Working Paper: CEPR ID: DP3034
Authors: Ravi Bansal; Magnus Dahlquist
Abstract: Standard asset pricing models have difficulty explaining cross-sectional differences in observed equity risk premia of developed and emerging markets. We argue that national equity returns are subject to sample selectivity and peso biases. The lack of credible commitment to keep capital markets open (risk of expropriation) leads to these biases. We develop a general equilibrium model for systematic risk (related to market risk and volatility risk) and sample selectivity. We find that after taking account of the sample selectivity bias, our model of systematic risk can account for the differences in risk premia quite well. We estimate the average expropriation risk to be about two-thirds of the ex-post risk premium for emerging economies and close to zero for developed economies. Further, we argue that the measured selectivity bias in equity premia provide valuable economic information regarding the incentives for sovereigns not to expropriate international investors. We find that the measured expropriation risk is related to reputations in capital markets (as argued in Eaton and Gersowitz, 1981) and to the magnitude of trade that an economy conducts (as argued in Bulow and Rogoff, 1989a, 1989b).
Keywords: Credibility; Dynamic General Equilibrium Model; International CAPM; Peso Problems; Sample Selectivity
JEL Codes: F31; F34; G12; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| national equity returns (G12) | systematic risk (G12) |
| selectivity bias (C24) | systematic risk (G12) |
| expropriation risk (H13) | ex-post risk premium for emerging economies (F31) |
| selectivity bias in equity premia (G41) | sovereign incentives not to expropriate international investors (F23) |
| better reputations in capital markets (G24) | lower expropriation risks (H13) |
| higher trade volumes (F10) | lower expropriation premia (H13) |
| selectivity premium (G19) | average risk premium in emerging markets (G15) |
| systematic risk (G12) | equity risk premia in developed markets (G12) |
| selectivity effects (C24) | cross-sectional variation in risk premia (G40) |