International Asset Pricing and the Reward to Macroeconomic Risk

Third essay, Ph. D. Thesis, Lund Economic Studies 99, Lund University, 2002. [Back]

Abstract: The main purpose of the paper is to identify macroeconomic and non-macroeconomic factors driving stock returns both across countries and over time. The paper estimates a conditional version of the APT by Ross (1976) developed by King, Sentana and Wadhwani (1994) simultaneously for 16 OECD national stock markets and 14 observable macroeconomic variables for the time period 1970-1999. A latent factor technique is used to extract a smaller number of factors relevant for asset pricing purposes from observable macroeconomic variables and the stock returns. In particular, we focus on the ability of the model to account for time-series and cross-sectional properties of risk-premiums. An understanding of the underlying economic forces that determine expected returns is of fundamental and immediate interest for international portfolio selection and diversification. For example, our analysis could be used to discuss why expected returns differ between countries. We find that a non-macroeconomic factor interpreted as an international stock market factor and a macroeconomic factor interpreted as an US-dollar exchange rate factor contributes positively to the risk-premiums for all stock markets. The average contributions over time and across countries from these factors are 5.48% per year and 1.13% per year, respectively. A macroeconomic factor interpreted as an international inflation factor is an important determinant of risk-premiums in many (but not all) countries, with an average contribution of 2.38% per year. A macroeconomic factor related to the slope of the US yield curve factor systematically contributes negatively to the risk-premiums, -3.44% per year on average. Boudoukh, Richardson and Smith (1993) find that for the US, negative expected returns are associated with high expected inflation and a downward sloping yield curve. Interestingly, this factor seems to be closely related to periods of a downward sloping US yield curve. The average contribution from macroeconomic factors across countries is only 0.99% per year, while the average contribution from non-macroeconomic factors across countries is 6.06% per year. This means that non-macroeconomic factors on average account for about 86% of the total average risk-premium, leaving only about 14% to macroeconomic factors. However, as discussed above an investigation of the contributions from individual macroeconomic factors provides a very different story. Our evidence also suggest that observable macroeconomic variables considered only explain a small portion of excess return variance of international stock returns from the 16 OECD countries, 13.7% on average, while the non-macroeconomic factors together capture 38.7% of return variance.

Keywords: international asset pricing, macroeconomic and non-macroeconomic risk.