Market incompleteness and the equity premium puzzle: Evidence from state-level data

This paper investigates the importance of market incompleteness by comparing the rates of risk aversion estimated from complete and incomplete markets environments. For the incomplete-markets case, we use consumption data for the 50 US states. We find that the rate of risk aversion under the incomplete-markets setup is much lower. Furthermore, including the second and third moments of the cross-sectional distribution of consumption growth in the pricing kernel lowers the estimate of risk aversion. These findings suggest that market incompleteness ought to be seen as an important component of solutions to the equity premium puzzle.     

The evolution of risk premium as a measure for intra-regional equity market integration

We estimate and test the conditional version of an international capital asset pricing model using a parsimonious multivariate GARCH process and the multivariate nonlinear least squares method. Since our approaches are fully parametric, we can recover any quantity that is a function of the first two conditional moments. Our findings strongly support using a model that includes both regional market and foreign exchange risk. However, both sources of risk are detected only when their prices are allowed to change over time. Our empirical results show clear evidence of market integration to varying degrees, explained by the US term premium and the level of market openness. Though it reaches high values during turmoil periods and exhibits an upward trend toward the end of the estimation period, the Indonesian stock market remains partially integrated into the ASEAN-5 regional market. These results suggest that diversification into Indonesian market assets continues to produce substantial profits and that asset pricing rules should reflect a state of partial integration.     

Skewness-based market integration: A systemic risk measure across international equity markets

This study develops a novel skewness-based integration measure to assess systemic risk across international equity markets. We exploit skewness to further consider the tail information of return distribution, thereby extend the return-based integration measure of Pukthuanthong and Roll (2009). The empirical results indicate that the skewness-based integration measure is closely correlated with market crashes, Value-at-Risk, and leading indicators of equity markets. Moreover, the skewness-based integration measure improves the information content of systemic risk relative to the return-based integration measure, implying that tail information plays an indispensable role in early warning of systemic risk.     

Testing for international equity market integration using regime switching cointegration techniques

Using MSCI total return index data, this paper analyses the degree of international equity market integration using modern cointegration techniques. The existence of a long run equilibrium across equity markets is important since it implies a violation of weak form market efficiency. Short run deviations away from equilibrium can be expected to reverse, thereby implying a degree of market predictability. This analysis adds to the existing literature by considering a regime switching cointegration relationship that allows for multiple structural breaks over time. The analysis provides scant evidence in favour of market integration with a single regime treatment. There is, however, significant evidence to support a two-regime Markov switching long-run equilibrium relationship that has evolved since the 1970s.     

Disappointment aversion and the equity premium puzzle: new international evidence

Drawing upon the seminal study of Ang, Bekaert, and Liu [2005. “Why Stock May Disappoint?” Journal of Financial Economics 76 (3): 471–508], we incorporate disappointment aversion (DA, that is, aversion to outcomes that are worse than prior expectations) within a simple theoretical portfolio-choice model. Based on the results of this model, we then empirically address the portfolio allocation problem of an investor who chooses between a risky and a risk-free asset using international data from 19 countries. Our findings strongly support the view that DA leads investors to reduce their exposure to the stock market (i.e. DA significantly depresses the portfolio weights on equities in all cases considered). Overall, our study shows that in addition to risk aversion, DA plays an important role in explaining the equity premium puzzle around the world.     

The dynamics of international equity market expectations

This paper develops a noisy rational expectations model of the way in which international investors adjust their expectations of asset payoffs in a given country in response not only to public information signals but also to private information signals whose precision differs across investors. The model predicts that the perceptions of investors in one country about the future market returns in another country are related differently to realized past returns depending on their informational disadvantage relative to other investors: the greater is that informational disadvantage, the greater is the change in perception associated with returns. The predictions are confirmed by monthly survey data of institutional money managers investing in developed markets from 1995 to 2000.     

Networks and equity market integration: European evidence

Deregulation, globalization, and technological developments have altered the business strategies of stock exchanges around the world. We investigate whether the adoption of network strategies by stock exchanges creates additional value in the provision of trading services. Using unbalanced panel data from all major European exchanges over the period 1996-2000, we examine the consequences of network cooperation on a number of stock market performance measures. We show that adopting a network strategy is associated with higher market capitalization, lower transaction costs, higher growth, and enhanced international stock market integration.     

