The Price of Inflation and Foreign Exchange Risk in International Equity Markets

This paper uses minimum-variance (MV) admissible kernels to estimate risk premia associated with inflation and foreign exchange risk and to test multi-beta models. Estimating risk premia using MV kernels is appealing because it avoids the need to: i) identify all relevant sources of risk; ii) assume a linear factor model for asset returns. Testing multi-beta models in terms of restricted minimum-variance kernels has the advantage that: i) the candidate kernel has the smallest volatility; ii) test statistics are easy to interpret in terms of Sharpe ratios. I find that only global market risk is significant both conditionally and unconditionally as indicated by the high positive and significant relative Sharpe ratio. When using the Hansen & Jagannathan (1991, 1997) variance bounds and distance measures as testing devices, I find that, while all international asset pricing models are formally rejected by the data, their pricing implications are significantly different. The international intertemporal CAPM in presence of deviations from Purchasing Power Parity (PPP) outperforms all the other asset pricing models.