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Understanding the cross-section of international equity markets

Businessman using tablet and laptop for analysing stock market data.
Argyris Tsiaras.
Dr Argyris Tsiaras

A large literature in international finance has established the relevance of a wide array of frictions in financial investments across borders leading to the concentration of equity investments within national borders (home bias in equity portfolios) and to large biases in the composition of investors’ foreign equity portfolios (foreign bias). Moreover, despite increasing integration of international equity markets in recent decades, asymmetries in bilateral return comovement between equity markets remain large. In a working paper entitled “Asset pricing of international equity under cross-border investment frictions” and recently presented at the 2020 American Finance Association meetings in San Diego, CCFin/CERF research associate Argyris Tsiaras and collaborator Thummim Cho (LSE) undertake a systematic theoretical investigation of how the cross-sections of equity returns and portfolio holdings across countries are jointly shaped by investment frictions and other characteristics of individual countries or equity markets, such as market size or the comovement of cash-flow fundamentals.

Overall, the authors argue that cross-country variation in the degree of cross-border investment frictions is the most important determinant of the cross-sections of equity return moments and of cross-border equity portfolio allocations. The paper investigates the implications of this observation for the literature on international asset pricing models, most of which are still tested under the assumption of frictionless cross-border investing.

The authors establish three robust empirical regularities (stylised facts) in the cross-section of international equities. First, equity markets whose returns are more highly correlated with the global equity market also have greater foreign investor presence. In particular, the share of a stock market held by US investors, henceforth referred to as the US investor (cross-border) position, has strong explanatory power for the cross-country variation in correlations of an equity market’s excess return with the US market return. In our sample of 40 countries, the US investor position in a country averaged over 2000-2017 explains about 40 per cent of the cross-sectional variation in the return correlations over the same period. Importantly, the relative size of the equity markets or indicators of real sector comovement, such as the size of bilateral trade and the GDP correlation between the country and the US, are unable to account for the cross-section of return comovement. These patterns are hard to reconcile with standard portfolio choice models under frictionless access to international equity markets, which typically predict that investors wish to avoid large positions in assets that are highly correlated with their overall portfolio return.

Second, equity markets whose returns comove less with the global (or US) equity market appear to have larger pricing errors with respect to the global Capital Asset Pricing Model (CAPM) and other multi-factor international asset pricing models. As a result, the security market line (average returns versus betas) in global equity markets appears to be flat or even negative, pointing to a puzzlingly low, or even negative, price of global market risk. Combining this regularity with the first stylised fact, international equity investors have low market positions in markets with high apparent expected returns and low global risk, an observation hard to reconcile with the predictions of frictionless portfolio choice models. Third, investors based in countries that comove less with the global (or US) equity market have equity portfolios that are more biased towards domestic stocks (greater “home bias”).

To rationalise these empirical patterns, the authors develop a general-equilibrium model of the global economy featuring heterogeneity across countries in cross-border financial investment frictions, modelled in reduced form as proportional holding costs, as well as rich heterogeneity in other potentially relevant aspects, such as risk preferences or cash-flow fundamentals. In the model, the activity of foreign investors in a country’s equity market amplifies return volatility relative to volatility in cash-flow fundamentals and causes fluctuations in countries’ valuation ratios. Importantly, the magnitude of this amplification is decreasing in the holding cost incurred by foreign investors, so that heterogeneity in holding cost across countries translates into heterogeneity in the degree of equity market return comovement with the large market (first stylised fact).

The model also explains the negative relationship between CAPM alphas and betas (second stylised fact), because the high apparent average returns on the stock markets of countries with low return correlations are not in fact attainable by foreign investors in these countries. Because countries with high holding costs, and thus high CAPM alphas, have endogenously low return correlations with global equity markets, a test of the standard market model, which only allows for a uniform intercept across all equity markets, yields a flat security market line and a deceptively low, or even negative, price of global market risk. Finally, high holding costs in a country’s equity market imply a large degree of home bias in the equity portfolio of investors based in that country mainly because high frictions to foreign investors in the local market in equilibrium translate into a comparative advantage of the local market relative to foreign markets as a financial investment for local investors. The impact of holding costs on the endogenous wealth of local investors amplifies the negative impact of local-investor home bias on the foreign position in the local equity market.


Cho, T. and Tsiaras, A. (2020) “Asset pricing of international equity under cross-border investment frictions.” Working paper.