An Evaluation of International Asset Pricing Models

This Paper assesses the ability of international asset pricing models to explain the cross-sectional variation in expected returns. All the models considered seem to capture national market returns fairly well. Global portfolios sorted on earnings-price ratio and market value, however, pose a special challenge. We find that an unconditional inter national CAPM cannot explain the cross-sectional variation in these portfolio returns. Interestingly, a conditional international asset-pricing model that includes foreign exchange risk factors is able to explain a large part of the variation in average returns. Our empirical work suggests that this model has the same explanatory ability as an inter national three-factor model, where zero-cost portfolios based on earnings-price ratios and market values are used in addition to the world market portfolio. Importantly, the loadings associated with the zero-cost portfolios are driven out by the characteristics themselves, indicating a misspecification.