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American Finance Association

The International Pricing of Risk: An Empirical Investigation of the World Capital Market
Structure
Author(s): B. H. Solnik
Source: The Journal of Finance, Vol. 29, No. 2, Papers and Proceedings of the Thirty-Second
Annual Meeting of the American Finance Association, New York, New York, December 28-30,
1973 (May, 1974), pp. 365-378
Published by: Wiley for the American Finance Association
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SESSION TOPIC: CAPITAL ASSET PRICING MODELS IN AN
INTERNATIONAL CONTEXT
SESSION CHAIRMAN: MICHAEL ADLER*
THE INTERNATIONAL PRICING OF RISK: AN EMPIRICAL
INVESTIGATION OF THE WORLD CAPITAL
MARKET STRUCTURE
B. H. SOLNIK**
I. INTRODUCTION
THE MARKET STRUCTURE of American stock prices is generally believed to
be closely approximated by a single index market model. The Markowitz-
Sharpe market model assumes that the return on any security is a linear
function of the return on the domestic market index.
This paper will attempt to determine the International market structure
of asset prices. It is doubtful that a single world index model would give a
realistic description of the international structure because of the importance
of national factors. Therefore several stochastic price processes will be in-
vestigated and tested. The most realistic description of the international
relations of stock prices seems to be a multi-index specification taking into
account both national and international factors. It will also be shown that
the results of the domestic capital asset pricing model for each country can
be consistent with a single and perfect international market. This study
makes use of theoretical framework developed earlier (see Solnik [20]).
The empirical results use a sample of 299 common stocks of 8 major
European countries and the U.S. The data is described in more detail below.
The paper is organized as follows: The data base to be used is described
in Section II. In Section III the theoretical framework of this study is intro-
duced. This is followed by an empirical examination of two market specifica-
tions of international price behavior.
II. THE DATA
The data base' consists of daily prices and dividend data for 234 common
stocks of eight European countries and 65 American stocks. The time period
covered is from March 1966 to April 1971. The American data was taken
*
Columbia University.
** Assistant Professor of Finance, Stanford University and Visiting Professor of Finance, Centre
d'Enseignement Superieur des Affaires, (France). The research for this paper was supported by a
grant from the Dean Witter Foundation. I am grateful to Robert Litzenberger, Gerald Pogue, and
William Sharpe for their helpful comments on an earlier draft.
1. This data base was generously provided by Eurofinance, a prominent European investment
research firm.
365
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366 The Journal of Finance
from the Standard and Poor's I.S.L. tape of New York Stock Exchange
securities.
The distribution of the sample by country is shown in Table 1. Within each
TABLE 1
SUMMARY OF DATA BASE USED
Number GNP
of Stocks (Billion
Country in Sample Market Index Used Risk Free Rate Used of $)
France 65 I.N.S.E.E. Short term prime bank 164
Italy 30 24 ORE Short term prime bank 99
United Kingdom 40 Financial Times, 31 day treasury notes 141
Industrial
Ordinary
Germany 35 Herstatt Index Short term prime bank 213
Netherlands 24 ANP/CBS Short term prime bank 23
Switzerland 17 Schweizerische Kreditanstalt Short term prime bank 36
Belgium 17 Indice de la Bourse de Short term prime bank 26
Bruxelles
Sweden 6 Jacobson & Ponsbach Short term prime bank 39
United States 65 Standard & Poor's 500 30 day U.S. Government
Stock Composite Index Treasury Bills 974
Japan All Shares, 1st Section Short term prime bank 237
European country, the companies in our sample tend to be the largest in terms
of market value of shares outstanding. The 30 Italian stocks, for example,
comprise about three-fourths of the market value of all listed Italian shares.
For the United Kingdom, France and Germany, the number is not as high
but still in excess of 50 percent in each case. Fifty of the 65 American stocks
were randomly selected from the population of all NYSE stocks in existence
as of March 1966. The remainder of the sample was composed of 15 corpora-
tions among those with the largest total equity market value listed on the
NYSE.
Biweekly security returns have been computed;2 they include dividends
and all capital adjustments. For each country, market indices were selected
independently and returns were computed including dividends. The indices
chosen are given in Table 1. An index for the Japanese market was also in-
cluded since it is the only large market outside Europe and the U.S.A. A
market value weighted world index was constructed from those 10 national
indices.3 Finally interest rates on some risk free comparable securities have
been collected for the 10 countries. The rates chosen also appear
in Table 1.
