Market Volatility Risk and Stock Returns around the World: Implication for Multinational Corporations*

Date01 December 2020
AuthorSamuel Xin Liang,K.C. John Wei
Published date01 December 2020
Market Volatility Risk and Stock
Returns around the World:
Implication for Multinational
Tyndale Seminary, Tyndale University College and Seminary, Toronto, Ontario,
Canada and
School of Accounting and Finance, The Hong Kong Polytechnic University,
Hong Kong
We investigate the pricing of market volatility risk as a risk factorthe inno-
vation risk and as a characteristic riskthe level risk. We find that the pric-
ing of the country-level (local) market volatility risk factor is not robust
across 21 developed markets and that the global market volatility risk factor
prices 21 developed market portfolios after controlling for global market,
value, and size factors. Capturing various market information, idiosyncratic
market volatility as a country-specific characteristic risk dominates global
market, value, size, and market volatility risk factors in predicting returns of
market portfolios. Countries with higher investor protection and accounting
standards have higher country-specific market volatility. Market volatility is
higher in these countries because corporate managers take higher risks on
innovative projects that benefit economic growth.
JEL Codes: G11; G12; G15
Accepted: 31 December 2018
Corporate investment is the driving force of a countrys economic develop-
ment and growth. In the meantime, the cost of capital is crucial for
* The authors appreciate the associate editor Ningjiu Ju and the anonymous referee for their con-
structive comments. We also acknowledge Kalok Chan, Inchi Hu, Lancelot James, Charles Lee, Peter
Mackay, Ahron Rosenfeld, Mungo Wilson, Chunchi Wu, Chu Zhang, and participants of seminars
held at the Hong Kong University of Science and Technology, Schulich School of Business York Uni-
versity, Barclay Global Investors (BGI), and participants of the 2010 China Finance Annual Confer-
ence in Jinan, China, the 2011 Securities and Financial Market Conference in Kaohsiung, Taiwan,
and the 2012 China International Conference in Finance (CICF) in Chongqing for their helpful
comments and suggestions. This paper won the Best Paper Award (third place) at the China Finance
Annual Conference. All errors are ours.
© 2019 International Review of Finance Ltd. 2019
International Review of Finance, 20:4, 2020: pp. 923959
DOI: 10.1111/irfi.12252
corporations around the world to make their investment decisions. Therefore,
it is very important for corporations and investors to know the determinants
of the cost of capital or the expected return in a country, in the context of the
capital asset pricing model (CAPM) of Sharpe (1964) or the intertemporal
CAPM (ICAPM) of Merton (1973). This is especially the case for multinational
corporations and global investors. Global investors are concerned whether the
level risk of market volatility or the innovation risk of market volatility is
important for stock returns (corporate-level cost of capital) and for market
portfolio returns (country-level cost of capital). In this paper, we focus on
how a market portfolios volatility affects its expected returns across 21 devel-
oped countries in a global setting.
Seeking potentially higher returns and diversification across the globe is
becoming increasingly popular among investors, as documented by de Santis
and Gerrard (1997). Global investorsinvestment in global index funds and
exchange-traded funds (ETFs) has rapidly increased in the past two decades.
Global index funds are mutual funds that track a particular global index, such
as country funds, emerging market funds, European funds, international funds,
and so on. ETFs are traded on a stock exchange and track a particular countrys
market portfolio, or a cluster of stocks or a specific industry portfolio that can
be either country-specific or global.
