International asset pricing with time-varying risk premia

Recent empirical evidence that forward exchange rates are biased predictors of future spot rates can also be interpreted as evidence against the hypothesis of a constant risk premium. Consequently, reconciliation of this evidence with efficient international capital markets requires the existence of time-varying risk premia. This paper modifies Kouri's (1977) asset pricing model to allow time-varying exected returns on assets, eliminates the assumption of a risk-free real asset and derives the characteristics of the risk premia in the forward market as well as the equilibrium yield relationships among the equities and riskless nominal bonds of all countries.     

The cross-section of returns in frontier equity markets: Integrated or segmented pricing?

Is asset pricing segmented or integrated in frontier equity markets? To answer this question, we examine the returns on more than 4500 stocks from 22 frontier countries for the years 1997–2018. We evaluate the performance of a few major asset pricing models. We document strong value and momentum effects but find no consistent evidence regarding size, investment, and profitability premia. The recent six-factor model of Fama and French (2018) outperforms other models and best explains the cross-sectional and time-series variation in returns. Our results point to low integration of frontier equities, even after the global financial crisis. Local risk factors explain the behavior of prices much better than their global counterparts do. The low correlation of these risk factors allows augmenting the efficient frontier of an international investor.     

Counter‐Credit‐Risk Yield Spreads: A Puzzle in China's Corporate Bond Market

In this paper, using China's risk‐free and corporate zero yields together with aggregate credit risk measures and various control variables from 2006 to 2013, we document a puzzle of counter‐credit‐risk corporate yield spreads. We interpret this puzzle as a symptom of the immaturity of China's credit bond market, which reveals a distorted pricing mechanism latent in the fundamental of this market. We also find interesting results about relationships between corporate yield spreads and interest rates and risk premia and the stock index, and these results are somewhat attributed to this puzzle.     

Organization Capital and Expected Returns in Service and Non‐Service Firms: Evidence from Thailand

Organization capital provides firms with competitive advantage, but because of its intangible and movable nature, investors view firms with high organization capital as risker and demand additional risk premia. Similar to Eisfeldt and Papanikolaou (2013), we find that firms in the Stock Exchange of Thailand with highest organization capital earn abnormal returns of 0.75% per month relative to the four‐factor asset pricing model. In addition, we also document that the organization capital risk premium is more relevant for service firms than non‐service ones.     

Liability driven investment with alternative assets: Evidence from Brazil

We study the portfolio choice problem for an asset-liability investor who invests in stocks, equity mutual funds, government bonds, short term interest, hedge funds, listed real estate, and commodities futures available in Brazil. Inflation and real interest play as important risk sources. We estimate the asset classes and liabilities time-varying conditional covariance structure using an asymmetric multivariate dynamic conditional correlation GARCH model and compare the asset-liability portfolio's global minimum variance allocation with Brazilian pension funds' market portfolio. The conditional covariance structure provides insights about the complex dynamic relationships between the asset classes and liabilities. We find that some (though not all) Brazilian alternative assets render strong diversification and liabilities hedging benefits for asset-liability investors. There are significant strategic asset allocation differences between the market portfolio and the liability driven portfolio as given by our model. We, therefore, question the Brazilian pension funds' allocation.     

Does home bias affect firm value? Evidence from holdings of mutual funds worldwide

This study finds strong evidence that home bias affects firm valuation at both country and firm levels. At the country level, increasing the bias of domestic investors toward home equity lowers the market valuation of home equity. At the firm level, firm value increases as the compositions of local equities held by domestic and foreign investors tend toward the firms' global market capitalization weights, but decreases as their weights deviate from global weights. Overall, the evidence is consistent with the optimal global risk-sharing hypothesis that the greater risk sharing between domestic and foreign investors in international capital markets reduces the cost of capital and hence enhances market valuation.     

