The Global Price of Market Risk and Country Inflation

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