Chapter 23 International Asset Pricing. 23.1 The Traditional Capital Asset Pricing Model (CAPM) 23.2 The International Asset Pricing Model (IAPM) 23.3 Roll’s Critique 23.4 Factor Models and Arbitrage Pricing Theory (APT) 23.5 Applications of Arbitrage Pricing Theory
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Chapter 23International Asset Pricing 23.1 The Traditional Capital Asset Pricing Model (CAPM) 23.2 The International Asset Pricing Model (IAPM) 23.3 Roll’s Critique 23.4 Factor Models and Arbitrage Pricing Theory (APT) 23.5 Applications of Arbitrage Pricing Theory 23.6 The Currency Risk Factor in Stock Returns 23.7 Currency Risk Exposure and MNC Hedging Activities 23.8 Summary
On asset pricing and market efficiency... It is the theory that decides what can be observed. Albert Einstein
The traditional capital asset pricing model (CAPM) • Perfect financial markets • Frictionless markets • Rational investors have equal access to costless information and market prices • Homogeneous expectations • Everyone can borrow and lend at the riskless rate of interest RF
The CAPM security market line Expected return E[Ri] Systematic risk (beta bi)
The International Asset Pricing Model (IAPM) In addition to the CAPM assumptions, suppose • Investors in each country have the same consumption basket • Purchasing power parity holds This leads to an international version of the CAPM • The market portfolio includes all assets in the world weighted according to their market values • Investors also hold a hedge portfolio of domestic and foreign bonds • as a store of value (that is, as a riskfree asset) • to hedge the currency risk of the market portfolio
Integrated vs segmented capital markets • Integrated financial markets There are no barriers to financial flows and purchasing power parity holds across equivalent assets wherever they are traded. • Segmented financial markets Prices are set independently in each national market. Real-world financial markets fall somewhere between these two extremes.
Roll’s critique of the CAPM • If performance is measured relative to an ex post efficient index, then all securities will lie along the security market line. • If performance is measured relative to an ex post inefficient index, then any ranking of portfolio performance is possible depending on the inefficient index chosen.
Roll’s critique of the CAPM • Because of home asset bias, investors do not hold the world market portfolio. • Consequently, market beta may be of little use in measuring risk in a globally diversified portfolio.
Arbitrage pricing theory (APT) Rj = mj + b1jF1 + ... + bKjFK + ej(23.5) where Rj = the random rate of return on asset j mj = the mean or expected return on asset j bkj = the sensitivity of asset j to factor k where k=1,...,K Fk = systematic risk factor k ej = a random error term
The one-factor market model • One-factor market model Rj = aj + bjRM + ej(23.6) Subtracting asset j’s mean return mj = aj + bjmM from both sides of (23.6) yields a one-factor market model in excess return form. Rj = mj + bjFM + ej(23.7) where FM = (RM - mM)
Beta as a regression coefficient Rj = aj + bjRM + ejÛ Rj - mj = bj FM + ej where FM = RM-mM
The relative importance of industry, national and international factors Rj = mM + bCjFCj + bIjFIj + ej(23.9) where Rj = local currency excess return to stock j mM = return to the global market factor FCj = return to stock j’s country factor and FIj = return to stock j’s industry factor Beckers, Connor and Curds, “National versus Global Influences on Equity Returns,” Financial Analysts Journal 52, March/April 1996.
The relative importance of industry, national and international factors Average EP (explanatory power) statistics • Global and national stock market factors play important roles in explaining stock return variability. • The exposure of stocks to industry factors is low.
APT factors • Chen, Roll and Ross identify five APT factors:* Rj = mj + b1jF1 + b2jF2 + b3jF3 + b4jF4 + b5jF5 +ej Fj: industrial production F2: risk premia (corporate - government bond yield) F3: term premia (long-term government - T-bill yield) F4: expected inflation F5: unexpected inflation • When the market return is included as a sixth factor, its coefficient is not significant. * Nai-Fu Chen, Richard Roll, and Stephen A. Ross, “Economic Forces and the Stock Market,” Journal of Business, July 1986.
