Chapter 23

International Asset Pricing

23.1 23.2 23.3 23.4 23.5 23.6 23.7 The Traditional Capital Asset Pricing Model (CAPM) The International Asset Pricing Model (IAPM) Rolls Critique Factor Models and Arbitrage Pricing Theory (APT) Applications of Arbitrage Pricing Theory The Currency Risk Factor in Stock Returns Currency Risk Exposure and MNC Hedging Activities 23.8 Summary
Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 23-1

On asset pricing and market efficiency...

It is the theory that decides what can be observed. Albert Einstein

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e

23-2

The traditional capital asset pricing model (CAPM)

Perfect financial markets Frictionless markets Rational investors have equal access to costless information and market prices Homogeneous expectations Everyone can borrow and lend at the riskless rate of interest RF

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e

23-3

The CAPM capital market line

Expected return E[Rj] Capital market line Market portfolio E[RM]
M

Efficient frontier

Investment opportunity set

RF

M Standard deviation of return

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 23-4

The CAPM security market line

Expected return E[Ri]
E[RM]

Security market line

Ri = RF + i (E[RM] - RF)

RF 0 1.0 Systematic risk (beta i)

23-5

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e

The International Asset Pricing Model (IAPM)

In addition to the CAPM assumptions, suppose
Investors in each country have the same consumption basket Purchasing power parity holds

This leads to an international version of the CAPM

The market portfolio includes all assets in the world weighted according to their market values Investors also hold a hedge portfolio of domestic and foreign bonds
as a store of value (that is, as a riskfree asset) to hedge the currency risk of the market portfolio

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e

23-6

Integrated vs segmented capital markets

Integrated financial markets
There are no barriers to financial flows and purchasing power parity holds across equivalent assets wherever they are traded.

Segmented financial markets

Prices are set independently in each national market.

Real-world financial markets fall somewhere between these two extremes.

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e

23-7

Rolls critique of the CAPM

If performance is measured relative to an ex post efficient index, then all securities will lie along the security market line. If performance is measured relative to an ex post inefficient index, then any ranking of portfolio performance is possible depending on the inefficient index chosen.

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e

23-8

Rolls critique of the CAPM

Because of home asset bias, investors do not hold the world market portfolio.
Consequently, market beta may be of little use in measuring risk in a globally diversified portfolio.

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e

23-9

Arbitrage pricing theory (APT)

Rj = mj + 1jF1 + ... + KjFK + ej

(23.5)

where Rj = the random rate of return on asset j mj = the mean or expected return on asset j kj = the sensitivity of asset j to factor k where k=1,...,K Fk = systematic risk factor k ej = a random error term

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e

23-10

The one-factor market model

One-factor market model

Rj = aj + jRM + ej

(23.6)

Subtracting asset js mean return mj = aj + j mM from both sides of (23.6) yields a one-factor market model in excess return form.

Rj = mj + jFM + ej

(23.7)

where FM = (RM - mM)

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e

23-11

Beta as a regression coefficient

Rj = aj + jRM + ej

Rj - mj = j FM + ej
where FM = RM - mM

Rj mj aj mM

Rj -mj

j RM -mM

RM

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e

23-12

The relative importance of industry, national and international factors

Rj = mM + CjFCj + IjFIj + ej
where Rj = local currency excess return to stock j mM = return to the global market factor FCj = return to stock js country factor and FIj = return to stock js industry factor

(23.9)

Beckers, Connor and Curds, National versus Global Influences on Equity Returns, Financial Analysts Journal 52, March/April 1996.

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e

23-13

The relative importance of industry, national and international factors

Average EP (explanatory power) statistics
Global factor alone 0.2107 Global & national stock market factors 0.3620 Global & industry factors 0.2537 Global, industry, & national stock market factors 0.3970

Global and national stock market factors play important roles in explaining stock return variability. The exposure of stocks to industry factors is low.
23-14

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e

Exposure to currency risk

Importers Rd Exporters

sd/f

Rd = md + f sd/f + ed
Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 23-15

The diversifiability of currency risk exposure

U.S. exporters risk profile V$/SFr
+

Swiss importers risk profile V$/SFr

Risk profile of combined position V$/SFr

S$/SFr

S$/SFr

S$/SFr

SFr100,000 -SFr100,000

SFr100,000 -SFr100,000

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e

23-16

APT factors

Chen, Roll and Ross identify five APT factors:* Rj = mj + 1jF1 + 2jF2 + 3jF3 + 4jF4 + 5jF5 +ej
Fj: F2 : F3 : F4 : F5 : industrial production risk premia (corporate - government bond yield) term premia (long-term government - T-bill yield) expected inflation unexpected inflation

When the market return is included as a sixth factor, its coefficient is not significant.
Nai-Fu Chen, Richard Roll, and Stephen A. Ross, Economic Forces and the Stock Market, Journal of Business, July 1986.
23-17

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e

Does currency risk matter in U.S. markets?

