Working Paper: CEPR ID: DP2640
Authors: Enrique Sentana
Abstract: We propose a dynamic APT multi-factor model with time-varying volatility for currency, bond and stock returns for ten European countries over the period 1977-1997. We exploit the cross-sectional dimension of the model to construct world portfolios, which, when added to the original list of assets, allow us to develop simple consistent methods of estimation and testing. Our results reject the implicit asset pricing restrictions, and suggest that decreases in idiosyncratic exchange rate risk tend to lower the cost of capital, although the effect is small. Finally, we assess the potential gains from increased stock market integration.
Keywords: currency risk; European monetary union; financial integration; international asset pricing
JEL Codes: F30; G10
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| decreases in idiosyncratic exchange rate risk (F31) | lower costs of capital (G31) |
| reduced exchange rate volatility (F31) | lower risk premiums for equity financing (G32) |
| EMS (through ERM) (H12) | reduce exchange rate volatility (F31) |
| reduce exchange rate volatility (F31) | lower cost of capital for firms relying on equity issuance (G32) |
| credible target zone system (E61) | increase interest rate volatility (E43) |
| local currency appreciation (F31) | higher local currency bond returns (G15) |
| local currency depreciation (F31) | lower local currency stock returns (G15) |
| reductions in exchange rate volatility (F31) | lower riskless component of the cost of capital (G32) |