The International Pricing of Risk an Empirical Investigation of the World Capital MarketStructure

American Finance Association

The International Pricing of Risk: An Empirical Investigation of the World Capital MarketStructureAuthor(s): B. H. SolnikSource: The Journal of Finance, Vol. 29, No. 2, Papers and Proceedings of the Thirty-SecondAnnual Meeting of the American Finance Association, New York, New York, December 28-30,1973 (May, 1974), pp. 365-378Published by: Wiley for the American Finance AssociationStable URL: http://www.jstor.org/stable/2978806 .

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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 investigated 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 specifications 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



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 corporations 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 included 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.



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 proportions 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 international 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 currency. 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.




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 consumption 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.




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],



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.




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 (" )




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 international 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)




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 intercept 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.




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 covariance 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.




-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 portfolios 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 observations 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 instrumental 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.




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 significantly 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 movements 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.




prices do depend on international events both indirectly by the foreign influence 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 international 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.

REFERENCES

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The International Pricing of Risk an Empirical Investigation of the World Capital MarketStructure

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