Are financial assets priced locally or globally?
G. Andrew Karolyi and René M. Stulz*
Revised, May 2002
We review the international finance literature to assess the extent to which international factors
affect financial asset demands and prices. International asset pricing models with mean-variance
investors predict that an asset’s risk premium depends on its covariance with the world market
portfolio and, possibly, with exchange rate changes. The existing empirical evidence shows that a
country’s risk premium depends on its covariance with the world market portfolio and that there
is some evidence that exchange rate risk affects expected returns. However, the theoretical asset
pricing literature relying on mean-variance optimizing investors fails in explaining the portfolio
holdings of investors, equity flows, and the time-varying properties of correlations across
countries. The home bias has the effect of increasing local influences on asset prices, while equity
flows and cross-country correlations increase global influences on asset prices.
Prepared for the Handbook of the Economics of Finance, George Constantinides, Milton Harris,
and René M. Stulz, eds., North-Holland.
* Respectively, Professor of Finance and Reese Chair of Banking and Monetary Economics,
Fisher College of Business, Ohio State University. René Stulz is also a Research Associate at the
National Bureau of Economic Research. We are grateful to Dong Lee and Boyce Watkins for
research assistance, and to Michael Adler, Kee-Hong Bae, Warren Bailey, Soehnke Bartram,
Laura Bottazzi, Magnus Dahlquist, Craig Doidge, Cheol Eun, Vihang Errunza, Jeff Frankel,
Thomas Gehrig, John Griffin, Cam Harvey, Mervyn King,