2. The biweekly interval was chosen (as opposed to daily or monthly) as a compromise between
the problems of measurement errors inherent in daily data and sampling inefficiencies associated
with longer intervals (see Pogue and Solnik [17]).
3. It is difficult to get figures on the total market value of all assets in each country. For some
countries the value of common shares outstanding was completely unrepresentative. Therefore it
was decided to use weights proportional to the 1970 GNP of each nation. The relevant figures are
given in Table 1. An average risk free rate Rm was constructed with the same weights.
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The International Pricing of Risk 367
III. THE INTERNATIONAL ASSET PRICING MODEL (IAPM)
The traditional form of the Sharpe [18]-Lintner [10] capital asset pricing
model has important limitations because it only considers national investment.
It is not true that it could easily be extended by simply including foreign
investment opportunities in the market portfolio. Among the various com-
plexities of such a task are the non-existence of a universal risk free asset
(and different interest rates) and the presence of exchange risk which alters
the characteristics of the same investment for different nationals. All investors
are not faced with the same investment opportunity set because of exchange
risk and one would expect individuals to hold portfolios with different pro-
portions of risky assets according to their nationality. Investors could also
decide to hold pure exchange risk assets besides their traditional stock
investment. Therefore there is little intuitive reason to expect that the simple
risk pricing relation of the CAPM could be applied at the international level.
Most of the work published is concerned with the investment behavior of
citizens of one country facing an enlarged investment opportunity set (see for
example Lee [9], Grubel [7], Miller and Whitman [15], Cohn and Pringle
[6]). Recently Agmon [2] considered the dependence on the U.S. stock price
behavior of several foreign markets; he found some evidence in favor of an
integrated multi-national market. However he does not provide the reader
with any conceptual justification of his tests. Besides his methodology has
many statistical shortcomings4 as pointed out by Solnik [21], and Adler and
Horesh [ 1 ].
Under certain assumptions about the Capital markets perfection and the
consumption behavior of investors, a partial equilibrium model of the inter-
national capital market has been developed elsewhere (Solnik [20]). In a
time continuous mean-variance framework, this model integrates exchange
risks and different interest rates across the world.5
All Capital markets are supposed to be perfect with free flow of capital
between nations. In each country there exists a market for borrowing and
lending at the same rate. However this rate does not have to be the same in
all countries. The risk free asset of one country becomes a pure exchange risk
asset for a foreign investor. Similarly an uncovered investment in the stock
market carries both market and exchange risk for a foreign investor. In the
CAPM spirit, all investors hold homogeneous expectations about exchange
rate variations and the distribution of returns in terms of each nation's cur-
rency. These are standard assumptions in portfolio theory. In a more restric-
tive manner, an investor's consumption is assumed to be limited to his home
country goods. This formulation implies a strict national segmentation of the
product market and only a partial equilibrium, since international trade for
consumption purposes is not considered. It retains however the core of the
exchange risk problem and means that for all residents of a country, exchange
rate changes affect the yield on a foreign asset in an identical way. No investor
4. Agmon uses the U.S. index as a proxy for the international index. He also uses the same period
to compute the risk estimates and test the cross-sectional relationship for individual stocks. This
creates an error-in-the-variable bias as pointed out by Miller and Scholes [14].
5. The model uses the intertemporal time-continuous framework developed by Merton [12], [13]
rather than the more questionable single period formulation.
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368 The Journal of Finance
has a need to hedge" his consumption of foreign goods against exchange risk,
since only consumption of the domestic good is permitted.
In maximizing expected utility, each individual will invest in his domestic
risk free asset, domestic common stocks, foreign stocks and foreign risk free
assets which are pure exchange risk assets. However he can cover or hedge
against exchange risk his foreign stock investment by either buying an
(instantaneous) forward contract or going short in the local risk free asset
(borrow). By interest parity these two methods are identical and covered
risk free yield differentials will be equal anywhere. This is equivalent to
define a unique international risk free rate on a covered basis.
Once the budget equation is formulated, the mathematical derivations follow
the domestic CAPM pattern. Some separation and risk pricing theorems can
be demonstrated. These results are even more intuitively appealing if market
and exchange risks are independent.
