DP2640 Did the EMS Reduce the Cost of Capital?

Author(s): Enrique Sentana
Publication Date: December 2000
Keyword(s): Currency Risk, European Monetary Union, Financial Integration, International Asset Pricing
JEL(s): F30, G10
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=2640

We propose a dynamic APT multi-factor model with time-varying volatility for currency, bond and stock returns for ten European countries over the period 1977-1997. We exploit the cross-sectional dimension of the model to construct world portfolios, which, when added to the original list of assets, allow us to develop simple consistent methods of estimation and testing. Our results reject the implicit asset pricing restrictions, and suggest that decreases in idiosyncratic exchange rate risk tend to lower the cost of capital, although the effect is small. Finally, we assess the potential gains from increased stock market integration.