International Arbitrage Pricing Theory: An Empirical Investigation

The Arbitrage Pricing Theory (APT) of Ross [23; 24], later refined and extended by Connor [8], Huberman [15], Huberman et al. [16], Dybvig [11], Stambaugh [29], Chamberlin and Rothchild [4], Grinblatt and Titman [14], Ingersoll [17], Chen, Roll, and Ross [5] among others, has attracted considerable attention as a testable alternative to the Sharpe [26]-Lintner [20]-Mossin [21] Capital Asset Pricing Model (CAPM).' The APT resembles the CAPM in the sense that both are linear models where the CAPM is a single factor (market) model while the APT assumes that m unobservable factors drive the security prices through time. The pricing equation of the APT is developed by imposing the no arbitrage condition, resulting in a linear relationship between expected return and systematic risk. Similar to the extensions of the single currency CAPM to a multicurrency environment, Solnik [27] extended the APT to the international capital markets, leading to the International Arbitrage Pricing Theory (IAPT).2 Since the IAPT provides a theoretical framework to investigate the existence of factors that generate returns, and to check whether these factors are priced in the international capital markets, it is possible to empirically test the validity of the IAPT jointly with the hypothesis that the international capital markets are integrated. The purpose of this study is to develop and empirically test these hypotheses and it is organized as follows. Section II provides a brief discussion of the IAPT. Section III describes the testable hypotheses implied by the IAPT and the data and the methodology utilized in this study to test these hypotheses. Empirical results obtained are reported in section IV and section V concludes the paper.