The main results are as follows:
(a) A "mutual fund theorem" is demonstrated which states that all investors
will be indifferent between choosing portfolios from the original assets or from
three funds, namely,
(1) An international market portfolio which is hedged against exchange risk
and having weights determined by the relative market value of each
country's stocks.
(2) A portfolio of risk free assets, speculative in the exchange risk dimen-
sion and having weights determined by the net foreign investment
position of each country.
(3) The risk free asset of their own country.
The desired level of risk can be attained by investing in only two risky
mutual funds, identical for everyone, while the risk free asset depends on the
investor's citizenship.
(b) A risk pricing relation is derived which shows that the risk premium
of a security over its national risk free rate is proportional to its international
systematic risk. The coefficient or proportionality is the risk premium of the
world market over an average international risk free rate (using the same
market value weights as in the international market portfolio):
ai -Ri
yj(am
-
Rm) (1)
where
a,
is the expected return on security i (in local currency),
Ri is the interest rate in the country of security i (in local currency),
am is the expected return on the world market portfolio (where each com-
ponent is expressed in its own currency) with market value weights,
Rm is the average interest rate in the world (with the same weights as the
world market portfolio),
yi
is the international systematic risk of security i.
6. The traditional CAPM makes a similar assumption on the separation of investment and con-
sumption decisions and no investor is assumed to hedge his human capital or domestic consumption
in his portfolio.
7. All tests performed support the linear independence assumption. If movement in stock prices
and exchange rates were correlated, it would not be possible to completely hedge against exchange
risk.
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The International Pricing of Risk 369
The most obvious differences between this relation and the capital asset
pricing model relation are:
-the systematic risk is the international systematic risk, involving the
covariance of the stock return with the world market portfolio.
-Ri
and Rm are, in general, different as it will be shown below.
Let's consider an investment in a "national" risk premium which means
being long in the stock and short in the risk free asset of that country. For
nationals of any country this investment yield will be independent of any
exchange rate fluctuations. This is why separate risk return relationships
can be derived for securities and for exchange risk assets.
(c) Another set of relations states that the difference between interest rates
of two countries is equal to the expected change of parities between these two
countries plus a term depending on exchange risk covariances:
R
n Mni +
(a R
where
[t11i
is the expected change of parity between currencies of country i and n.
Pi-
is the covariance of
currency
i movements with the international riskless
fund described above,
R,- is the return on that fund where the weights of each risk free asset are
proportional to the net foreign investment position of each country; it
will in general be different from Rm.
Because exchange rates are price relatives, all rates are expressed in an arbi-
trary unit, the currency of country n. Combined with the interest rate parity
theorem, the above relation implies that the forward exchange rate is a biased
estimate of the future spot rate. The bias is due to risk diversification argu-
ments.
This paper will now focus on the empirical test of the international asset
pricing model and its risk pricing relation for common stocks.
IV. TEST OF THE INTERNATIONAL MARKET STRUCTURE
Introduction: A Single Index Market Model
Several specifications of the stochastic price process are consistent with the
international asset pricing model presented above. Equation (1) is stated in
terms of the expected returns on any security or portfolio i and the expected
returns on the international market portfolio:
ai-
Ri yi(am Rm.
) (1 )
Since these expectations are strictly unobservable, we wish to show how
(1) can be recast in terms of the objectively measurable. realizations of
returns on any stock or portfolio i and the market M. The same problem is
present for the test of a single market asset pricing model and a special
structure of asset returns has to be postulated. For individual countries,
it was generally assumed a particular relation between security returns called
the "market model."8 A direct extension of this model to the study of inter-
8. Initially called the "diagonal model" it has been analyzed in considerable detail by Sharpe [18],
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3 70 The Journal of Finance
national price behavior would be a single world index model. This would
imply an international market structure where the return on any security is
a linear function of the return on the world market portfolio.9 The traditional
beta would be replaced by the international systematic risk y and the risk
free rates would vary for different countries (in general
Rm
+
Ri).
