Essays on international capital asset pricing

Essay1. We study the risk dynamics and pricing in international economies through a joint analysis of the time-series returns and option prices on the S&P 500 Index of the United States, the FTSE 100 Index of the United Kingdom, and the Nikkei-225 Stock Average of Japan. We develop an international capital asset pricing model, under which the return on each equity index is decomposed into a global component and a country-specific component. Both components are controlled by separate volatility processes. For each economy, separate market prices are assigned for the two return risk components and the two volatility risk components. Model estimation reveals several interesting insights. First, global and country-specific return and volatility risks show different dynamics. Global return movements contain a larger discontinuous component, and global return volatility is more persistent than the country-specific counterparts. Second, investors charge positive prices for global return risk and negative prices for volatility risk, suggesting that investors are willing to pay positive premiums to hedge against downside global return movements and upside volatility movements. Third, the three economies contain different risk profiles and also price risks differently. Japan contains the largest idiosyncratic risk component and smallest global risk component. Investors in the Japanese market also price more heavily against future volatility increases than against future market downfalls.Essay2. We study the pricing of illiquid cross exchange rate options by identifying stochastic discount factors embedded in currency triangles. We develop dynamic models of stochastic discount factors, under which the stochastic discount factor in each economy is decomposed into a global diffusion risk component and a country-specific jump-diffusion risk component. Separate stochastic time changes are further applied to the two components so that stochastic volatilities can come separately from both global and country-specific risks. We propose to identify both the global and the country-specific risks for three economies using options on the three currency pairs that form a currency triangle. Then, by incorporating options on any other currency pair that links to one of the three economies, we can also identify the country-specific risk dynamics in the fourth economy and thus price options on currency pairs that involve the fourth economy.