International asset pricing models and currency risk: Evidence from Finland 1970–2004
ABSTRACT In this paper we investigate whether global, local and currency risks are priced in the Finnish stock market using conditional international asset pricing models. We take the view of a US investor. The estimation is conducted using a modified version of the multivariate GARCH framework of [De Santis, G., Gérard, B., 1998. How big is the premium for currency risk? Journal of Financial Economics 49, 375–412]. For a sample period from 1970 to 2004, we find the world risk to be time-varying. While local risk is not priced for the USA, the local component is significant and time-varying for Finland. Currency risk is priced in the Finnish market, but is not time-varying using the De Santis and Gérard specification. This suggests that the linear specification for the currency risk may not be adequate for non-free floating currencies.
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ABSTRACT: In this paper an intertemporal model of international asset pricing is constructed which admits differences in consumption opportunity sets across countries. It is shown that the real expected excess return on a risky asset is proportional to the covariance of the return of that asset with changes in the world real consumption rate. (World real consumption does not, in general, correspond to a basket of commodities consumed by all investors.) The model has no barriers to international investment, but it is compatible with empirical facts which contradict the predictions of earlier models and which seem to imply that asset markets are internationally segmented.Journal of Financial Economics. 01/1981;
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ABSTRACT: A new representation of the diagonal Vech model is given using the Hadamard product. Sufficient conditions on parameter matrices are provided to ensure the positive definiteness of covariance matrices from the new representation. Based on this, some new and simple models are discussed. A set of diagnostic tests for multivariate ARCH models is proposed. The tests are able to detect various model misspecifications by examing the orthogonality of the squared normalized residuals. A small Monte-Carlo study is carried out to check the small sample performance of the test. An empirical example is also given as guidance for model estimation and selection in the multivariate framework. For the specific data set considered, it is found that the simple one and two parameter models and the constant conditional correlation model perform fairly well.05/2001;
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ABSTRACT: The authors examine the relationship between stock prices and market segmentation induced by ownership restrictions in Mexico. The focus is on multiple classes of equity that differentiate between foreign and domestic traders, and between domestic individuals and institutions. Significant stock price premia are documented for shares not restricted to a particular investor group. The authors analyze the theoretical and empirical determinants of premia across firms and over time. In addition to economywide factors, segmentation reflects the relative scarcity of unrestricted shares. The results provide additional support for Rene Stulz and Walter Wasserfallen's (1995) hypothesis that firms discriminate between investor groups with different demand elasticities. Copyright 1997 by American Finance Association.Journal of Finance. 02/1997; 52(3):1059-85.
INTERNATIONAL ASSET PRICING MODELS AND
CURRENCY RISK: EVIDENCE FROM FINLAND 1970-2004
Jan Antell – Mika Vaihekoski1
Work in process, do not quote without permission
April 22, 2005
This paper investigates whether global, local and currency risks are priced in the
Finnish stock market using conditional international asset pricing models. We take the
view of U.S. investors. The estimation is conducted using the multivariate GARCH
framework of De Santis and Gérard (1998) using a sample period from 1970 to 2004.
In a time-varying specification for the prices of world and currency risk, we find both
of them time-varying, even though only the world risk is statistically significant. After
joining the EMU, the price of currency risk decreased. The local price of risk is also
found to be priced on the Finnish stock market, but not on the US equity market.
While world market risk accounts for most of the US equity market risk premium, it
accounts only for 60 per cent of the corresponding Finnish premium, which is driven
mostly by the local market risk, and to some degree by the currency risk component.
The local price of risk is also found time-varying. The results differ partly from De
Santis and Gérard (1998).
world asset pricing model, conditional, time-varying, price of
market risk, local vs. global pricing, segmentation, foreign
exchange risk, multivariate GARCH-M, Finland, USA, U.S.
1 Jan Antell: HANKEN Swedish School of Economics and Business Administration, Department of
Finance and Statistics. Address: P.O. Box 479, 00101 Helsinki, Finland. E-mail: email@example.com.
Mika Vaihekoski: Lappeenranta University of Technology, Department of Business Administration,
Section of Accounting and Finance. Address: P.O. Box 20, 53851 Lappeenranta, Finland. E-mail:
firstname.lastname@example.org, tel. +358 5 621 7270, fax +358 5 621 7299. We are grateful for the comments
from the participants at the GSF’s Joint Finance Seminar, Helsinki.
International aspects of asset pricing have recently received increasing attention. Many
papers explore the degree to which national capital markets are integrated with world
capital markets. For example, Dumas and Solnik (1995) show that there is little evidence
that global equity and foreign exchange markets deviate from full integration. On the
other hand, Bekaert and Harvey (1995) find that many emerging stock markets exhibit
time-varying integration with world stock markets. Furthermore, Bekaert and Harvey
report some evidence opposing the popular notion that global capital market integration
has increased over time.
