A central question in financial economics is how to find the pricing kernel across asset classes in international markets and how that kernel could be measured empirically.
Joon Woo Bae, assistant professor of banking and finance, has a new article “Global Equity Correlation in International Markets” forthcoming in Management Science on the role of global equity correlation. Through a stylized consumption-based international asset pricing model, the article presents that the change in global risk aversion is a common driver of returns across all assets in different countries.
However, the change in global risk aversionis not observable and is challenging to measure. The authors in this article illustrates that the innovation in the common correlation across international equity returns is a close proxy for that and hence aviablefactor for their empirical exercise.
Bae and his co-author confirm empirically that the factor indeed has a has a robust negative price of risk and significantly improves the joint cross-sectional fits across various asset classes, including global equities, commodities, sovereign bonds, foreign exchange rates, and options.
In exploring the pricing ability of our factor on the FX market, the article also shed light on the link between international equity and currency markets through global equity correlations as an instrument for aggregate risks.
Download the full paper.
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