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The Impact of Macroeconomic and Financial Variables on Market Risk: Evidence from International Equity Returns

Using a GARCH approach, we estimate a time-varying two-factor international asset pricing model for the weekly equity index returns of 16 OECD countries. We find significant time-variation in the exposure (beta) of country equity index returns to the world market index and in the risk-adjusted excess returns (alpha). We then explain these world market betas and alphas using a number of country-specific macroeconomic and financial variables with a panel approach. We find that several variables including imports, exports, inflation, market capitalisation, dividend yields and price-to-book ratios significantly affect a country’s exposure to world market risk. Similar conclusions are obtained by using lagged explanatory variables, and thus these variables may be useful as predictors of world market risks. Several variables also significantly impact the risk-adjusted excess returns over this time period. Our results are robust to a number of alternative specifications. We further discuss some economic hypotheses that may explain these relationships.