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

Posted: 16 Oct 1996

See all articles by Kees C. G. Koedijk

Kees C. G. Koedijk

Tilburg University - Department of Finance

Clemens J.M. Kool

Utrecht University - School of Economics

Francois Nissen

MeesPierson Investment Bank

Peter C. Schotman

Maastricht University - Department of Finance

Date Written: July 30, 1996

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

Suggested Citation

Koedijk, Kees G. and Kool, Clemens J.M. and Nissen, Francois and Schotman, Peter C., An Empirical Investigation of the Domestic Pricing Error in an Integrated World (July 30, 1996). Available at SSRN: https://ssrn.com/abstract=7819

Kees G. Koedijk (Contact Author)

Tilburg University - Department of Finance ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands
+31 13 4663048 (Phone)
+31 13 4662052 (Fax)

Clemens J.M. Kool

Utrecht University - School of Economics ( email )

Kriekenpitplein 21-22
Adam Smith Building
Utrecht, 3584 EC
Netherlands

Francois Nissen

MeesPierson Investment Bank

P.O. Box 243
1000 AE Amsterdam
Netherlands
+31 20 527 7921 (Phone)
+31 20 527 1984 (Fax)

Peter C. Schotman

Maastricht University - Department of Finance ( email )

P.O. Box 616
Maastricht, 6200 MD
Netherlands
+31 43 388 3862 (Phone)
+31 43 388 4875 (Fax)

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