The Global Price of Market Risk and Country Inflation

The advent of globalisation has meant greater access to foreign stocks for a US investor. The question of whether these are priced locally or globally is thus an important one. In this paper we examine the performance of international asset pricing models, both unconditional and conditional, for the size, book-to-market and momentum portfolios for the US, UK and Japan. We first consider a global asset pricing model where we augment the World CAPM with skewness and kurtosis factors, allowing for time-varying factor risk premiums that are functions of global variables. We then augment these global factors with two sets of local factors, First country-specific unexpected inflation and inflation skewness and then the country-specific Fama-French factors. This allows us to ascertain the global price of market risk factors as well as country-specific factors.

We find that a five factor model which augments the global three factor model with country-specific inflation and inflation skewness and has time-varying risk premiums that are functions of global variables is the best performing model overall. It outperforms the global three factor model augmented by country-specific size and book-to-market factors, even when the size and book-to-market factor premiums are allowed to be time-varying. Our findings suggest that the factor risk premiums for the World index, skewness and kurtosis factors are functions of lagged world market variables, while the inflation risk premiums are functions of term structure variables. We also find, somewhat surprisingly, that the factor risk premiums for the size and book-to-market factors are functions of lagged world market variables, rather than term structure variables, which casts doubt on whether these factors are a proxy for country-specific macro-economic risks.