A very important difference, however, is the existence of strong country
factors. This can be illustrated by Table 2 which gives the average proportion
TABLE 2
PROPORTIONS OF SECURITY RISK EXPLAINED BY NATIONAL OR INTERNATIONAL
FACTORS (1966-1971, BIWEEKLY RETURNS)
Average Proportion of Average Proportion of
Variance Attributable Variance Attributable
to National (Market) to International (Market)
Country Variations* Variations**
France 30% 9%
Italy 46% 14%
U.K. 37% 11%
Germany 45% 16%
Netherlands 23% 18%
Belgium 16% 15%
Switzerland 35% 21%
Sweden 45% 18%
U.S.A. 22% 16%
*
R-square of the regression: rki =
aki
+
Oki
Ik
+
Eki
where Ik is the national index.
** R-square of the regression: rk. =
aki
+
Yki
Im +
Eki
where Im is the world index.
of security risk explained by national or international factors. One approach
would be to construct portfolios well diversified across countries. The use of
the portfolios parameters in the cross-sectional tests would eliminate biases
created by these country effects. A more efficient approach
would be to
find the exact market structure of stock prices and deal explicitly with
national factors in the tests of the international asset pricing
model. This
method will now be used.
The first step will be to show that the risk pricing relations derived from
the traditional capital asset pricing model for each individual country can be
fully consistent with a single and perfect international capital market. Then a
more realistic specification of security price behavior will be presented and
tested.
A Nationalistic Model
A stochastic security price process which considers the national characteris-
tics of the international capital market structure would be more appropriate.
The most "nationalistic" specification consistent with the IAPM postulates
that on each market place, security prices have in common a national factor,
[19] and empirically tested by Blume [3] and others in the U.S. market and Pogue and Solnik [17]
on the European markets.
9. See Solnik [22] for a more detailed derivation.
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The International Pricing of Risk 371
which is in turn dependent on a single common world factor.'0 In other words,
all securities are affected by the international factor through their national
index.
For a security
k,
of country k, this can be written as
rk
1=Cki
+k1 ( -k ak)
+ ?kid
for all i and k (2)
where rkI is the (realized) return on security
k,
of country k, Ik is the
(realized) return on the national index of country k, a, is the expected return
on that index,
Pk
is the national systematic risk of security
k,.
And for national
indices:
jIk
=
ak + Yk(rm
-cm) + Ek
for all k (3)
where Yk is the international systematic risk of country k.
The variables
9k,
and ok are assumed to be normal random variables with
standard linear independence conditions between themselves, rm and Ik*
Some important results can be derived from this price structure. If this
specification holds, it can easily be shown" that the international systematic
risk Ykk of a security k, is equal to the product of the national systematic risk
of that security,
Pk,,
by the international risk of its country, Yk:
Yki
=
ki kYk (4)
Since the international asset pricing model states that
ak,
. Rk ykj ( am Rm) for all k, i
and in particular
Lk -Rk Yk ( am -Rm) for all k
the above relation implies that
aki
-
Rk
=
IkYk(Qm
-
Rm) P k(ak
-
Rk)
for all
k,
i.
This is the capital asset pricing model relation for each national market,
10. Such a model would be in a line with the famous "Europe des Patries" of General de Gaulle.
cov(rkirm)
11. This can be shown by computing
Ykj:
Yk1
=varier )
replacing from equation (2) and (3)
cov(rm -
am~kiYk(rm
-
am) +
Oki
+ k)
Yki=~
var(r'm)
Since
cov(im
-
am, ek)
=
cov(m
-
am
1ki)
= 0 it can be derived that
cov(rm
-
amrm
-am)
Yk1
=
PkiYk
ar=
Pikiyk
var
(" )
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372 The Journal of Finance
therefore the capital asset pricing model can be derived from the IAPM under
this specification. This is a very important result since it makes the interna-
tional model compatible with the results found for each national market
separately. A test of the IAPM would simply be a test of the CAPM for the
various national markets coupled with a test of the international risk pricing
relation for national indices. This last relation is the only difference between
an international market structure as postulated here and a segmented market
structure with no international relations between perfect national capital
markets.
Interesting implications can be derived from the consistency of the CAPM
with the IAPM. The risk return pricing relation of French stocks, for example,
will be linear whether the systematic risk on the French market or on the
world market is considered. The slopes will only differ by a multiplicative
factor. An investor unaware of international investment opportunities will still
base his decisions on sound measures of relative risk since the excess return
he can expect should be proportional to the national systematic risk or
P.