Prior studies on international asset pricing models use data mainly from large markets
closely integrated with global financial markets.2 However, many small developed
countries have only recently experienced full liberalization of their capital markets and
many emerging countries are still in the midst of the liberalization process. For example,
all restrictions on foreign investments into Finland were abolished as late as in 1993. As a
result, researchers have suggested models of partial segmentation could be more
appropriate for these markets (see, e.g., Errunza and Losq, 1985). These models suggest
that both local and world factors should influence equilibrium asset returns. In their
study, Nummelin and Vaihekoski (2002) indeed find that both the local and global
sources of risks are priced in the Finnish market. Furthermore, Vaihekoski and
Nummelin (2001) find that the degree of equity market integration for Finland has
increased over time from 1987 to 1996 indicating that a partial segmented model could
be more appropriate in pricing Finnish stocks.
Besides, the segmentation issue, the currency risk can play a very important role
especially in many small and/or emerging markets, since their exchange rate mechanism
often differs, e.g., from that of the USA. The pricing of currency risk in the stock market
is though still a somewhat controversial issue. Using an unconditional approach, Jorion
(1991) reports that the currency risk is not priced in the US market. However, several
researchers have later found currency risk to be highly time-varying. For example, De
Santis and Gérard (1998) conclude that the time variation in the risk premium could
explain why the unconditional models are unable to detect highly time-varying currency
Taking the results together, the evidence suggests, that the relation between expected
returns and measures of global market risks is unstable over time, and that exposures to
global risks could be increasingly important in determining expected returns in most
national stock markets, even though the local risk could still be priced in the market.
Furthermore, one should include also time-varying currency risk into the pricing model.
In this paper, we use the framework of De Santis and Gerard (1998) to study the pricing
of global and local market risks, and currency risk on the relatively small Finnish stock
market.3 We utilize a rather long sample period, from 1970 to 2004. This sample period
2 See, e.g., Cho, Eun, and Senbet (1986), Korajczyk and Viallet (1989), Cumby and Glen (1990), Harvey
and Zhou (1993), Dumas (1994), Bekaert and Harvey (1995, 1997), Harvey (1995a,b), and Dumas and
Solnik (1995). A review of the issues involved can be found, e.g., from Adler and Dumas (1983). A
more recent review can be found, e.g., in Stulz (1995).
3 For example, at the end of September 1997, the Finnish stock market was the fifth smallest market
included in the MSCI world stock market index right after Norway and before Denmark. Finland
represented less than one percent of the total market capitalization of the MSCI world index with its
market capitalization value of USD 87 billion. Although the Finnish stock market is small, it has
and the Finnish stock market are an interesting test laboratory for international asset
pricing models, justified by the fact that the Finnish stock market has developed during
this period from a relatively closed market to open and integrated market, especially after
the final abolishment of all restrictions on foreign ownership in 1993. On the other hand,
Finland is interesting from currency risk’s point of view, since the Finnish currency has
undergone several currency regimes (multiple cases of devaluations and revaluations,
periods of fixed and floating exchange rates, and joining the EMU in 1999). On the other
hand, many Finnish companies and especially Nokia have drawn foreign investors’
attention and increasing ownership recently.
Overall, we believe these institutional features and this particular sample period make
the Finnish stock market an interesting one for tests of conditional international asset
pricing models. Our primary goal is to explore whether the global market risk is priced
in the Finnish stock market and what is its role in the pricing. Second, we ask whether
currency risk is priced in the stock market. Third, we study whether the partially
segmented model is more appropriate for a small country. Finally, we study whether the
global market and currency risks are time-varying and to what degree these sources of
risks account for the risk premium. The results can shed light on the role of the currency
risk and local risk on the pricing of stocks in countries that are currently emerging from
segmentation and which are also restricting the free valuation of their currencies (e.g.,
China and Eastern European new EU members).
The remainder of the paper is as follows. Section 2 presents the research methodology.
Section 3 gives a short introduction to the history of Finnish currency policy and
presents the data in this study. Section 4 shows the empirical results. Section 5 concludes.
We begin our examination with the conditional international capital asset pricing model
consistent with fully integrated capital markets. If world markets are fully integrated, then
the expected return on all assets should be the same after adjusting for exposure to global
sources of risk. Hence, in a single-factor-setting, the single relevant source of global risk
is a benchmark portfolio comprised of the world equity market portfolio.
