The Risk-Return Tradeoff in International Stock Markets: One-Step Multivariate GARCH-M Estimation with Many Assets

Abstract

We study international asset pricing in a large-dimensional multivariate GARCH-in-mean framework. We examine different estimation methods and find that the two-step estimation method proposed by Bali and Engle (2010) tends to underestimate the risk-return coefficient and the corresponding standard error. We also show that the estimate is improved by one-step estimation and by increasing the cross-sectional dimension. Using stock index returns for up to 24 countries and 4 major currencies in the period 2001-2015, one-step estimation gives a market risk-return coefficient of around 6. The estimate is robust to variations in model specification, data frequency, and the number of stock markets considered.

Keywords: international asset pricing, currency risk, multivariate GARCH-M