The equity premium: A puzzle

Restrictions that a class of general equilibrium models place upon the average returns of equity and Treasury bills are found to be strongly violated by the U.S. data in the 1889–1978 period. This result is robust to model specification and measurement problems. We conclude that, most likely, an equilibrium model which is not an Arrow-Debreu economy will be the one that simultaneously rationalizes both historically observed large average equity return and the small average risk-free return.     

Financial market development and the importance of internal cash: Evidence from international data

We examine the impact of financial market development on the extent to which firms have to rely on internal capital for making investments. Using international data from 31 countries for the 1987–1997 period, we find evidence of a negative relationship between financial market development and the importance of internal capital. The evidence is consistent across different estimation procedures, alternative measures of financial constraints and cash flow, and the use of bootstrapped standard errors. Finally, we find that the distortionary effect of negative cash flow observations reported earlier for US data extends to international data as well.     

Inequality,stock market participation,and the equity premium

The last 30 years saw substantial increases in wealth inequality and stock market participation, smaller increases in consumption inequality and the fraction of indebted households, a decline in interest rates and the expected equity premium, as well as a prolonged stock market boom. In an incomplete markets, overlapping generations model I jointly explain these trends by the observed rise in wage inequality, decrease in participation costs, and loosening of borrowing constraints. After accounting for these changes, I show that the stock market played a major role in increasing wealth inequality. Crucially, these phenomena must be considered jointly; studying one independently leads to counterfactual predictions about others.     

The macroeconomic content of international equity market factors

Although existing research has examined the association between macroeconomic data and particular equity markets, little is known regarding the economic content of the latent factors common to international equity markets. This paper considers the macroeconomic information incorporated in unobserved common equity market factors, as well as the possibility that the macroeconomic sensitivities of the factors differ across alternative levels of volatility. Several models are estimated for 15 developed equity markets to examine the economic composition of the common factors, thereby providing an alternative perspective on the economic fundamentals underlying equity markets. A formal Bayesian selection process suggests that a common structure incorporating global and European factors is preferred to the baseline case of a single global factor or the extended scenario of dual global factors. The common factors are associated with a small set of macroeconomic variables.     

Herd behavior and equity market liquidity: Evidence from major markets

This paper provides new evidence on the relation between herd behavior and equity market liquidity, an issue that has been neglected when it comes to studying herd behavior towards the consensus. We use equity price data for the G5 markets, and initially find no evidence of herding. When, however, we condition on the liquidity of stocks we find significant evidence of herd behavior for high liquidity stocks, for most countries, a result robust to different definitions of the crisis period and different measures of liquidity. The only exception is Germany for which there is weaker evidence of herding in high liquidity stocks. Variance decomposition tests indicate that the variance of the average equity market liquidity is affected by return clustering, especially during the crisis and post-crisis period an effect that is more pronounced for the US market.     

Volatility risk and the value premium: Evidence from the French stock market

This paper documents that systematic volatility risk is an important factor that drives the value premium observed in the French stock market. Using returns on at-the-money straddles written on the CAC 40 index as a proxy for systematic volatility risk, I document significant differences between volatility factor loadings of value and growth stocks. Furthermore, when markets are classified into expected booms and recessions, volatility factor loadings are also time-varying. When expected market risk premium is above its average, i.e. during expected recessions, value stocks are seen riskier than their growth counterparts. This implies in bad times, investors shift their preferences away from value firms. Instead they use growth stocks as hedges against deteriorations in their wealth during those times. The findings are in line with the predictions of rational asset pricing theory and support a “flight-to-quality” explanation.     

The equity premium: a deeper puzzle

Traditional pre-1929 consumption measures understate the extent of serial correlation in the US annual real growth rate of per capita consumption of non-durables and services due to measurement limitations in the construction of their major components. Under alternative measures proposed in this study, the serial correlation of consumption growth is \(0.42\) for the \(1899\) – \(2012\) , contrary to the estimate of \(-0.15\) under the traditional measures. This new evidence implies that the class of economies studied by Mehra and Prescott (J Monet Econ 15(2):145–161, 1985) generates a negative equity premium for reasonable risk aversion levels, thus, further exacerbating the equity premium puzzle.     