However, even if he gets a perfect diversification on his (national) investment
he is still left with some unique country risk which he could have diversified
away internationally.
Test of the IAPM
Tests of the capital asset pricing model for the major European stock
markets have been performed in Modigliani, Pogue, Scholes, and Solnik [16].
Table 3 gives the results of portfolio cross-sectional regressions conducted
TABLE 3
TEST OF THE CAPM
(from
MPSS,
Table 3)
ri=
a+aoi++
i1
No. of Theoretical Values
Country Portfolios
a.
a1
R2
a0
= Rk
al
=
Ik-
Rk
France 17 0.19 0.30 0.33 0.33 0.30
(0.13) (0.14)
Italy 9 0.38 0.12 0.23 0.24 0.25
(0.13) (0.08)
U.K. 12 0.13 0.16 0.23 0.20 0.13
(0.09) (0.09)
Germany 10 3.25 -2.54 0.74 0.36 0.21
(0.55) (0.52)
U.S.A. 10 0.41 -0.42 0.55 0.48 -0.23
(0.31) (0.20)
*
For the period March 1967-April 1971 except for Italy and the USA: March 1967-June 1970.
TEST OF THE IAPM
Regression of Indices
T-Rk = a() +
alYk
+
Ek
Theoretical Values
ao
al
R2
a.
= O
al
= rm-Rm
-0.08 0.31 0.21 0 0.23
(0.20) (0.20)
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The International Pricing of Risk 373
independently for each country. A grouping-instrumental variable approach
had been used to lessen error-in-the-variables biases. Except in the case of
Germany, these results provide some support to the capital asset pricing model
for each country and therefore to the international asset pricing model. Other
empirical research of the national risk-return relation on United States data
has so far had mixed results.12 The most careful examination performed by
Black, Jensen and Scholes shows that the relation between realized return
and beta appears to be linear as predicted by the CAPM. However the inter-
cept was different from its predicted value.
The results of the international regression for country indices support an
international pricing of risk as it can be seen in Table 3:
Ii Ri
= -0.08
+
0.31
Yk
(0.20) (0.20) R2 0.21.
The estimated values'3 of the coefficients are close to the values predicted by
the IAPM:
ao
=
0, a1 0.23, and the IAPM cannot be rejected. This last
equation is the real test of the IAPM as opposed to a domestic CAPM valid
for each national market.
The last regression, however, is subject to many statistical biases. For
example, the same period is used to compute the gammas and estimate cross-
sectionally the intercept and the slope (see Black, Jensen and Scholes [3]).
Besides a better approach would be to run a generalized cross-sectional test
of the CAPM for all countries (rather than independently). This generalized
test will be used in the final part of this paper.
The results presented in this section, although consistent with the theory,
can hardly be considered as irrefutable evidence in favor of the capital asset
pricing model and therefore the international asset pricing model. One obvious
criticism can be made to improve this multinational index specification. This
"nationalistic" model postulates that all stock prices are identically affected
by international price movements through their national index. This is a
rather unrealistic statement; two stocks with the same country risk ((3)
could have different sensitivity to international events because of the nature
of the firm's business.
This assumption can be directly tested by verifying the fundamental relation
of this specification,
Yki
=
ikiYk.
A t-test was performed for each stock and PkiYk was significantly different
from Yki at the
95%7
level of confidence for more than half of the stocks. This
suggests a more realistic specification which will now be investigated in more
detail.
A Multinational Index Model
Independently of their national risk, stocks might be affected differently by
international events. This might be due to the international links of the firm,
its foreign subsidiaries, the kind of international competition its products are
experiencing, its import-export pattern, etc. The final specification to be pre-
12. See Blume and Friend [5], Jacob [8] and Black, Jensen and Scholes [3].
13. All returns are expressed in percentage per biweekly periods. Therefore the market return
is equal to 0.23% per 2 weeks or about 6.25% annually.
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374 The Journal of Finance
sented now will attempt to account for these differences, thereby providing a
more appropriate framework to test the international asset pricing model.
a) The Specification
The same international relation between country factors is assumed. How-
ever all securities returns are assumed to be influenced by two factors, the
world factor and a purely national factor common to all securities of a country.
