A state-dependent international CAPM for partially integrated markets: Using local and US risk factors

Abstract

This study investigates the impact of emerging economies' trade levels with the US and exchange rate systems on their interdependency with the US market. We employ a comprehensive approach, analyzing both local factors (such as illiquidity and dividend yield) and US risk factors (including the S&P500 Index, US effective exchange rate, and term spread) to discern various market phases and capture equity returns. Utilizing a State-dependent International CAPM framework, we reveal a common trend among market returns: the reduced informativeness of both US and local variables during transitions from low to high volatility states. Notably, the majority of emerging markets respond to signals from the US equity market during bullish periods. We also highlight the critical role of exchange rate regimes in explaining the sensitivity of emerging markets to US risk factors. While the illiquidity ratio emerges as a significant local risk factor, its informativeness wanes during bear markets. These findings offer valuable insights for asset allocation, diversification, and risk management strategies tailored to the dynamic nature of emerging markets.