Did the EMS Reduce the Cost of Capital?
We propose a dynamic arbitrage pricing theory (APT) multi--factor model with time--varying volatility for currency, bond and stock returns for ten European countries over 1977--97. We exploit the cross--sectional dimension of the model to construct world portfolios, which when added to the original list of assets, allow us to develop simple consistent methods of estimation and testing. Our results reject the implicit asset pricing restrictions, and suggest decreases in idiosyncratic exchange rate risk tend to lower the cost of capital, although the effect is small. We assess the potential gains from increased stock market integration. Copyright Royal Economic Society 2002
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Volume (Year): 112 (2002)
Issue (Month): 482 (October)
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