Tests of Alternative International Asset Pricing Models
Posted: 13 Jul 1998
Date Written: November 1995
Previous studies have concluded that equity returns do not carry unconditional risk premia for exchange rate and inflation risks. We decompose changes in exchange rates into a component common across different exchange rates, and an idiosyncratic component. This approach allows the estimation of unconditional exchange rate premia on a large number of exchange rates. We also estimate both domestic and foreign inflation risk premia. Our analysis, carried out in the context of three alternative international asset pricing models and using stock returns from ten industrial countries, strongly rejects the hypotheses that equities carry a zero common or idiosyncratic exchange rate risk premium, or a zero domestic or foreign inflation risk premium. We find that an asset pricing model that accounts for the pricing of exchange rate and inflation risk, can explain cross country differences in asset returns reasonably well.
JEL Classification: F31, E31, G12, G15
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