Doctoral thesis

Cash Flow risk, dispersion risk and world consumption: role and relevance for the cross-section of international equity returns

Cash-flow risk and world consumption: role and relevance for the cross-section of international equity returns: Issues such as foreign exchange effects, level of integration across ...

Author(s) :

Cybele Almeida, PhD

Investment Algorithms & Validation at UBS (Switzerland)

Abstract :

Cash-flow risk and world consumption: role and relevance for the cross-section of international equity returns: Issues such as foreign exchange effects, level of integration across countries, the influence of local versus global factors and heterogeneity risk become relevant when an asset pricing model is tranposed to an international framework. Taking some of those elements into account, this paper investigates the influence and relevance of cash-flow risk for the cross section of international returns. Results are based upon the assumption that consumption risks are globally shared and markets are integrated: investors worry mostly about global consumption risks and how to construct and hedge their portfolios against future global market turbulences. Under such background, I investigate the role of cash flow risk in an international setting, using either aggregated country earnings or dividends as cash-flow proxies. I test whether cash-flow betas are able to better describe the cross-section of international returns than does the traditional CCAPM, as it seems to be the case domestically. Among the conclusions, it could be verified that the potential risk carried by cash-flows and their dependencies to the evolution of a long-term, smoothed measure of global consumption growth are able to explain a significant portion of the cross-section of country returns, up to 60 percent. This, in stark contrast to the very weak performance of the traditional Consumption CAPM. Low P/D countries deliver on average higher returns as investors expect higher reward given their higher cash flow risk. This is, in turn, reflected via their resulting higher cash flow betas, thus suggesting the validity of adopting cash flow risk as a fundamental driver for country returns.

Dispersion risk and world consumption: role and relevance for the cross-section of international equity returns: In a representative agent framework, investors are constrained to equalize their marginal rates of substitution so that the resulting equilibrium is consistent with the existence of a unique Representative Agent. This is a rather strict assumption as it underlies the requirement that markets are complete and all risks can be fully insured. More exible settings relax this condition, allowing for the existence of heterogeneity among agents. In a CCAPM environment, that would correspond to a world where agents display heterogeneous income processes, where consumption is only partially insured and where the cross-sectional variance of consumption growth is priced. Relying on the rejection of the traditional Representative Agent theories, this paper will analyze the performance of a model that accounts for cross-sectional dispersion in country consumption, originally not priced under the canonical International CCAPM. Among the results, the relevance of dispersion risk for pricing was made evident, with dispersion betas explaining a significant fraction of country mean returns. Furthermore, an even better  fit has been achieved when the exposure of cash flows to consumption dispersion was used to compute the dispersion betas, thus highlighting the fact that countries whose cash flows are more exposed to consumption dispersion are as well countries that pay higher premia on average over time. Finally, a setting that allows for both cash flow risk and dispersion risk to be priced provides an optimal cross-sectional  fit, with both of those factors playing an essential role on describing the differences in returns across countries.

Cash Flow risk, dispersion risk and world consumption: role and relevance for th...
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Date : 13/03/2013
Thesis Committee :

Supervisor: Abraham Lioui, EDHEC Business School

External reviewer: Romeo Tedongap, Stockholm School of Economics

Other committee member: René Garcia, EDHEC Business School

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