The Global Price of Market Risk and Country Inflation

41 Pages Posted: 3 Mar 2008 Last revised: 6 May 2009

See all articles by Devraj Basu

Devraj Basu

SKEMA Business School - Lille Campus

Chi-Hsiou Daniel Hung

University of Glasgow - Adam Smith Business School

Date Written: May 5, 2009

Abstract

This paper approaches the central questions of the identification and the price of risk in an international asset pricing context. We construct and use factor mimicking portfolios to obtain factor loadings for testing unconditional and conditional pricing. We use a new measure of specification error for conditional models. The dynamic stochastic discount factor which explicitly admits skewness and kurtosis factors in the aggregate global market portfolio significantly expands the factor frontier more than the effect achieved by adding the Fama-French factors to the return on the world market portfolio. A cubic SDF augmented by country-specific inflation and inflation skewness with time-varying risk premiums that are functions of global predictive variables is the best performing model overall for pricing the size, book-to-market and momentum portfolios in the U.S., U.K. and Japan. The country-specific risks are significantly priced, suggesting that the financial markets in these countries may be partially-segmented.

Keywords: Country-specific asset pricing, Nonlinear SDF, Time-varying risk premiums

JEL Classification: C31, C32, G12, G15

Suggested Citation

Basu, Devraj and Hung, Chi-Hsiou Daniel, The Global Price of Market Risk and Country Inflation (May 5, 2009). Available at SSRN: https://ssrn.com/abstract=971124 or http://dx.doi.org/10.2139/ssrn.971124

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

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