Time-Varying Risk and Risk Premiums in Frontier Markets

Abstract

We study risk-return relationship in twenty Frontier country stock markets by setting up an international version of the intertemporal capital asset pricing model (International ICAPM). The systematic risk in this model comes from covariance of Frontier market stock index returns with world returns, proxied by US stock index returns. We also incorporate own country variances as additional determinants of Frontier country returns. Our model allows for the covariance risk to be time-varying. Time-varying correlations are captured by utilizing the Dynamic Conditional Correlations (DCC) model. The premium per unit of covariance risk is allowed to vary over time as well. Thus, both the risk and risk premium on Frontier country market returns are time-varying in our model. We find the conditional correlations, although modest on average, to vary over time, and suggestive of substantial diversification benefits from investing in Frontier markets versus a portfolio holding just US stocks. These correlations display no time trend, suggesting that diversification benefits have not diminished with recent globalization. Our results suggest statistically significant impact of both US covariance risk and own country variance risk in explaining Frontier country returns. Time-variation in the price of covariance risk is also found to be statistically significant for most Frontier market returns. However, own country variance risk is found to be quantitatively more important.

Keywords: ICAPM, dynamic conditional correlations (DCC), timevarying parameters (TVP), stock market returns, frontier markets

JEL Classification: F36, G15, C58