The Cross-Section of Stock Returns: Evidence from Emerging Markets

Abstract

Several factors besides market risk - including firm size, earnings-price ratio, and turnover - are significant in explaining a cross-section of stock returns in 19 emerging markets. The signs for some factors are contrary to those documented in U.S. and Japanese markets.

Cross-sectional tests of asset returns have a long tradition in finance. The often-used capital asset pricing model (CAPM) and the arbitrage pricing theory both imply cross-sectional relationships between individual asset returns and other factors, and tests of those models have done much to increase understanding of how markets price risk.

But much about the way assets are priced remains unclear. After much testing, numerous empirical anomalies about the CAPM cast doubt on the central hypothesis of that theory: that on a cross-sectional basis a positive relationship exists between asset returns and assets' relative riskiness as measured by their ßs (beta being the ratio of the covariance of an asset's return with the market return to the variance of the market return).

As tenuous as the relationship between ß and returns may be, other risk factors apparently influence U.S. equity market returns significantly: market capitalization (or size), earnings-price ratios, and book-to-market value of equity ratios. Once these factors are included as explanatory variables in the cross-sectional model, the relationship between ß and returns disappears.

Much international empirical work has focused on more developed markets, especially Japan and the United Kingdom, with some evidence from other European markets as well. The international evidence largely confirms the hypothesis that other factors besides ß are important in explaining asset returns.

Claessens, Dasgupta, and Glen expand the empirical evidence on the nature of asset returns by examining the cross-sectional pattern of returns in the emerging markets. Using data from the International Finance Corporation for 19 developing country markets, they examine the effect on asset returns of several risk factors in addition to ß.

They find that, in addition to ß, two factors - size and trading volume -having significant explanatory power in a number of these markets. Dividend yield and earnings-price ratio are also important, but in slightly fewer markets. For several of the markets studied, the relationships between all four of these variables and returns is contrary to the relationships documented for U.S. and Japanese markets. In several countries, exchange-rate risk is a significant factor.

With independent new empirical evidence introduced into the asset-pricing debate, future research must now cope with the idea that any theory hoping to explain asset pricing in all markets must explain how factors can be priced differently simply by crossing an international border. Is it market microstructure that causes these substantial differences? Or (perhaps more likely) do regulatory and tax regimes force investors to behave differently in various countries? As a final hypothesis, can any of these results be attributed to the segmentation or increasing integration of financial markets? Claessens, Dasgupta, and Glen offer little evidence on these questions but hope their results will spur further work on the cross-sectional relationships of markets and of assets in testing asset pricing theories.

This paper - a joint product of the Economics Department, International Finance Corporation; Environment, Infrastructure, and Agriculture Division, Policy Research Department; and the World Development Report office - is part of a larger effort to study the behavior of equity markets in developing countries. The study was funded by the Bank's Research Support Budget under the research project Equity Portfolio Flows to Developing Countries (RPO 678-01).