Working Paper: NBER ID: w4660
Authors: Campbell R. Harvey; Bruno Solnik; Guofu Thou
Abstract: This paper characterizes the forces that determine time-variation in expected international asset returns. We offer a number of innovations. By using the latent factor technique, we do not have to prespecify the sources of risk. We solve for the latent premiums and characterize their time-variation. We find evidence that the first factor premium resembles the expected return on the world market portfolio. However, the inclusion of this premium alone is not sufficient to explain the conditional variation in the returns. We find evidence of a second factor premium which is related to foreign exchange risk. Our sample includes new data on both international industry portfolios and international fixed income portfolios. We find that the two latent factor model performs better in explaining the conditional variation in asset returns than a prespecified two factor model. Finally, we show that differences in the risk loadings are important in accounting for the cross-sectional variation in the international returns.
Keywords: International Asset Pricing; Latent Factors; Expected Returns; Foreign Exchange Risk
JEL Codes: G12; F36
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| first latent factor premium (F16) | expected returns (G17) |
| foreign exchange risk (F31) | expected returns (G17) |
| two latent factor model (C38) | explanation of conditional variation in asset returns (C22) |
| differences in risk loadings (G22) | cross-sectional variation in expected returns (G12) |