Economic Forces and the Stock Market: an International Perspective

At the heart of any asset pricing theory is the view that a few pervasive factors are the dominant source of covariation among asset returns. While the existence of such systematic state variables is implied by comovements of asset prices, the theoretical asset pricing models do not (and perhaps cannot) provide an identity of these exogeneous economic forces. In light of this, empirical studies of factorbased asset pricing models have followed two distinct strategies. Fist, they employ factor analysis (Roll and Ross [ 141) which implicitly measures unobservable common factors. The focus here is on systematic risk exposures of individual securities or factor loadings. Unfortunately, due to the rotation problem inherent in factor loadings, the nature of pricing factors cannot be identified with this approach. Second, they specify a priori common factors which are measured by macroeconomic or financial data. Chen-Roll-Ross (CRR) [5] posit that five economic and non-equity financial variables-industrial production, unanticipated inflation, changes in anticipated inflation, twist in the yield curve, and changes in the risk premium-are plausible sources of common variation among equity