Review of Quantitative Finance and Accounting, 15 (2000): 235±257
# 2000 Kluwer Academic Publishers. Manufactured in The Netherlands.
An International Asset Pricing Model with
Time-Varying Hedging Risk
JOW-RAN CHANG AND MAO-WEI HUNG*
College of Management, National Taiwan University
Abstract. This paper employs a two-factor international equilibrium asset pricing model to examine the pricing
relationships among the world's ®ve largest equity markets. In addition to the traditional market factor premium,
a hedging factor premium is included as the second factor to explain the relationship between risks and returns in
the international stock markets. Moreover, a GARCH parameterization is adopted to characterize the general
dynamics of the conditional second moments. The results suggest that the additional hedging risk premium is
needed to explain rates of return on international equities. Furthermore, the restriction that the coef®cient on the
hedge-portfolio covariance is one smaller than the coef®cient on the market-portfolio covariance can not be
rejected. This suggests that the intertemporal asset pricing model proposed by Campbell (1993) can be used to
explain the returns on the ®ve largest stock market indices.
Key words: international asset pricing, hedging risk, GARCH
JEL Classi®cation: C32, F30, G12, G15
The relationship between risk and return has been the focus of recent ®nance research.
Numerous papers have derived various versions of the international asset pricing model.
For example, Solnik (1974) extends the static capital asset pricing model (CAPM) of
Sharpe (1964) and Lintner (1965) to an international framework. His empirical ®ndings
reveal that national factors are important in the pricing of stock markets. Furthermore,
Korajczyk and Viallet (1989) propose that the international CAPM outperforms its
domestic counterpart in explaining the price behavior of equity markets.
In a fruitful attempt to extend the conditional version of the static CAPM, Harvey
(1991) employs the generalized method of moments (GMM) to examine an international
asset pricing model that captures some of the dynamic behavior of the country returns.
De Santis and Gerard (1997) test the conditional CAPM for international stock markets,
but they apply a parsimonious generalized auto-regressive conditional heteroscedasticity
(GARCH) parameterization as the speci®cation for second moments. Their results
indicate that a one-factor model cannot fully explain the dynamics of international
expected returns and price of market risk is not signi®cant.
On the other hand, recent studies have applied the arbitrage pricing theory (APT) of
Ross (1976) to an international setting. For instance, Cho, Eun, and Senbet (1986)
employ factor analysis to demonstrate that additional factors other than covariance risk
*Send all correspondence to: Professor Mao-wei Hung, Department of International Business, College of
Management, National Taiwan University, No. 1, Section 4, Roosevelt Road, Taipei, Taiwan.