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Sovereign Risk and Return in Global Equity Markets

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Author Info
Bansal, Ravi
Dahlquist, Magnus
Abstract

Standard asset pricing models have difficulty explaining cross-sectional differences in observed equity risk premia of developed and emerging markets. We argue that national equity returns are subject to sample selectivity and peso biases. The lack of credible commitment to keep capital markets open (risk of expropriation) leads to these biases. We develop a general equilibrium model for systematic risk (related to market risk and volatility risk) and sample selectivity. We find that after taking account of the sample selectivity bias, our model of systematic risk can account for the differences in risk premia quite well. We estimate the average expropriation risk to be about two-thirds of the ex-post risk premium for emerging economies and close to zero for developed economies. Further, we argue that the measured selectivity bias in equity premia provide valuable economic information regarding the incentives for sovereigns not to expropriate international investors. We find that the measured expropriation risk is related to reputations in capital markets (as argued in Eaton and Gersowitz, 1981) and to the magnitude of trade that an economy conducts (as argued in Bulow and Rogoff, 1989a, 1989b).

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 3034.

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Date of creation: Oct 2001
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Handle: RePEc:cpr:ceprdp:3034

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Related research
Keywords: credibility; dynamic general equilibrium model; international CAPM; Peso Problems; sample selectivity;

Find related papers by JEL classification:
F31 - International Economics - - International Finance - - - Foreign Exchange
F34 - International Economics - - International Finance - - - International Lending and Debt Problems
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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  19. Heckman, James J, 1979. "Sample Selection Bias as a Specification Error," Econometrica, Econometric Society, vol. 47(1), pages 153-61, January. [Downloadable!] (restricted)
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  21. English, William B, 1996. "Understanding the Costs of Sovereign Default: American State Debts in the 1840's," American Economic Review, American Economic Association, vol. 86(1), pages 259-75, March. [Downloadable!] (restricted)
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  23. Bulow, Jeremy & Rogoff, Kenneth, 1989. "A Constant Recontracting Model of Sovereign Debt," Journal of Political Economy, University of Chicago Press, vol. 97(1), pages 155-78, February. [Downloadable!] (restricted)
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  24. Darrell Duffie & Lasse Heje Pedersen & Kenneth J. Singleton, 2003. "Modeling Sovereign Yield Spreads: A Case Study of Russian Debt," Journal of Finance, American Finance Association, vol. 58(1), pages 119-159, 02. [Downloadable!] (restricted)
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  28. Peter Blair Henry, 2000. "Stock Market Liberalization, Economic Reform, and Emerging Market Equity Prices," Journal of Finance, American Finance Association, vol. 55(2), pages 529-564, 04. [Downloadable!] (restricted)
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