An Empirical Investigation of the Domestic Pricing Error in an Integrated World

Abstract

Increasing capital market integration has important implications for the calculation of the cost of capital. In an integrated world the cost of capital should be determined using the International Capital Asset Pricing Model rather than the domestic Capital Asset Pricing Model. In this paper we investigate this issue with an asset pricing model that explicitly allows for deviations from Purchasing PowerParity. The pricing error when using the domestic Capital Asset Pricing Model rather than an International Capital Asset Pricing Model is zero if diversifiable domestic risk is orthogonal to the global market portfolio return and foreign currency changes. We use Hansen's (1982) Generalized Method of Moments to test for orthogonality and implement this test for more than 3000 individual stocks of 10 different countries. We cannot reject that the global market portfolio and the foreign currencies affect the cost of capital of an individual firm through the effect of the global market on the risk premium of the local market and not through the global beta of the firm.

JEL Classification: G12