International asset pricing and portfolio choice: A multi-factor approach to addressing remaining puzzles

The capital asset pricing model (CAPM) provides a quantifiable measure of risk for individual assets, but has been found to be of limited use when applied in an international setting. Further, the international version of the CAPM (the ICAPM) which extends the model to allow for varying investment and consumption opportunity sets fails to significantly outperform the standard domestic model in asset pricing studies. Moreover, when applied to the problem of portfolio choice, neither the ICAPM, competing multi-factor models, nor consumption-based models satisfactorily address the empirical observation that investors in different countries tend to unduly favor domestic assets over foreign ones when constructing portfolios—a phenomenon referred to as home bias in investing. In this paper, a multi-factor pricing model (IAPM) is used to describe international equity returns in emerging markets and to determine the extent of home bias vis-à-vis these markets. The results show that asset prices depend not only on global risk factors, but on regional factors, as well as on a given market's level of real and financial integration. More specifically; (a) differences in investor information sets, and (b) the influence of contagion, or “spillover” effects from large countries to small ones, are shown to be significant in explaining the cross-sectional variation of emerging market equity returns. The IAPM is also particularly useful in identifying periods in which markets effectively integrate with world financial markets. Finally, portfolios selected using the IAPM indicate a home bias among U.S. investors that is only one-half as large as found using the CAPM, implying that a large proportion of previously observed instances of home bias may be due to model misspecification. The results also suggest that there is limited home bias on the part of investors domiciled in emerging markets. The latter result is consistent with previous research which finds that specific anomalies commonly associated with developed financial markets (e.g., “turn-of-the-year” and “small-firm” effects) do not manifest themselves in emerging ones.