International Asset Pricing and Time-Varying Risk Premia

36 Pages Posted: 27 Feb 2007

See all articles by Devraj Basu

Devraj Basu

SKEMA Business School - Lille Campus

Chi-Hsiou Daniel Hung

University of Glasgow - Adam Smith Business School

Alexander Stremme

University of Warwick - Finance Group

Date Written: June 2007

Abstract

This paper introduces an international asset pricing model with time-varying risk premia. It augments the two factor model which has the return on the world index and trade weighted exchange rates as factors, with skewness and kurtosis factors. This leads to a stochastic discount factor that is non-linear and has time-varying factor loadings that are functions of global variables. We test this model on market indices, size and momentum sorted portfolios that are formed from stocks listed in G8 countries, as well as country-neutral size, book-to-market and momentum portfolios. Overall, the model is capable of pricing almost all sets of base assets unconditionally using only global predictive variables. It also explains much of the cross sectional variation of the country, size and momentum portfolios, and also achieves much of the substantial size and momentum premiums. The role of time-varying risk premiums that are functions of global variables is crucial to the performance of the model, particularly in the case of the exchange rate factor.

Keywords: International asset pricing, Time-varying Risk Premia

JEL Classification: C31, C32, G12, G15

Suggested Citation

Basu, Devraj and Hung, Chi-Hsiou Daniel and Stremme, Alexander, International Asset Pricing and Time-Varying Risk Premia (June 2007). EFA 2007 Ljubljana Meetings Paper, WBS Finance Group Research Paper No. 73, Available at SSRN: https://ssrn.com/abstract=965751 or http://dx.doi.org/10.2139/ssrn.965751

Devraj Basu

SKEMA Business School - Lille Campus ( email )

Avenue Willy Brandt, Euralille
Lille, 59777
France

Chi-Hsiou Daniel Hung (Contact Author)

University of Glasgow - Adam Smith Business School ( email )

Gilbert Scott Building
University of Glasgow
Glasgow, Scotland G12 8QQ
United Kingdom

Alexander Stremme

University of Warwick - Finance Group ( email )

Gibbet Hill Rd
Coventry, CV4 7AL
Great Britain
+44 (0) 2476 - 522 066 (Phone)
+44 (0) 2476 - 523 779 (Fax)

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