This paper takes an option-theoretic approach to explain why pricing anomalies are observed when traditional CAPM is used. By extending CAPM to incorporate the option-risk factor of stocks, we show that stockholders’ limited liability can explain Fama and French’s size and value effects. We use bonds’ excess credit spread as a proxy for stocks’ default risk to control for the changing non-diversifiable option-risk characteristic of stocks. Because sensitivity to the excess credit spread becomes smaller as size increases and as value decreases, excess credit spread explains the CAPM anomalies in a fashion similar to the Fama–French factors. While the excess credit spread is significant in explaining Fama and French’s size and value effects, adding the Fama–French factors does not improve the performance of our model. Our revised model resembles conditional CAPM, but it offers a more intuitive explanation for the size and value effects.     

International stock return predictability under model uncertainty

This paper examines return predictability when the investor is uncertain about the right state variables. A novel feature of the model averaging approach used in this paper is to account for finite-sample bias of the coefficients in the predictive regressions. Drawing on an extensive international dataset, we find that interest-rate related variables are usually among the most prominent predictive variables, whereas valuation ratios perform rather poorly. Yet, predictability of market excess returns weakens substantially, once model uncertainty is accounted for. We document notable differences in the degree of in-sample and out-of-sample predictability across different stock markets. Overall, these findings suggest that return predictability is neither a uniform, nor a universal feature across international capital markets.     

Pricing American interest rate options under the jump-extended constant-elasticity-of-variance short rate models

This paper demonstrates how to value American interest rate options under the jump-extended constant-elasticity-of-variance (CEV) models. We consider both exponential jumps (see Duffie et al., 2000) and lognormal jumps (see Johannes, 2004) in the short rate process. We show how to superimpose recombining multinomial jump trees on the diffusion trees, creating mixed jump-diffusion trees for the CEV models of short rate extended with exponential and lognormal jumps. Our simulations for the special case of jump-extended Cox, Ingersoll, and Ross (CIR) square root model show a significant computational advantage over the Longstaff and Schwartz’s (2001) least-squares regression method (LSM) for pricing American options on zero-coupon bonds.