Indian equity options: Smile,risk premiums,and efficiency

We study the pricing of equity options in India which is one of the world's largest options markets. Our findings are supportive of market efficiency: A parsimonious smile-adjusted Black model fits option prices well, and the implied volatility (IV) has incremental predictive power for future volatility. However, the risk premium embedded in IV for Single Stock Options appears to be higher than in other markets. The study suggests that even a very liquid market with substantial participation of global institutional investors can have structural features that lead to systematic departures from the behavior of a fully rational market while being “microefficient.”     

Exchange rate regimes, globalisation, and the cost of capital in emerging markets

This paper presents a multifactor asset pricing model for currency, bond, and stock returns for ten emerging markets to investigate the effect of the exchange rate regime on the cost of capital and the integration of emerging financial markets. Our results suggest that a fixed exchange rate regime system can help reduce the cost of capital in emerging markets by reducing the currency risk premia demanded by foreign investors.     

Can commodity futures risk factors predict economic growth?

This paper examines whether commodity futures risk factors can predict future economic growth. We test risk factors capturing various spot or term premia and find that only three factors capturing term premia on the basis-momentum, basis, and change in slope are robust predictors for future economic growth, especially for long horizons. Our findings highlight the importance of the term premia, rather than the spot premia on which the literature has mainly focused. Moreover, we find that possible explanations for predictability of commodity factors—the intertemporal asset pricing model and information diffusion explanation—are all inconsistent with our empirical results.     

International capital flows,returns and world financial integration

International capital flows have increased dramatically since the 1980s, with much of the increase being due to trade in equity and bond markets. Such developments are often attributed to the increased integration of world financial markets. We present a model that allows us to examine how greater integration in world financial markets affects the behavior of international capital flows and financial returns. Our model predicts that international capital flows are large (in absolute value) and very volatile during the early stages of financial integration when international asset trading is concentrated in bonds. As integration progresses and households gain access to world equity markets, the size and volatility of international bond flows decline. This is the natural outcome of greater risk sharing facilitated by increased integration. This pattern is consistent with declining volatility observed during 1975–2007 period in the G-7 countries. We also find that the equilibrium flows in bonds and stocks predicted by the model are larger than their empirical counterparts, and are largely driven by variations in equity risk premia. The model also predicts that volatility of equity and bond returns decline with integration, again consistent with the data for G-7 economies.     

Are the East Asian markets integrated? Evidence from the ICAPM

We test a conditional international asset pricing model with both world market and domestic risk included as independent pricing factors for five East Asian markets, the US and World markets. We model second moments and risk exposures using a bi-diagonal multivariate GARCH(1,1) process. We document that this novel GARCH specification provides a significantly better fit of the return process than a standard diagonal specification. Although exposure to world market risk carries a significant premium across all markets, we find little support for the hypothesis that exposure to residual country risk is rewarded. However, residual country returns are significantly related to exchange rate changes. Hence, we find surprisingly little evidence of market segmentation in East Asia over the period 1985–1998.     

General equilibrium pricing of nonredundant forward contracts

We derive the general equilibrium of a dynamic financial market in which the investors' opportunity set includes nonredundant forward contracts. We show that Breeden's (1979) consumption‐based CAPM equation for forward contracts contains an extra term relative to that for cash assets. We name this term a strategy risk premium. It compensates investors for the (systematic) risk that stems from their very portfolio strategies when the latter involve nonredundant forward contracts. We also show that Merton's (1973) multibeta intertemporal CAPM must be amended for forward contracts to exhibit adjusted risk premia for the market portfolio and all relevant state variables, as opposed to the usual risk premia for cash assets. Our results are shown not to depend on the usual cash‐and‐carry relationship, which, in general, does not hold. We, nevertheless, provide a well‐known special case where it does hold, albeit not grounded on the usual no‐arbitrage argument. © 2003 Wiley Periodicals, Inc. Jrl Fut Mark 23:817–840, 2003     

Dividend policy and capital structure of a defaultable firm

Default risk significantly affects the corporate policies of a firm. We develop a model in which a limited liability entity subject to default at an exponential random time jointly sets its dividend policy and capital structure to maximize the expected lifetime utility from consumption of risk‐averse equity investors. We give a complete characterization of the solution to the singular stochastic control problem. The optimal policy involves paying dividends to keep the ratio of firm's equity value to investors' wealth below a critical threshold. Dividend payout acts as a precautionary channel to transfer wealth from the firm to investors for mitigation of losses in the event of default. Higher the default risk, more aggressively the firm leverages and pays dividends.     

