1 global versus local asset pricing: a speculation based test of market integration imperial college...
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Global versus Local Asset Pricing:A Speculation Based Test of Market Integration
Imperial College London October 19, 2010
Harald Hau
INSEADhttp://www.haraldhau.com
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Motivation
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Cost of capital calculation depend on stock betas and are a key input into capital budgeting decisions
We have no consensus about whether global or local market betas most appropriate
This paper uses a large global index revision as an identification mechanism to study market integration in terms of risk pricing
Idea: Index change was large enough to change market benchmark and therefore all stock betas
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Three Dimensions of the Analysis
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Asset
Pricing
Market
Integration
Limited
Arbitrage
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Asset Pricing Issues
Asset pricing test are joint tests of the market benchmark and the pricing model
Roll’s critique: Market benchmark is difficult (impossible) to identify
What is the market benchmark? All capital in assets subject to dynamic optimization Not part of the market benchmark:
Capital of index funds Capital held for control reasons (family ownership, etc) Capital of retail investors? (no diversification, investment
inertia)
© Harald Hau, INSEAD 4
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Idea: Test asset pricing model in differences for a change in the market benchmark
Large index change can identify a market benchmark change: Old benchmark: (kx1 vector) Index change: (kx1 weight
changes) New benchmark:
Market benchmark change identifies exogenous beta change
wSS on
Asset Pricing for Market Benchmark Change
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on www
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Asset Pricing for Market Benchmark Change
Beta is the return covariance with the market benchmark
Benchmark change alters all stock betas:
Return effect (for constant cash flows):
© Harald Hau, INSEAD
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Market
Integration
Three Dimensions of the Analysis
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Asset
Pricing
Limited
Arbitrage
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Market Integration Issues
Global or local market benchmark? Integration test depend on the correct identification of both benchmarks Conditional asset pricing models: Difficult specification choices and
implementation issues
Event study approach provides alternative: Covariance decomposition:
Global covariance: National covariance terms: International covariance terms:
IntLG G
LInt
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Testing for Market Integration
Local asset pricing: Only weight changes of local stocks affect (via local benchmark
change) asset prices:
Global asset pricing: Weight changes of all stocks (globally) affect (via global benchmark
change) asset prices:
Equally strong returns effects from local and international covariance terms
Need not identify either global or local market benchmark
© Harald Hau, INSEAD 9
wwp IntL for effect return no ,
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Limited
Arbitrage
Market
Integration
Three Dimensions of the Analysis
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Asset
Pricing
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Arbitrage of Index Change
Index change ∆w might have been predicted by some speculators (arbitrageurs)
Front-running might accelerate price adjustment Speculators may acquire hedging positions to reduce
arbitrage risk: Positions of risk neutral speculators:
Positions of risk averse speculators:
Need to control of price impact of hedging term
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Limited Arbitrage Literature
Limited arbitrage in multiple assets: Degree of arbitrage depends each asset depends on marginal
risk contribution of each asset “Return chasing” arbitrage vector is modified by hedging terms
which creates an additional price effect
Generalize Greenwood model (2007) by allowing a price elastic (uninformed) liquidity supply in each asset
Arbitrageurs learn about index change: Liquidity suppliers learns about index change: Index change occurs:
© Harald Hau, INSEAD 12
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Speculative Price Dynamics
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Event and Data
MSCI (Morgan Stanley Capital International Inc.) Most important international index US$ 3 trillion benchmarked, US$ 300-350 directly indexed MSCI all country world index (= 50 countries, 2077 stocks)
Event: Move to new free float weights Nov 2000: Industry Consultation on index change Dec 1, 2000: Announcement that decision on free float weights
adoption is imminent and to be communicated on Dec 10, 2000 Dec 10, 2000: Time table for index change becomes public:
First adjustment of 50% on Nov 30, 2001 Second adjustment of 50% on May 31, 2002
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Country Weight Changes of Index Revision
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Estimate covariance matrix over period July 1, 1998 to July 1, 2000
Event and Data
Hedge
Liquidation
Period Nov 30, 2001:
1. Implementation
Event
May 31, 2002:
2. Implementation
Event
Position
Build-up
Period
Dec 1, 2000:Decision day announcement
Dec 10, 2000:
Index change announcement
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Position Build-up and Hedge Liquidation
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Event and Data
MSCI ACWI: 2077 stocks originally 489 inclusions and 298 deletions Exclude two crisis countries: Turkey and
Argentina with 62 stocks 31 stocks not found in Datastream and 182 with
incomplete price history Sample: 2291 stocks (of which 396 are
inclusions and 265 excluded stocks)
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Summary Statistics I
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Summary Statistics II
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Evidence
Testing dynamic predictions: Position buildup period: Event windows up to December 1 Hedge Liquidation period: Event windows after December 1
Global versus local risk pricing:
Integrated risk pricing between developed and emerging market stocks?
Segmentation of EM stocks by cross-listing and liquidity?
© Harald Hau, INSEAD 21
CHHG
IntLG
ListListHCHHG
LiqLiqHCHHG
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Position Buildup Period
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Predictions:
0
0
1
1
Stocks with beta decreases experience positive event returns Stocks with high arbitrage risk have negative returns (short selling)
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Hedge Liquidation Period
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Prediction:
Gradual liquidation of the hedge position (after December 1) generates a positive return effect for stocks with high arbitrage risk
02
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Global versus Local Pricing
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Integration: Segmentation:
0
0)(
11
11
IntL
IntLi
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IntL
IntLii
Local asset pricing hypothesis strongly rejected Global asset pricing hypothesis cannot be rejected
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Segmentation between Emerging and Developed Markets
Decompose into two hemispheres: Matrix captures risk pricing integration between developed and
emerging markets
Find evidence for market integration between developed and emerging markets
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CHHG CH
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Role of Cross-Listing and Liquidity
Cross-Listing Decomposition: Liquidity Decomposition:
Cross-listed and liquid emerging market stocks are integrated
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ListListHCHHG
LiqLiqHCHHG
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Robustness I
Traditional (univariate) price pressure hypothesis does not have a good cross-sectional fit:
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Robustness II
Robustness with respect to the matrix Replace by a new matrix based the 20, 40 or 60 principle
components of Obtain qualitatively similar results
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~
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Conclusions
MSCI index revision allows us to apply CAPM in differences (without benchmark identification) obtain insights into the structure of arbitrage trading (the role of
hedging positions) explore the degree of integrated risk pricing (global versus local beta)
Evidence: Predicted beta changes explain front-running returns Hedging demand has an important (temporary) price effect Market Integration:
Global risk pricing is supported by the event returns, while local risk pricing is rejected in the data
Only illiquid stocks emerging market and stocks without cross listing show evidence for segmentation
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