The long-run equity risk premium

Based on a survey of US Chief Financial Officers (CFOs), we present expectations of the equity risk premium measured over a 10-year horizon relative to a 10-year US Treasury bond. This multi-year survey has been conducted each quarter from June 2000 to June 2005. Each quarter the survey also provides measures of cross-sectional disagreement about the risk premium, skewness, and a measure of individual uncertainty. The individual uncertainty is deduced from the 80% confidence interval that each respondent provides for his or her risk premium assessment. We also present evidence on the determinants of the long-run risk premium. Our analysis suggests there is a positive correlation between the ex ante risk premium and real interest rates as reflected in Treasury Inflation Indexed Notes.     

Barriers to international investing and market segmentation: Evidence from Indian GDR market

In this paper we evaluate market segmentation and its effect on the pricing of cross-listed securities using Indian Global Depositary Receipts (GDRs). When international capital markets are segmented, cross-listed securities may trade at different prices. We test this market segmentation hypothesis using a theoretical and empirical model developed along the lines of Hietala [Hietala, P.T., 1989, Asset pricing in partially segmented markets: Evidence from the Finnish market, Journal of Finance 44, 697–718]) and Foerster and Karolyi [Foerster, S.R., Karolyi, A.G., 1999, The effects of market segmentation and investor recognition on asset prices: Evidence from foreign stocks listing in the United States, Journal of Finance 54, 981–1013; Foerster, S.R., Karolyi, A.G., 1999, The long-run performance of global equity offerings, Working Paper, Ohio State University]. Our model looks at a specific type of market segmentation in India, where capital flow barriers are such that domestic investors are allowed to invest only in domestic securities, while the foreign investors can invest in dollar-denominated Indian GDRs as well as other foreign securities. Tests on these GDRs indicate that foreign investors, who hold these depositary receipts, estimate the expected returns at a lower level than the domestic investors do. This leads to the GDRs being priced at a premium over the exchange rate adjusted prices of the underlying Indian securities. GDR index returns are affected by both domestic and international factors, while the underlying Indian securities are affected only by domestic variables.     

International equity market integration: Theory, evidence and implications

We survey the literature on international equity market integration. In doing so, we examine the theory of integration, the burgeoning literature on empirical evidence, and the implications. It is clear from our review that significant methodological advances in recent years have provided a new perspective on the degree of such integration. Among the most important implications of the rapidly amassing evidence of substantial integration among both the developed and the emerging markets is the need for international investors to carefully monitor the risk associated with varying benefits of diversification.     

The growth in equity market size and trading activity: An international study

This paper presents new evidence on the role of macroeconomic and institutional factors in equity market development and on the sources of equity market growth. Using panel data on 33 countries, I find that development of financial intermediaries and trade openness are positively associated with equity market size, and that development of financial intermediaries is also positively associated with the level of activity in equity markets. Government consumption is negatively associated with equity market activity. I construct a direct estimate of the effect of institutional factors on equity market development that compares a country's actual level of development to a hypothetical “best-practice” country having the same macroeconomic fundamentals as the original country. I show that the level of equity market development of an average country is around 30% below its maximum potential. There are wide differences in institutional characteristics across countries and over time, and Canada, the United States, and Singapore possess the most shareholder-friendly institutional frameworks that foster larger and more active equity markets. It appears that institutional improvements and changes in financial technology have provided the major impetus for the phenomenal expansion of global equity markets.     

Predicting international equity returns: Evidence from time-varying parameter vector autoregressive models

In this paper, we forecast monthly stock returns of eight advanced economies using a time-varying parameter vector autoregressive model (TVP-VAR) with mixture innovations. Compared to standard TVP-VARs, our proposed model automatically detects whether time-variation in the parameters is needed through the introduction of a latent process. This framework is capable of dynamically detecting whether a given regression coefficient is constant or time-varying during distinct time periods. We moreover compare the performance of this model with a wide range of nested alternative time-varying and constant parameter VAR models. Our results indicate that our proposed framework outperforms its competitors in terms of point and density forecasts. A portfolio allocation exercise confirms the superiority of our proposed model. In addition, a copula-based analysis shows that it pays off to adopt a multivariate modeling framework during periods of stress, like the recent financial crisis.