1 Global versus Local Asset Pricing: A Speculation Based Test of Market Integration Imperial College London October 19, 2010 Harald Hau INSEAD

Motivation © Harald Hau, INSEAD 2 Cost of capital calculation depend on stock betas and are a key input into capital budgeting decisions We have no consensus about whether global or local market betas most appropriate This paper uses a large global index revision as an identification mechanism to study market integration in terms of risk pricing Idea: Index change was large enough to change market benchmark and therefore all stock betas

Three Dimensions of the Analysis © Harald Hau, INSEAD 3 Asset Pricing Market Integration Limited Arbitrage

Asset Pricing Issues Asset pricing test are joint tests of the market benchmark and the pricing model Rolls critique: Market benchmark is difficult (impossible) to identify What is the market benchmark? All capital in assets subject to dynamic optimization Not part of the market benchmark: Capital of index funds Capital held for control reasons (family ownership, etc) Capital of retail investors? (no diversification, investment inertia) © Harald Hau, INSEAD 4

Idea: Test asset pricing model in differences for a change in the market benchmark Large index change can identify a market benchmark change: Old benchmark: (kx1 vector) Index change:(kx1 weight changes) New benchmark: Market benchmark change identifies exogenous beta change Asset Pricing for Market Benchmark Change © Harald Hau, INSEAD 5

Asset Pricing for Market Benchmark Change Beta is the return covariance with the market benchmark Benchmark change alters all stock betas: Return effect (for constant cash flows): © Harald Hau, INSEAD

Market Integration Three Dimensions of the Analysis © Harald Hau, INSEAD 7 Asset Pricing Limited Arbitrage

© Harald Hau, INSEAD 8 Market Integration Issues Global or local market benchmark? Integration test depend on the correct identification of both benchmarks Conditional asset pricing models: Difficult specification choices and implementation issues Event study approach provides alternative: Covariance decomposition: Global covariance: National covariance terms: International covariance terms:

Testing for Market Integration Local asset pricing: Only weight changes of local stocks affect (via local benchmark change) asset prices: Global asset pricing: Weight changes of all stocks (globally) affect (via global benchmark change) asset prices: Equally strong returns effects from local and international covariance terms Need not identify either global or local market benchmark © Harald Hau, INSEAD 9

Limited Arbitrage Market Integration Three Dimensions of the Analysis © Harald Hau, INSEAD 10 Asset Pricing

Arbitrage of Index Change Index change w might have been predicted by some speculators (arbitrageurs) Front-running might accelerate price adjustment Speculators may acquire hedging positions to reduce arbitrage risk: Positions of risk neutral speculators: Positions of risk averse speculators: Need to control of price impact of hedging term © Harald Hau, INSEAD 11

Limited Arbitrage Literature Limited arbitrage in multiple assets: Degree of arbitrage depends each asset depends on marginal risk contribution of each asset Return chasing arbitrage vector is modified by hedging terms which creates an additional price effect Generalize Greenwood model (2007) by allowing a price elastic (uninformed) liquidity supply in each asset Arbitrageurs learn about index change: Liquidity suppliers learns about index change: Index change occurs: © Harald Hau, INSEAD 12

Speculative Price Dynamics © Harald Hau, INSEAD 13

© Harald Hau, INSEAD 14 Event and Data MSCI (Morgan Stanley Capital International Inc.) Most important international index US$ 3 trillion benchmarked, US$ directly indexed MSCI all country world index (= 50 countries, 2077 stocks) Event: Move to new free float weights Nov 2000: Industry Consultation on index change Dec 1, 2000: Announcement that decision on free float weights adoption is imminent and to be communicated on Dec 10, 2000 Dec 10, 2000: Time table for index change becomes public: First adjustment of 50% on Nov 30, 2001 Second adjustment of 50% on May 31, 2002

Country Weight Changes of Index Revision © Harald Hau, INSEAD 15

© Harald Hau, INSEAD 16 Estimate covariance matrix over period July 1, 1998 to July 1, 2000 Event and Data Hedge Liquidation Period Nov 30, 2001: 1. Implementation Event May 31, 2002: 2. Implementation Event Position Build-up Period Dec 1, 2000: Decision day announcement Dec 10, 2000: Index change announcement

© Harald Hau, INSEAD 17 Position Build-up and Hedge Liquidation

© Harald Hau, INSEAD 18 Event and Data MSCI ACWI: 2077 stocks originally 489 inclusions and 298 deletions Exclude two crisis countries: Turkey and Argentina with 62 stocks 31 stocks not found in Datastream and 182 with incomplete price history Sample: 2291 stocks (of which 396 are inclusions and 265 excluded stocks)

Summary Statistics I © Harald Hau, INSEAD 19

Summary Statistics II © Harald Hau, INSEAD 20

Evidence Testing dynamic predictions: Position buildup period: Event windows up to December 1 Hedge Liquidation period: Event windows after December 1 Global versus local risk pricing: Integrated risk pricing between developed and emerging market stocks? Segmentation of EM stocks by cross-listing and liquidity? © Harald Hau, INSEAD 21

Position Buildup Period © Harald Hau, INSEAD 22 Predictions: Stocks with beta decreases experience positive event returns Stocks with high arbitrage risk have negative returns (short selling)

Hedge Liquidation Period © Harald Hau, INSEAD 23 Prediction: Gradual liquidation of the hedge position (after December 1) generates a positive return effect for stocks with high arbitrage risk

Global versus Local Pricing © Harald Hau, INSEAD 24 Integration: Segmentation: Local asset pricing hypothesis strongly rejected Global asset pricing hypothesis cannot be rejected

Segmentation between Emerging and Developed Markets Decompose into two hemispheres: Matrix captures risk pricing integration between developed and emerging markets Find evidence for market integration between developed and emerging markets © Harald Hau, INSEAD 25

Role of Cross-Listing and Liquidity Cross-Listing Decomposition: Liquidity Decomposition: Cross-listed and liquid emerging market stocks are integrated © Harald Hau, INSEAD 26

Robustness I Traditional (univariate) price pressure hypothesis does not have a good cross-sectional fit: © Harald Hau, INSEAD 27

Robustness II Robustness with respect to the matrix Replace by a new matrix based the 20, 40 or 60 principle components of Obtain qualitatively similar results © Harald Hau, INSEAD 28

Conclusions MSCI index revision allows us to apply CAPM in differences (without benchmark identification) obtain insights into the structure of arbitrage trading (the role of hedging positions) explore the degree of integrated risk pricing (global versus local beta) Evidence: Predicted beta changes explain front-running returns Hedging demand has an important (temporary) price effect Market Integration: Global risk pricing is supported by the event returns, while local risk pricing is rejected in the data Only illiquid stocks emerging market and stocks without cross listing show evidence for segmentation © Harald Hau, INSEAD 29