Summary: Cross-sectional tests of asset returns have a long tradition in finance. The often-used capital asset pricing model (CAPM) and the arbitrage pricing theory both imply cross-sectional relationships between individual asset returns and other factors, and tests of those models have done much to increase understanding of how markets price risk. But much about the way assets are priced remains unclear. After much testing, numerous empirical anomalies about the CAPM cast doubt on the central hypothesis of that theory: that on a cross-sectional basis a positive relationship exists between asset returns and assets' relative riskiness as measured by their Bs (beta being the ratio of the covariance of an asset's return with the market return to the variance of the market return). As tenuous as the relationship between B and returns may be, other risk factors apparently influence U.S. equity market returns significantly: market capitalization (or size), earnings-price ratios, and book-to-market value of equity ratios. Once these factors are included as explanatory variables in the cross-sectional model, the relationship between B and returns disappears. Much "international" empirical work has focused on more developed markets, especially Japan and the United Kingdom, with some evidence from other European markets as well. The international evidence largerly confirms the hypothesis that other factors besides B are important in explaining asset returns. The authors expand the empirical evidence on the nature of asset returns by examining the cross-sectional pattern of returns in the emerging markets. Using data from the International Finance Corporation for 19 developing country markets, they examine the effect on asset returns of several risk factors in addition to B. They find that, in addition to B, two factors - size and trading volume - have significant explanatory power in a number of these markets. Dividend yield and earnings-price ratio are also important, but in slightly fewer markets. For several of the markets studied, the relationship between all four of these variables and returns is contrary to the relationship documented for U.S. and Japanese markets. In several countries, exchange-rate risk is a significant factor. With independent new empirical evidence introduced into the asset-pricing debate, future research must now cope with the idea that any theory hoping to explain asset pricing in all markets must explain how factors can be priced differently simply by crossing an international border. Is it market microstructure that causes these substantial differences? Or (perhaps more likely) do regulatory and tax regimes force investors to behave differently in various countries? As a final hypothesis, can any of these results be attributed to the segmentation or increasing integration of financial markets? The authors offer little evidence on these questions but hope their results will spur further work on the cross-sectional relationship of markets and of assets in testing asset pricing theories.
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