Durable Consumption-Based Asset Pricing Model with Foreign Factors for the Korean Stock Market

Cheol-Keun Cho and Bosung Jang ()
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Cheol-Keun Cho: Department of Economics, University of Ulsan, 93 Daehak-ro, Nam-gu, Ulsan 44610, Republic of Korea
Bosung Jang: Korea Capital Market Institute, 143 Uisadang-daero, Yeongdeungpo-gu, Seoul 07332, Republic of Korea

IJFS, 2023, vol. 11, issue 2, 1-20

Abstract: This paper explores the implications of consumption heterogeneity between domestic and foreign investors on the cross-section of stock returns in a host country. We argue that foreign investors in a small open economy integrated into global financial markets may face consumption risk, which could result in risk premia being reflected in stock returns. To account for the potential influence of foreign investors on asset prices in a host country, we develop a two-country durable consumption model under market incompleteness, which extends the one-country durable consumption model. The proposed model includes both domestic and foreign pricing factors. We investigate the empirical performance of our model with Fama–French portfolios for Korea, taking U.S. investors as representative foreign investors. The empirical results advocate the two-country durable consumption model, confirming the significant role of foreign factors in the cross-section of domestic stock returns. Additionally, R 2 tests conducted with different sets of test assets show that the explanatory power of our model is comparable to that of the Fama–French three-factor model.

Keywords: durable goods consumption; Epstein–Zin preference; consumption heterogeneity; foreign stochastic discount factor; non-nested models; Kan–Robotti–Shanken test (search for similar items in EconPapers)
JEL-codes: F2 F3 F41 F42 G1 G2 G3 (search for similar items in EconPapers)
Date: 2023
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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