Does currency risk matter in U.S. markets? • Jorion added a currency risk factor to the one-factor market model and the five-factor model of Chen, Roll and Ross?* Rjd = mjd + b1j (RMd-mMd) + b2jf sd/f + ejd(23.13) Rjd = mjd + b1jF1d + b2jF12d + ... + b5jF5d + b6jfsd/f + ejd(23.14) • In actively traded U.S. markets, the currency risk factor is subsumed into the other factors. • Nevertheless, there is considerable cross-sectional variation among U.S.-based MNCs. * Philippe Jorion, “The Pricing of Exchange Rate Risk in the Stock Market,” Journal of Financial and Quantitative Analysis, September 1991.
Does currency risk matter in non-U.S. markets? • De Santis and Gérard estimated a conditional version of a two-factor (market and currency risk) model.* • Conditional asset pricing models allow risks (ie., currency and market risks) to vary over time. • Different national markets had different exposures to currency risks. • Currency risk was a small fraction of total risk in the United States • Currency risk was a significant percentage of total risk in Germany, Japan, and the United Kingdom * Giorgio De Santis and Bruno Gérard, “How Big is the Premium for Currency Risk,” Journal of Financial Economics 49, September 1998.
The value premium and the size effect • Fama and French fit a three-factor model:* Rj = mj + bj (RM - mM) + bZj FSize + bDj FDistress + ej • Market factor(RM-mM) = excess return on the market • Firm sizeFSize= the difference in mean return between the smallest 10% and the largest 10% of firms. • Relative financial distressFDistress= the difference in mean return between value stocks (high equity book-to-market ratios) and growth stocks (low equity book-to-market ratios) * Eugene F. Fama and Kenneth R. French, “The Cross-Section of Expected Stock Returns,” Journal of Finance, June 1992.
The value premium and the size effect • Firm size: Small firms outperformed large firms by an average of 7 percent per year. • Relative financial distress: Value stocks (high equity book-to-market stocks) outperformed growth stocks by an average of 12 percent per year. • After controlling for size and relative financial distress, the market factor contributed nothing to the explanatory power of the regression. * Eugene F. Fama and Kenneth R. French, “The Cross-Section of Expected Stock Returns,” Journal of Finance, June 1992.
The value premium in U.S. stocks Annualized return Portfolios ranked on book-to-market equity High Low
The international value premium • Fama and French then extended their study to international stocks:* • Value (low MV/BV) stocks have higher mean returns than growth (high MV/BV) stocks in 12 of 13 international markets. • The difference in mean return is 7.60% per year. * Eugene F. Fama and Kenneth R. French, “Value versus Growth: The International Evidence,” Journal of Finance 53 (December 1998).
The international value premium The Difference in Annual Dollar Returns in Excess of the U.S. T-Bill Rate for Value and Growth Stock Portfolios
Momentum strategies • Momentum (or relative strength) strategies selectively buy or sell securities based on their recent price performance. • Jegadeesh and Titman categorized stocks into ten equal-sized portfolios according to return over the preceding six months.* • Winners are stocks with the highest six-month returns • Losers are stocks with the highest six-month returns * Narasimhan Jegadeesh and Sheridan Titman, “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency,” Journal of Finance, March 1993.
Momentum in international stocks • Rouwenhorst examined momentum in 12 European stock markets:* • Past Winnersoutperformed Losers by more than 1 percent per month after correcting for risk. • Return continuation lasts for about one year, and then is partially reversed. * K. Geert Rouwenhorst, “International Momentum Strategies,” Journal of Finance, February 1998.
Momentum in international stocks(monthly returns to Winner-minus-Loser portfolios)
International momentum(cumulative returns to Winner-minus-Loser portfolios)
Momentum in international stocks(average monthly returns to Winner-minus-Loser portfolios) 1.5% 1.0% 0.5% 0.0% Italy Spain France Austria Norway Belgium Sweden Kingdom United Denmark Germany Switzerland Netherlands