If there are no restrictions on capital movements so that domestic investors are free to
diversify internationally and foreign investors are allowed to invest in local markets,
markets are said to be legally integrated. By financial market integration we understand
that assets in all markets are exposed to the same set of risk factors with the risk premia
on each factor being the same in all markets. In this case, e.g., Adler and Dumas (1983)
have shown that the global value-weighted market portfolio is the relevant risk factor to
consider. Assuming that investors do not hedge against exchange risks and a riskfree
traditionally been included among the developed stock markets (for criterion between developed and
emerging stock markets see, e.g., MSCI, 1998).
asset exists, the conditional version of the world CAPM implies the following restriction
for the nominal4 excess returns
(1) E[rit|Ωt-1] = βit(Ωt-1) E[rmt|Ωt-1],
where and E[rit|Ωt-1] and E[rmt|Ωt-1] are expected returns on asset i and the global market
portfolio conditional on investors' information set Ωt-1 available at time t–1. Both returns
are in excess of the local riskless rate of return rft-1 for the period of time from t–1 to t.
The global market portfolio comprises all securities in the world in proportion to their
capitalization relative to world wealth (see Stulz, 1995). All returns are measured in one
Since the conditional beta is defined as Cov(rit, rmt|Ωt-1]Var(rmt|Ωt-1)-1, we can rewrite
equation (1) as the ratio E[rmt|Ωt-1]Var(rmt|Ωt-1)-1. It can be considered as the conditional
price of global market risk λmt.5 It measures the compensation the representative investor
must receive for a unit increase in the variance of the market return (see Merton, 1980).
Now the model gives the following restriction for the expected excess returns for assets:
(2) E[rit|Ωt-1] =λmtCov(rit,rmt|Ωt-1).
Since the market portfolio is also a tradable asset, the model gives the following
restriction for the global market portfolio's expected excess returns
(3) E[rmt|Ωt-1] =λmtVar(rmt|Ωt-1).
As the returns are measured in a numeraire currency, the model also implies that
expected returns do not have to be the same for investors coming from different
currency areas even though they do not price the currency risk. On the contrary, the
price of global market risk is the same for all investors irrespective of their country of
However, if some assets deviate from pricing under full integration, their risk-adjusted
return will differ from the global CAPM. If this is the case, the market price of global risk
should be the same for all assets everywhere, after adjusting for the costs arising from the
barrier constraints. Following Errunza and Losq (1985), the pricing equation may include
also the local market portfolio as a source of local market risk. The pricing equation can
be written as follows:
4 Originally, the restriction implied by the ICAPM holds for the real excess returns, but since we are
testing the model within one country, the real returns can be replaced with nominal returns (see Stulz,
5 The price of risk is sometimes also called as reward-to-risk, compensation for covariance risk, or
aggregate relative risk aversion measure.
6 The price of global market risk is the average of the risk aversion coefficients for each national group,
weighted by their corresponding relative share of global wealth. Note that, in theory, these weights do
not have to be the same if measured in different currencies, but lack of arbitrage between currencies is
sufficient to give the same λmt.
However, any investment in a foreign asset is always a combination of an investment in
the performance of the asset and in the movement of the foreign currency relative to the
domestic currency. Adler and Dumas (1983) show that if the purchasing power parity
(PPP) does not hold, then investors view real returns differently and they want to hedge
against exchange rate risks.7 Specifically, the risk induced by the PPP deviations is
measured as the exposure to both the inflation risk and the currency risk associated with
currencies. Assuming that the domestic inflation is non-stochastic over short-period of
times, the PPP risk contains only the relative change in the exchange rate between the
numeraire currency and the currency of C+1 countries (see, e.g., De Santis and Gérard,
1998). In this case the conditional asset pricing model for partially segmented markets
implies the following restriction for the expected return of asset i in the numeraire
where λct is the conditional price of exchange rate risk for currency c. Vart-1(.) and Covt-1(.)
are short-hand notations for conditional variance and covariance operators, all
conditional on information Ωt-1.
Now, the risk premium for the local market risk premium can be written as follows
mt|Ωt-1) + λl
λ are the conditional prices of world and local market risk.
Finally, the currency risk premiums can be written as follows
Unfortunately, the model above is intractable in practice if C is large. Thus, one can
either focus on a subset of currencies or use a more parsimonious measure for the
currency risk. Ferson and Harvey (1993) and Harvey (1995) show how one can use a
single aggregate exchange risk factor to proxy for the deviations from the PPP to the
model. In this case, the model (5) boils down into a three-factor model.
If we want to study the implications of the conditional asset pricing models in a
conditional framework, we need to decide how we model investors' conditional
7 Moreover, currency risk may enter indirectly into asset pricing, if companies are exposed to unhedged
currency risk for example through foreign trade and/or foreign debt. Empirical evidence has found
conflicting support for the pricing of the foreign exchange rate risk (see, e.g., Jorion 1990, 1991; Roll,
1992; De Santis and Gérard, 1997, 1998; Doukas, Hall, and Lang, 1999).