Ik
=
ak + Yk(rm am) + Ek (5)
and
rk1 -
Cki + -Yki(rm
am)
+ 3kisk +
S1ki
(6)
Ek is the residual of the
regression
of the national index versus the world
index with the standard assumptions of linear independence between 7r,
Eki
Tlkj*
It can be considered as a purely national factor orthogonal
to the world
factor. Since security prices are assumed to be sensitive in different degrees
to national and international influence, Yki is not in general equal to
PkiYk.
b) A Testable Hypothesis
Let us now try to eliminate unobservable expectations from the JAPM
equation and get a testable relation between (ex post) realized return using
this specification. We already know that (5) and the IAPM can be combined
into (4):
Ik -Rk-Yk(r -Rm) + Ek (7)
Substituting
caki
and
a,
from (6) into the IAPM, we get
rk- RRk Yki(m
-
Rm) + Iki
Ek + lki
(8)
replacing rk by its value in (7):
rk1 Rk
-
(Yki -(3iYk)
(?'m -
Rm) + kic(Ik
-
Rk) + 'lki (9)
since
qkj
is orthogonal to 'rm and
E,
it is also orthogonal to Ik
Let's
define, k
-
Yki
-
PkiYk.
The above relation is different from that
derived from the "nationalistic" specification,4
wheneverYki
7&
#
kiY
or
8ki
& 0?
If
Yki
>
PkiYk,
the stock is more sensitive to international variations than a
typical stock of that country; if
8ki
is negative, the stock price is less sensitive
to international influence than a typical stock.
Two steps are necessary to test the international asset pricing model, using
this relation:
-Estimate
8ki
and,
k ,
using returns time series for national portfolios.
These estimates
bki
and
Pk,
can be obtained by running the regression:
rkt-
aki + 8ki rmt +
Pki
1kt
+
!tkit
14. It should be noticed that in equation (9) the national factors are not orthogonal to the
international factor as in (8). Therefore one should not be surprised to find that the national
factors have a non-zero expected value. However any positive expected return is due to its covari-
ance with the international factor as it can be seen from equation (7).
In the time series regression tests of this model, the results will be unaffected by this transforma-
tion since regression coefficients are not changed by a linear combination of the variables. Since the
national indices are not highly correlated with the world index, we do not get into multicolinearity
problems. The same kind of formulation could be used for multi-industry index models.
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The International Pricing of Risk 375
-Run a cross-sectional regression of mean realized excess returns (over the
mean risk free rate of the country) versus the estimates for international
and national systematic risk
n
- A A
rki
-Rk
=
bo + bl6ki +
ajpji
+
'qk
j-=1
where
Pji
0 except for j = k; i.e., it will be zero for all countries except
that of the stock.15
The theoretical value predicted by the IAPM are:
b(
-
0,
bi =m -Rm, a,
= R, .' . , ak
=
Yk
-
Rk, ...
c) The Test
The estimate of a risk asset's beta (delta) may be viewed as its actual
beta (delta) plus a measurement error. As pointed out by Miller and Scholes
[14] these measurement errors will create biases in the parameter estimates
of the cross-sectional regression. Since the error of measurement for different
risk assets are less than perfectly correlated, grouping risk assets into port-
folios reduces the variance of the error term. Using grouping procedures,
least squares estimates are consistent only if measurement errors within groups
are independent. However, asymptotic bias is reduced by grouping whenever
measurement errors are less than perfectly correlated. For a two-variable
least squares regression model the reduction in efficiency caused by the loss
of information from the grouping of observations is minimized by maximizing
the between group variation in the independent variable. Grouping observa-
tions according to estimated beta maximizes the between group variation in
estimated betas. However, the grouping should be done independently of the
measurement error otherwise the bias will not be eliminated. More specifically,
Black, Jensen and Scholes
[3]
note that risk assets classified into high (low)
beta groups tend to have beta estimates with positive (negative) measurement
errors. Malinvaud [11] suggests that groupings be determined by an instru-
mental variable that is independent of the measurement error but correlated
with the true value of the independent variable. Black, Jensen and Scholes
used beta estimates from a previous period as the instrument for classifying
risk assets into groups; Modigliani, Pogue, Scholes & Solnik [16] used the
same approach in their test of the capital asset pricing model on European
capital market. For a n-variables regression model the appropriate grouping
criterion is less clear.