Jorion

added a currency risk factor to the one-factor market model and the five-factor model of Chen, Roll and Ross?* Rjd = mjd + 1j (RMd - mMd) + 2jf sd/f + ejd Rjd = mjd + 1jF1d + 2jF12d + ... + 5jF5d + 6jfsd/f + ejd
(23.13) (23.14)

In actively traded U.S. markets, the currency risk factor is subsumed into the other factors. Nevertheless, there is considerable cross-sectional variation among U.S.-based MNCs.
*

Philippe Jorion, The Pricing of Exchange Rate Risk in the Stock Market, Journal of Financial and Quantitative Analysis, September 1991.
23-18

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e

Does currency risk matter in non-U.S. markets?

De

Santis and Grard estimated a conditional version of a two-factor (market and currency risk) model.*
Conditional asset pricing models allow risks (ie., currency and market risks) to vary over time. Different national markets had different exposures to currency risks.

Currency risk was a small fraction of total risk in the United States Currency risk was a significant percentage of total risk in Germany, Japan, and the United Kingdom
*

Giorgio De Santis and Bruno Grard, How Big is the Premium for Currency Risk, Journal of Financial Economics 49, September 1998.
23-19

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e

The value premium and the size effect

Fama and French fit a three-factor model:*

Rj = mj + j (RM - mM) + Zj FSize + Dj FDistress + ej

Market factor (RM-mM) = excess return on the market Firm size FSize = the difference in mean return between
the smallest 10% and the largest 10% of firms.

Relative financial distress FDistress = the difference in

mean return between value stocks (high equity book-tomarket ratios) and growth stocks (low equity book-tomarket ratios)
*

Eugene F. Fama and Kenneth R. French, The Cross-Section of Expected Stock Returns, Journal of Finance, June 1992.
23-20

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e

The value premium and the size effect

Firm size: Small firms outperformed large firms by an average of 7 percent per year. Relative financial distress: Value stocks (high equity book-to-market stocks) outperformed growth stocks by an average of 12 percent per year. After controlling for size and relative financial distress, the market factor contributed nothing to the explanatory power of the regression.
Eugene F. Fama and Kenneth R. French, The Cross-Section of Expected Stock Returns, Journal of Finance, June 1992.
23-21

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e

The value premium in U.S. stocks

Annualized return
25%

Portfolios ranked on book-to-market equity

20%

15%

10%

5%

0% 1 2 3 4 5 6 7 8 9 10

High
Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e

Low
23-22

The international value premium

Fama and French then extended their study to international stocks:* Value (low MV/BV) stocks have higher mean returns than growth (high MV/BV) stocks in 12 of 13 international markets. The difference in mean return is 7.60% per year.

Eugene F. Fama and Kenneth R. French, Value versus Growth: The International Evidence, Journal of Finance 53 (December 1998).
23-23

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e

The international value premium

15%

The Difference in Annual Dollar Returns in Excess of the U.S. T-Bill Rate for Value and Growth Stock Portfolios

10%

5%

0%
Australia United Kingdom Belgium Hong Kong Italy Singapore Germany France Switzerland Japan United States Netherlands Sweden

-5%

-10%

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e

23-24

Momentum strategies

Momentum (or relative strength) strategies selectively buy or sell securities based on their recent price performance. Jegadeesh and Titman categorized stocks into ten equal-sized portfolios according to return over the preceding six months.*

Winners are stocks with the highest six-month returns Losers are stocks with the highest six-month returns
*

Narasimhan Jegadeesh and Sheridan Titman, Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency, Journal of Finance, March 1993.
23-25

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e

Momentum in U.S. stocks

+1.0%

United States
24 12 36

0.0%

-1.0%

Months relative to portfolio formation

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e

23-26

Momentum in international stocks

Rouwenhorst examined momentum in 12 European stock markets:*

Past Winners outperformed Losers by more than 1 percent per month after correcting for risk. Return continuation lasts for about one year, and then is partially reversed.

K. Geert Rouwenhorst, International Momentum Strategies, Journal of Finance, February 1998.

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e

23-27

Momentum in international stocks

(monthly returns to Winner-minus-Loser portfolios)

+1.0%

Europe

0.0%

12

24

-1.0%

Months relative to portfolio formation

23-28

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e

International momentum
(cumulative returns to Winner-minus-Loser portfolios)

15%

Europe United States

10%

5%

0% 0 12 24 36

-5%

Months relative to portfolio formation

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 23-29

Momentum in international stocks

(average monthly returns to Winner-minus-Loser portfolios)
1.5%

1.0%

0.5%

Netherlands

Switzerland

Germany

Denmark

Norway

France

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e

23-30

United Kingdom

Belgium

Austria

Italy

Sweden

Spain

0.0%