Essays on asset pricing: Linking macroeconomic factors to expected returns

This thesis examines two major areas of asset pricing: the choice of risk factors in pricing stocks in a single country context, and in an international context. First, the thesis provides an economic explanation for an empirical fact that stock returns are related to firm size and the book-to-market ratio. We show that profit maximizing homogenous firms should converge to a stable long-run equilibrium, in which firm capital size and growth rates are shaped by the economic environment. Internal firm characteristics such as market value and the book to market ratio influence returns by reflecting existing macroeconomic conditions. Fama and French (1992, 1993, 1995) relate stock returns to firm characteristics and provide an intuitive explanation why firm attributes may proxy for firm risk sensitivities. In our theoretical model we provide an economic argument why this may be the case.; Second, we empirically test our theory. We find supporting evidence that firms converge to an optimal size. We also find that an increased growth rate of technology is associated with an increase in optimal size of firm capital.; Next, we estimate a time-varying market integration model to analyze the effect of the European monetary unification and economic liberalization. We use a sample of three EMU (France, Germany, Netherlands) and two non-EMU (U.K. and Switzerland) countries, as well as the European stock market index and a currency index, using monthly data from March 1984 to November 2002. We find that financial markets in Europe followed a gradual integration process that did not jump to full integration even after the introduction of the Euro in 1999.; We find that countries with higher degrees of financial integration tend to have lower prices for market and currency risk, consistent with the prediction of models of capital market integration. We also provide additional evidence that prices of market and currency risks are significant and time varying. Evidence suggests that financial integration reduces prices of risks and risk premia. We identify two dates when integration-related structural breaks occurred in European asset pricing. No dramatic upward shift in integration associated with the introduction of the Euro is detected.