Within the limitation of our data, this paper will use a somewhat similar
grouping-instrumental variable approach. The problem is greatly simplified
by the structure of the regression equation (the country factors are separable).
An estimated beta,
fki
is calculated for each stock in the period March 1966-
15. For a portfolio
ki
of country k:
_ A
rk -Rk =
bo
+
blbki
+
ai-O
+ ... +
ak-1
0 +
ak~k
+11k
This is due to the fact that the international factor 8 appears for all stocks, whiles the national
factor
0
appears only for stocks of country k. This is a dummy variable method.
This content downloaded from 201.230.236.227 on Fri, 14 Mar 2014 00:31:26 AM
All use subject to JSTOR Terms and Conditions
376 The Journal of Finance
February 1967. Within each country, stocks are ranked on the basis of beta
estimates and grouped into (national) portfolios.16 The mean excess rate of
return, estimated beta,
Pkj,
and estimated delta,
bki,
are calculated for the
remaining four-year period (March 1967-April 1971) and used in the cross-
sectional regressions.
The number of stocks included in the sample was too small to allow for a
complete cross-classification within and across countries. However the delta
estimates are negatively correlated with the beta estimates (correlation of
-0.40). Therefore the above ranking on beta provided sufficient spread on
deltas.'7
The cross-sectional results of the test of the international asset pricing
model are given in Table 4. The estimate of the market price of international
TABLE 4
CROSS-SECTIONAL REGRESSION RESULTS FOR 73 NATIONAL PORTFOLIOS (1967-1971)
Independent Estimated Standard Theoretical
Variable Coefficient Error t-Statistic** Value
C -0.09 0.06 -1.5 0
Delta 0.33 0.09 1.1 0.23
i U.K. 0.15 0.06 0.3 0.13
i France 0.45 0.07 2.1 0.30
13 Italy -0.02 0.06 0.3 -0.04
i Germany 0.41 0.07 2.8 0.21
l U.S.A. 0.03 0.05 0.2 0.02
RX= 0.785
*
The results are expressed in percent per two weeks.
** This is the t-statistic of the difference of the estimated coefficient from its predicted value.
The .05 significance level is obtained for
Itl
= 2.0 and the .01 significance level for
Itl
= 2.7.
risk is significantly positive and not significantly different from its predicted
value. The market prices of national risk are generally not different from the
mean excess return on the domestic index as predicted by our theoretical
model. This is not true for Germany where the estimated coefficient is sig-
nificantly different from its theoretical value at the .01 level. However the
standard errors of the risk-return estimates are understated because of non-
stationarity of the relation and insufficient aggregation; it is most likely that
the above deviations would not be significant if the true standard error was
used. (See Black, Jensen and Scholes [3]).
V. CONCLUDING COMMENTS
This paper attempts to determine the factors which affect stock price move-
ments across the world. An empirical investigation of the price generative
processes gives useful insights on the international capital market structure.
Several market specifications have been successively studied. The research
indicates that stock prices are strongly affected by domestic factors. However,
16. Seventy-three "national" portfolios are thus formed.
17. This negative correlation could be expected since multinational companies or firms with an
important international orientation (6 > 0) tend to be large, stable, and low beta corporations.
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The International Pricing of Risk 377
prices do depend on international events both indirectly by the foreign influ-
ence on the general domestic market behavior and selectively among stocks;
some stocks might be more sensitive to international factors because of their
multinational characteristics, import-export pattern, foreign
competition,
etc.
Some evidence of an international pricing of risk has been presented and
an international market structure of price behavior appears to exist. This
market structure implies that securities are priced according to their inter-
national systematic risk but confirms the large dependence on national factors.
This result would indicate that the domestic
P
of a security cannot be taken
as the true measure of its risk. The true systematic risk of a stock, ykiOm2, is
much smaller than the domestically-non-diversifiable-risk, 3klck2. However,
because of the large dependence on national factors, the domestic beta of a
stock will still give, in many cases, useful information on the relative risks of
securities in a country. It has also been shown that the results of the domestic
capital asset pricing model as well as many others can be consistent with an
international pricing of risk.
The conclusions are tentative in nature because of the short time period
used and the relatively small sample of stocks available. Further research is
needed to examine more carefully the pricing structure. Industrial factors
might be more important than geographical influences in explaining on which
basis the market evaluates security prices.
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