Domestic investors hold a substantially larger proportion of their wealth portfolios in domestic assets than standard portfolio theory would suggest, a phenomenon called "equity home bias. " In the absence of this bias, investors would optimally diversify domestic output risk using foreign equities. Therefore, consumption growth rates would tend to comove across countries even when output growth rates do not. Empirically, however, consumption growth rates tend to have a lower correlation across countries than do output growth rates, a phenomenon I call "consumption home bias. " In this paper, I discuss these two biases and their potential relationship. I appreciate useful suggestions and comments from three anonymous referees and John Pencavel, the editor. I am also grateful to Michael Adler, Urban Jermann, and Amir Yaron for helpful discussions. Any errors or omissions are my responsibility alone. 1 Do individuals hold the optimal portfolio? Do they do a good job of hedging risks? The answer to these questions are clearly important for understanding the economy. If individuals indeed hedge risk optimally, then resources are allocated to their most efficient uses. If not, then many other questions arise. Why not? What is the explanation for these inefficiencies? And what

Value stocks have higher returns than growth stocks in markets around the world. For the period 1975 through 1995, the difference between the average returns on global portfolios of high and low book-to-market stocks is 7.68 percent per year, and value stocks outperform growth stocks in twelve of thirteen major markets. An international capital asset pricing model cannot explain the value premium, but a two-factor model that includes a risk factor for relative distress captures the value premium in international returns. INVESTMENT MANAGERS CLASSIFY FIRMS that have high ratios of book-to-market equity ~B0M!, earnings to price ~E0P!, or cash flow to price ~C0P! as value stocks. Fama and French ~1992, 1996! and Lakonishok, Shleifer, and Vishny ~1994! show that for U.S. stocks there is a strong value premium in average returns. High B0M, E0P, or C0P stocks have higher average returns than low B0M, E0P, or C0P stocks. Fama and French ~1995! and Lakonishok et al. ~1994! also show that the value premium is associated with relative distress.

We estimate and test the conditional version of an International Capital Asset Pricing Model using a parsimonious multivariate GARCH process. Since our approach is fully parametric, we can recover any quantity that is a function of the first two conditional moments. Our findings strongly support a model which includes both market and foreign exchange risk. However, both sources of risk are only detected when their prices are allowed to change over time. The evidence also indicates that, with the exception of the U.S. equity market, the premium for bearing currency risk often represents a significant

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In this paper we investigate the properties of the standard two-pass methodology of testing beta pricing models with misspecified factors. In a setting where a factor is useless, defined as being independent of all the asse t returns, we provide theoretical results and simulation evidence that the second-pass cross-sectional regression tends to find the beta risk of the useless factor priced more often than it should. More surprisingly, this misspecification bias exacerbates when the number of time series observations increases. Possible ways of detecting useless factors are also examined. When testing asset pricing models relating risk premiums on assets to their betas, the primary question of interest is whether the beta risk of a particular factor is priced (i.e., whether the estimated risk premium associated with a given factor is significantly di#erent from zero). Black, Jensen, and Scholes (1972) and Fama and MacBeth (1973) develop a two-pass methodology in which the beta of each asset with respect to a factor is estimated in a first-pass time series regression, and estimated betas are then used in second-pass cross-sectional regressions (CSRs) to estimate the risk premium of the factor. This two-pass methodology is very intuitive and has been widely used in the literature. The properties of the test statistics and goodness-of-fit measures under the two-pass methodology are usually developed under the assumptions that the asset pricing model is correctly specified and that the factors are correctly identified. Shanken (1992) provides an excellent discussion of this two-pass methodology, especially the large sample properties of the two-pass CSR for the correctly specified model under the assumption that returns are conditionally homoskedastic. Jagannathan and Wa...

Contagion in equity markets refers to the notion that markets move more closely together during periods of crisis. One of the most interesting aspects of the contagion debate is the disagreement

This paper analyzes the integration process of European equity markets since the 1980s. Its central focus is on the role that EMU, and specifically, changes in exchange rate volatility, has played in this process of financial integration. Building on an uncovered interest rate parity condition to measure financial integration, a trivariate GARCH model with time-varying coefficients yields three key results: first, European equity markets have become highly integrated only since 1996. Second, the Euro area market has gained considerably in importance in world financial markets and has taken over from the US as the dominant market in Europe.And third, the integration of European equity markets is in large part explained by the drive towards EMU, and in particular the elimination of exchange rate volatility and uncertainty in the process of monetary unification. JEL classification: C32, F3, G15 Keywords: financial integration, stock markets, EMU, exchange rate volatility, GARCH model, timevariation. 5 ECB Working Paper No 48 March 2001 6 ECB Working Paper No 48 March 2001 1

The Stock Market’s Reaction………… We find that on average an announcement of rising unemployment is “good news ” for stocks during economic expansions and “bad news ” during economic contractions. Thus stock prices usually increase on news of rising unemployment, since the economy is usually in an expansion phase. We provide an explanation for this phenomenon. Unemployment news bundles two primitive types of information relevant for valuing stocks: information about future interest rates and future corporate earnings and dividends. A rise in unemployment typically signals a decline in interest rates, which is good news for stocks, as well as a decline in future corporate earnings and dividends, which is bad news for stocks. The nature of the bundle — and hence the relative importance of the two effects — changes over time depending on the state of the economy. For stocks as a group information about interest rates dominates during expansions and information about future corporate earnings dominates during contractions. 3 1.

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