Excess Risk Premia of Asian Banks

This paper develops a framework for gauging the risks of emerging market banks by using stock market data. Employing a multifactor asset pricing model that allows for time‐varying risk premia, we find the presence of large excess risk premia on Asian bank stocks, especially in those markets affected by the Asian financial crisis. We find that the excess risk premia appear to be negatively related to the degree of economic freedom of a country but positively related to its corruption level. Thus, our findings are consistent with the view that crony capitalism in Asia may have distorted the market mechanism or the systematic risk exposure of banks. This suggests that the excess risk premium provides useful information on risk exposure for opaque banking systems where quality accounting information is not available.     

Systematic risk in emerging markets: the D-CAPM

There is by now a growing literature arguing against the use of the CAPM to estimate required returns on equity in emerging markets (EMs). One of the characteristics of this model is that it measures risk by beta, which follows from an equilibrium in which investors display mean–variance behavior. In that framework, risk is assessed by the variance of returns, a questionable and restrictive measure of risk. The semivariance of returns is a more plausible measure of risk and can be used to generate an alternative behavioral hypothesis (mean–semivariance behavior), an alternative measure of risk for diversified investors (the downside beta), and an alternative pricing model (the downside CAPM, or D-CAPM for short). The empirical evidence discussed below for the entire Morgan Stanley Capital Indices database of EMs clearly supports the downside beta and the D-CAPM over beta and the CAPM.     

Put Your Money Where Your Mouth Is: A Model of Certification with Informed Finance

We consider how funding from informed investors such as banks certifies the quality of the recipient firms to investors uninformed of it. We show that informed finance leads to full separation of firms’ quality types, with a larger quantity of it certifying a better quality. Moreover, the increase in the market value of the recipient firm is a convex, increasing function of the quantity of informed finance that it obtains. Lastly, firms with attribute X derive a greater value from the certification service of informed finance than those without it if the distribution of firms’ quality conditional on X is second‐order stochastically dominated by that conditional on its absence. The informed finance could be commercial bank loans or the purchase of a firm's equity preceding its IPO by renowned investment banks.     

Foreign Direct Investment in Sub-Saharan Africa: Motivating Factors and Policy Issues

Sub-Saharan Africa's (SSA) foreign direct investment (FDI) share has persistently averaged 1% of global flows. The location decision and perceptions of investors are therefore instructive for policy making. This article factor analyses a survey of perceptions, operations, and motivations of 758 foreign investors in 10 SSA countries. We find that the provision of transaction cost–reducing information on industries and markets and utility services to investors before and after a firm's FDI decision are significant factors. FDI location decision in SSA is influenced strongly by political economy considerations. Labor and production input variables are not influential.     

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.     

China's segmented stock market: An application of the conditional international capital asset pricing model

China's segmented stock market provides an opportunity to study conditional international asset pricing from multiple viewpoints—domestic and foreign. We use the multivariate GARCH-M framework of De Santis and Gérard [De Santis, G., and Gérard, B., 1998. How big is the premium for currency risk? Journal of Financial Economics 49, pp. 375–412.], but add conditional local specific risk and find global, local, and currency risk to be priced and time-varying in Chinese markets, suggesting mild segmentation for developing country markets. The time-varying price of currency risk indicates that the strict currency restrictions in China do not sufficiently reduce currency risk to stabilize the price of currency risk. We also find that the price of local risk in the Chinese A stock market is non-time-varying relative to the developed market, but time-varying relative to the emerging market. This finding implies that the Chinese A stock market is more comparable to a developed market than an emerging market. However, results on Chinese B shares show the opposite relationship: from a foreign investor's perspective, Chinese B shares are better categorized as being emerging than developed. This is further supported by an Engle–Granger cointegration test.