Ang et al. (2006) and Adrian and Rosenberg (2008) show that the market
volatility risk factor is a systematic pricing factor in addition to market,
value, size, and momentum factors in the U.S. market. Ang et al. (2006) con-
struct their market volatility risk factor as the tradable portfolio that mimics
the innovation in market volatility (i.e., the change in the aggregate market
portfolios return volatility) in the United States. The negative pricing of the
market volatility risk factor documented by Ang et al. (2006) and Adrian
and Rosenberg (2008) is consistent with Mertons (1973) ICAPM because
this market volatility risk factor represents investment opportunities. As
Campbell (1993, 1996) and Chen (2003) have shown, investors want to
hedge against the innovation in market volatility since an increase in mar-
ket volatility indicates shrinking investment opportunities. As a result,
global investors and multinational corporations are eager to know
(i) whether the local market volatility risk factora local market volatility
innovation risk is a systematic pricing factor for stocks within each of the
developed countries and (ii) whether the global market volatility risk
factora global market volatility innovation risk is a systematic pricing fac-
tor for locally diversified market portfolios. Our paper addresses these issues
at both the individual stock and market portfolio levels within and across
21 developed countries.
Ang et al. (2006, 2009) also show that higher idiosyncratic stock volatility is
associated with lower expected returns on individual stocks in each of the G7
countries and in European and Asian economies. Research by Ang et al. (2006,
2009) suggests that companies with lower volatility will have a higher expected
© 2019 International Review of Finance Ltd. 2019924
International Review of Finance
return, which appears to be inconsistent with Mertons (1987) incomplete
information CAPM.
The model argues that investors should be compensated
with higher returns with higher idiosyncratic volatility. In contrast, Bali and
Cakici (2010) find that a high total or idiosyncratic volatility of a market portfolio
is associated with a higher expected return for 37 market portfolios consisted of
21 developed markets and 16 emerging markets. Their findings are consistent with
the global version of the incomplete information CAPM of Merton (1987). How-
ever, it is unclear whether Bali and Cakicis (2010) results are driven by the expo-
sure of a market portfolio to the global market volatility risk factor because this
global risk factor demands a negative pricing premium if Ang et al.s(2006)results
carry over to the market portfolio level.
If Bali and Cakicis (2010) findings are
robust after controlling for the global market volatility risk factor, we can infer that
countries with higher country-specific market volatility will have fewer investment
opportunities for multinational corporations and global investors. The reason is
that the higher countrywide cost of capital will lead to fewer projects with positive
net present value (NPV) available to corporations in these countries.
It is also critical for global investors and multinational corporations to know
how a market portfolios volatility, as a country characteristicthe level risk,
competes with global risk factors including the global volatility innovation risk,
in predicting the future return of market portfolios. In other words, are betas of
global systematic risk factors more important than country-specific market
volatilitythe level risk in predicting the expected returns of market portfolios?
Do market volatility-level risk still demand a positive pricing premium after
controlling for global risk factors? If so, what are the economic forces and ratio-
nale behind this asset pricing phenomenon? The second task of this paper
addresses these global asset pricing issues, and international business and inter-
national financial management issues.
Liang and Wei (2012) find that the country-level corporate governance has a
significant relation with the countrywide market-liquidity risk premium. In par-
ticular, they find that countries with more effective corporate boards and less
insider trading activities have lower market-liquidity risk premiums because
these countries have lower monitoring risk and lower regulation risk. Therefore,
if market volatility drives the expected returns of market portfolios, global
investors and multinational corporations would also eager to know whether
country-level corporate governance is associated with country-level market
1 These results also contradict Barberis and Huangs (2001) behavioral model, which predicts
that individual stocks with higher idiosyncratic volatility should have higher expected
2 Ang et al. (2006) also show that their findings in the United Sttaes are not caused by a stocks
exposure to the market volatility factor and that analyst coverage, institutional ownership,
and skewness of stock returns do not explain this puzzling phenomenon. Guo and Savickas
(2008) also find that the average idiosyncratic stock volatility can predict stock market returns
in G7 countries. Carroll and Wei (1988) and Fu (2008) also find that stock returns correlate
positively with idiosyncratic risk. In addition, Huang et al. (2010) find that the negative rela-
tion between a stocks idiosyncratic volatility and its returns disappears after controlling stock
return reversal.
© 2019 International Review of Finance Ltd. 2019 925
Market Volatility Risk

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