Pricing Global Macroeconomic Risk in Equity Markets: Evidence from Selected G20 Economies

TL;DR

This paper demonstrates that a four-factor model based on macroeconomic latent factors extracted via a Dynamic Factor Model significantly improves the explanation of cross-country equity returns over traditional single-factor models like the CAPM.

Contribution

It introduces a four-factor macroeconomic risk model using DFM that outperforms the CAPM in explaining international equity returns across G20 countries.

Findings

A four-factor model significantly improves explanatory power over the three-factor model.

Macro-driven latent factors are more comprehensive for international asset pricing.

The CAPM shows limited explanatory power due to its single-factor structure.

Abstract

This study investigates whether international equity markets systematically price global macroeconomic risks. The empirical analysis is conducted using monthly excess returns for ten G20 countries over the period 2000-2024. A Dynamic Factor Model (DFM) is employed to extract latent global factors from a set of macroeconomic variables capturing global inflation, real activity, monetary policy, term structure, exchange rates, volatility, and oil prices. The model selection criteria of the dynamic factor framework, which support a 3 factor specification that is parsimonious. The Fama MacBeth regressions demonstrate the low explanatory power of the 3-factor model. In contrast, a 4 factor specification results in economically large and statistically significant factor loadings, an obvious rise in explanatory power, and a significant improvement in model performance. The results indicate that a four-factor specification provides the best balance between explanatory power and model stability, significantly improving the ability to explain cross-sectional variation in excess returns , with all factors statistically significant. The Capital Asset Pricing Model, while offering a parsimonious and stable benchmark with consistently significant market betas, exhibits limited explanatory power due to its single factor structure. Overall, the findings suggest that macro driven latent factors extracted through the DFM provide a more comprehensive and empirically robust framework for international asset pricing than the CAPM, highlighting the importance of incorporating multiple sources of systematic risk in explaining cross-country equity returns.