Specification tests of international asset pricing models

This study evaluates the cross-sectional pricing performances of several international asset pricing models. The comparison metric is the Hansen and Jagannathan [Hansen, L., Jagannathan, R., 1997. Assessing specification errors in stochastic discount factor models. Journal of Finance 52, 557–590] distance, and the models are required to price size and book-to-market portfolios from the US, the UK and Japan. When betas and risk premiums are constant over business cycles, none of the models can pass the specification test. By allowing time-varying betas and risk premiums in conditional models, most models can pass the specification test. This is because these models capture the assets' different sensitivities to the time-varying risk premiums, which explain most of the book-to-market return spread. The Fama–French factors are redundant in conditional models. Finally, exchange risk premiums account for a significant part of the excess returns on international assets, and the conditional International CAPM with exchange risk performs the best. The market integration hypothesis is also supported.