Credit, Liquidity and Emerging Market Risk in the Global Equity Market

Abstract: We use data on 78 national market indices over 9 years and show that the world CAPM fails to explain stock market index excess returns both in time-series and in cross-section. We introduce credit, liquidity and emerging market factors and report that the performance of the pricing model is increased, with liquidity and emerging market contributing most. We show that the latter two are not priced by the conventional size, value, momentum, short and long-term reversals factors. The market prices of risk are found to be around 10% per year for liquidity and emerging market and close to 0 for credit and world market. The time-varying prices of risk seem to be consistent with the corresponding economic developments. In order to produce investable factors that reflect the liquidity and emerging market risks, the 'dynamic orthogonalization' concept is applied.