An intertemporal international asset pricing model: Theory and evidence

Abstract

We utilize an intertemporal CAPM (Merton, 1973) framework to examine how exposure to currency risk is priced in foreign equity markets. We identify the fundamental determinants of foreign equity return and foreign currency loadings with respect to a world equity factor and global currency risk factor. To capture the time-varying nature of risk exposures, we employ the mean-reverting dynamic conditional correlation (DCC) model of Engle (2002) to estimate conditional covariances and betas. Our regression results show that estimated risk-return coefficients on betas and covariances are significant and robust to subsample tests based on emerging markets and developed markets. We also show that the risk-return tradeoff on foreign equity returns and relative risk aversion vary cyclically across financial stress regimes.