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Tests of International CAPM with Time-Varying Covariances

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Author Info
Charles Engel
Anthony P. Rodrigues

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Abstract

We perform maximum likelihood estimation of a model of international asset pricing based on CAPM. We test the restrictions imposed by CAPM against a more general asset pricing model. The "betas" in our CAPM vary over time from two sources -- the supplies of the assets (government obligations of France, Germany, Italy, Japan, the U.K. and the U.S.) change over time, and so do the conditional covariances of returns on these assets. We let the covariances change over time as a function of macroeconomic data. We also estimate the model when the covariances follow a multivariate ARCH process. When the covariance of forecast errors are time-varying, we can identify a modified CAFM model with measurement error -- which we also estimate. We find that the model in which the CAPM restrictions are imposed (which involve cross-equation constraints between coefficients and the variances of the residuals) perform much better when variances are not constant over time. Nonetheless, the CAPM model is rejected in favor of the less restricted model of asset pricing.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 2303.

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Date of creation: Jul 1987
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Handle: RePEc:nbr:nberwo:2303

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Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Bollerslev, Tim & Engle, Robert F & Wooldridge, Jeffrey M, 1988. "A Capital Asset Pricing Model with Time-Varying Covariances," Journal of Political Economy, University of Chicago Press, vol. 96(1), pages 116-31, February. [Downloadable!] (restricted)
  2. Cumby, Robert E & Obstfeld, Maurice, 1981. "A Note on Exchange-Rate Expectations and Nominal Interest Differentials: A Test of the Fisher Hypothesis," Journal of Finance, American Finance Association, vol. 36(3), pages 697-703, June. [Downloadable!] (restricted)
  3. Pagan, Adrian, 1988. "A note on the magnitude of risk premia," Journal of International Money and Finance, Elsevier, vol. 7(1), pages 109-110, March. [Downloadable!] (restricted)
  4. Giovannini, Alberto & Jorion, Philippe, 1987. "Interest rates and risk premia in the stock market and in the foreign exchange market," Journal of International Money and Finance, Elsevier, vol. 6(1), pages 107-123, March. [Downloadable!] (restricted)
  5. Frankel, Jeffrey & Engel, Charles M., 1984. "Do asset-demand functions optimize over the mean and variance of real returns? A six-currency test," Journal of International Economics, Elsevier, vol. 17(3-4), pages 309-323, November. [Downloadable!] (restricted)
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  6. Dooley, Michael & Isard, Peter, 1982. "A portfolio-balance rational-expectations model of the dollar-mark exchange rate," Journal of International Economics, Elsevier, vol. 12(3-4), pages 257-276, May. [Downloadable!] (restricted)
  7. Hansen, Lars Peter & Hodrick, Robert J, 1980. "Forward Exchange Rates as Optimal Predictors of Future Spot Rates: An Econometric Analysis," Journal of Political Economy, University of Chicago Press, vol. 88(5), pages 829-53, October. [Downloadable!] (restricted)
  8. Robert E. Cumby & Maurice Obstfeld, 1985. "International Interest-Rate and Price-Level Linkages Under Flexible Exchalge Rates: A Review of Recent Evidence," NBER Working Papers 0921, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  9. Michael P. Dooley & Peter Isard, 1979. "The portfolio-balance model of exchange rates," International Finance Discussion Papers 141, Board of Governors of the Federal Reserve System (U.S.).
  10. Geweke, John F & Feige, Edgar L, 1979. "Some Joint Tests of the Efficiency of Markets for Forward Foreign Exchange," The Review of Economics and Statistics, MIT Press, vol. 61(3), pages 334-41, August. [Downloadable!] (restricted)
  11. Domowitz, Ian & Hakkio, Craig S., 1985. "Conditional variance and the risk premium in the foreign exchange market," Journal of International Economics, Elsevier, vol. 19(1-2), pages 47-66, August. [Downloadable!] (restricted)
  12. Hsieh, David A., 1984. "Tests of rational expectations and no risk premium in forward exchange markets," Journal of International Economics, Elsevier, vol. 17(1-2), pages 173-184, August. [Downloadable!] (restricted)
  13. Francis X. Diebold & Marc Nerlove, 1986. "The dynamics of exchange rate volatility: a multivariate latent factor ARCH model," Special Studies Papers 205, Board of Governors of the Federal Reserve System (U.S.).
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  14. Jeffrey A. Frankel, 1988. "Recent Estimates of Time-Variation in the Conditional Variance and in the Exchange Risk Premium," NBER Working Papers 2367, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  15. Jeffrey A. Frankel, 1986. "The Implications of Mean-Variance Optimization for Four Questions in International Macroeconomics," NBER Working Papers 1617, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  16. Branson, William H. & Halttunen, Hannu & Masson, Paul, 1977. "Exchange rates in the short run: The dollar-dentschemark rate," European Economic Review, Elsevier, vol. 10(3), pages 303-324. [Downloadable!] (restricted)
  17. Jeffrey A. Frankel, 1984. "Tests of Monetary and Portfolio Balance Models of Exchange Rate Determination," NBER Chapters, in: Exchange Rate Theory and Practice, pages 239-260 National Bureau of Economic Research, Inc. [Downloadable!]
  18. Bollerslev, Tim, 1986. "Generalized autoregressive conditional heteroskedasticity," Journal of Econometrics, Elsevier, vol. 31(3), pages 307-327, April. [Downloadable!] (restricted)
  19. Hamilton, James D, 1985. "Uncovering Financial Market Expectations of Inflation," Journal of Political Economy, University of Chicago Press, vol. 93(6), pages 1224-41, December. [Downloadable!] (restricted)
  20. Branson, William H. & Halttunen, Hannu & Masson, Paul, 1979. "Exchange rates in the short run : Some further results," European Economic Review, Elsevier, vol. 12(4), pages 395-402, October. [Downloadable!] (restricted)
  21. Robert Engle & Tim Bollerslev, 1986. "Modelling the persistence of conditional variances," Econometric Reviews, Taylor and Francis Journals, vol. 5(1), pages 1-50. [Downloadable!] (restricted)
  22. Giovannini, Alberto & Jorion, Philippe, 1988. "Foreign exchange risk premia volatility once again," Journal of International Money and Finance, Elsevier, vol. 7(1), pages 111-113, March. [Downloadable!] (restricted)
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