Working Paper: CEPR ID: DP3145
Authors: Magnus Dahlquist; Torbjrn Sllstrm
Abstract: This Paper assesses the ability of international asset pricing models to explain the cross-sectional variation in expected returns. All the models considered seem to capture national market returns fairly well. Global portfolios sorted on earnings-price ratio and market value, however, pose a special challenge. We find that an unconditional inter national CAPM cannot explain the cross-sectional variation in these portfolio returns. Interestingly, a conditional international asset-pricing model that includes foreign exchange risk factors is able to explain a large part of the variation in average returns. Our empirical work suggests that this model has the same explanatory ability as an inter national three-factor model, where zero-cost portfolios based on earnings-price ratios and market values are used in addition to the world market portfolio. Importantly, the loadings associated with the zero-cost portfolios are driven out by the characteristics themselves, indicating a misspecification.
Keywords: characteristics; conditional; information; foreign exchange risk; HML; SMB; world CAPM
JEL Codes: F31; G12; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| unconditional international CAPM (F29) | cross-sectional variation in portfolio returns (G11) |
| conditional international asset pricing model (including foreign exchange risk factors) (G15) | cross-sectional variation in portfolio returns (G11) |
| foreign exchange risk factors (F31) | explanatory power of the conditional international asset pricing model (G15) |
| characteristics (earnings-price ratios and market values) (G12) | cross-sectional variation in portfolio returns (G11) |
| characteristics (earnings-price ratios and market values) (G12) | loadings associated with zerocost portfolios (G19) |