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

Motivation

© Harald Hau, INSEAD 2

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

Three Dimensions of the Analysis


Asset

Pricing

Market

Integration

Limited

Arbitrage

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)


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


on www

oS

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

oi

mjjji

mmi

mi SRwRRR 222

1,cov

1,cov

1

)Σ(

)(1

2

on

oni

mi

ww

ww

)()(loglog oniit

otit

nittiti wwrrPPr

Market

Integration



Asset

Pricing

Limited

Arbitrage


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

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


wwp IntL for effect return no ,

wwwp IntLG

Limited

Arbitrage

Market

Integration



Asset

Pricing

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


wx

wwx

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:


At

Ltut

Speculative Price Dynamics



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

Country Weight Changes of Index Revision


)(21 on

on

ww

ww


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


Position Build-up and Hedge Liquidation


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)

Summary Statistics I


Summary Statistics II


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?


CHHG

IntLG

ListListHCHHG

LiqLiqHCHHG

Position Buildup Period


Predictions:

0

0

1

1

Stocks with beta decreases experience positive event returns Stocks with high arbitrage risk have negative returns (short selling)

Hedge Liquidation Period


Prediction:

Gradual liquidation of the hedge position (after December 1) generates a positive return effect for stocks with high arbitrage risk

02

Global versus Local Pricing


Integration: Segmentation:

0

0)(

11

11

IntL

IntLi

0

0)(

11

11

IntL

IntLii

Local asset pricing hypothesis strongly rejected Global asset pricing hypothesis cannot be rejected

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


CHHG CH

Role of Cross-Listing and Liquidity

Cross-Listing Decomposition: Liquidity Decomposition:

Cross-listed and liquid emerging market stocks are integrated


ListListHCHHG

LiqLiqHCHHG

Robustness I

Traditional (univariate) price pressure hypothesis does not have a good cross-sectional fit:


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


~

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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