Working Paper Nº 12

“The Cost of Equity in Latin America”

Martin Grandes, Demian Panigo and Ricardo
Pasquini

December 2005
 The Cost of Equity in Latin America

Martin Grandes
The American University of Paris and CEF

Demian Panigo
PSE-ENS, Univ. de la Plata, CEIL-PIETTE and CEF

Ricardo Pasquini
CEF

Abstract
The aim of this paper is twofold. First, it applies standard Capi-
tal Asset Pricing Models (CAPM) to look into cross-section (at the …rm
and industry levels) and time series di¤erences in the opportunity cost
of equity (COE) across seven major Latin American countries. Using an
unbalanced panel spanning monthly observations for about 921 publicly
traded …rms in 1986-2005, it comes up with more than 312,000 COE esti-
mates from 6 di¤erent econometric (rolling GMM) speci…cations. Second,
the paper statistically tests the econometric output obtained from those
CAPM-type models to …nd out how well and how much systematic risk
(the single determinant of COE in CAPM) accounts for both, cross-section
and time series variations in COE.

JEL codes: G12, G15.

Keywords: Cost of equity, CAPM, Latin America, rolling GMM,

variance decomposition, systematic risk, idiosyncratic risk.

We are grateful to the Swiss Agency for Development and Cooperation for generous …-
nancial support. We would also like to thank Alberto R. Musalem, Ricardo Bebczuck, Pedro
Elosegui, Gisela Juliano and Horacio Pozzo for helpful comments and suggestions. Usual
disclaimers apply.

1
Contents
1 Introduction 3

2 Survey of the Literature 5

2.1 What do we know about emerging countries and in particular
about Latin America? . . . . . . . . . . . . . . . . . . . . . . . . 14

3 Stylized Facts, Data and Methodology 16

3.1 Stylized facts for Latin America . . . . . . . . . . . . . . . . . . . 17
3.2 Dataset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
3.3 Econometric and statistical methodology to estimate the CAPM
COE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
3.3.1 Data frequency . . . . . . . . . . . . . . . . . . . . . . . . 28
3.3.2 Optimal sample size . . . . . . . . . . . . . . . . . . . . . 29
3.3.3 The assumption of real market integration . . . . . . . . . 29
3.3.4 Sovereign spreads calculation and pricing into the CAPM
framework . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
3.3.5 Risk-free interest rate and emerging market bond yield
stability . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
3.3.6 Corrections for illiquidity . . . . . . . . . . . . . . . . . . 35
3.3.7 Beta (systematic risk loading) robustness or instability . . 36
3.3.8 The econometric method . . . . . . . . . . . . . . . . . . 37
3.3.9 Negative COE estimates . . . . . . . . . . . . . . . . . . . 39
3.3.10 Weighting strategies . . . . . . . . . . . . . . . . . . . . . 39
3.4 Variance Decomposition . . . . . . . . . . . . . . . . . . . . . . . 40

4 Empirical results for Latin American markets 40

4.1 Asset pricing model speci…cation . . . . . . . . . . . . . . . . . . 41
4.2 The COE Derived from Black’s CAPM Beta estimates . . . . . . 43
4.3 The explanatory power of CAPM . . . . . . . . . . . . . . . . . . 50
4.4 Variance Decomposition Results . . . . . . . . . . . . . . . . . . 52

5 Conclusions 53

6 Appendix 63

2
1 Introduction
The weighted average cost of capital (WACC) –a combination of equity and debt
costs paid by either public or private entities - is an important determinant of
economic growth, in turn a necessary condition for poverty reduction (see Henry
(2003) or Grandes and Pinaud (2004)).

In Latin America, WACC, and in particular the opportunity1 cost of eq-

uity capital (henceforth COE), has been generally relatively higher and volatile
compared to OECD countries excluding Mexico. This may be attributable to a
number of reasons beyond –though not unrelated to- historically weak macro-
economic policy framework, macroeconomic volatility, external vulnerability,
low national savings and investment rates and as a consequence a remarkable
dependence on external …nancing. Latin American stock markets are relatively
underdeveloped and are characterized by: a) rather shallow markets (low market
capitalization to GDP ratios, low volume of business, limited number of pub-
licly traded …rms and scant free ‡oats), b) illiquidity (low traded volumes and
many observations without any transaction), c) high average stock returns, d)
stock return volatility,and e) and non-gaussian excess returns (see Wong Davila,
2003).
Reducing the COE in Latin American countries should be a major devel-
opmental objective in the policy maker’s agenda. There are several arguments
underpinning the case for a sustained reduction in the COE and ultimately in
WACC:
First, a lower COE is critical to raise investment in both physical and human
capital, hence inducing a higher rate of capital accumulation and faster economic
growth. In other words, when the expected returns to equity are higher than
COE, investment projects become pro…table and more …rms will be investing,
thus driving investment rates higher.
Second, reducing COE may create more opportunities for new …rms –not
only large ones but also SME- to tap stock markets and raise funds at more af-
fordable costs than other sources of …nance such as banking loans. An increased
number of …rms raising capital in the (domestic) stock market favours capital
markets development and provides additional opportunities for portfolio diver-
si…cation, fostering e¢ cient allocation of capital. As a result, …nancial market
development should be enhanced.
Third, the COE is a key variable to corporate …nance management. The rel-
ative (to debt) COE is always necessary to obtain the optimal capital structure
of any publicly traded …rm, i.e. the capital structure which minimizes WACC
(see Harris and Raviv, 1991; or Elton and Gruber, 1995). Please also note that
1 In contrast to an “accounting cost”, the “opportunity cost” stands for the notion of the

rate of return that capital providers will expect to receive if they would invest the capital in
the most valuable alternative.

3
lower COE would lead …rms to operate with lower leverage thereby contributing
to improve …rms resiliance to demand, interest rate or other shocks.
Last, but not least, it stands out in the context of the post-Monterrey discus-
sions on providing developing countries with cheaper and sustainable sources of
…nancing for development. Moreover, decreasing WACC and in particular COE
could contribute to achieving the Millennium Development Goals.
The main objective of this paper is to shed some light on the pricing of
Latin American stocks and the COE for Latin American …rms in seven coun-
tries: Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela . More
speci…cally, this contribution presents a unique panel database of COE estimates
by country, sector and …rm for the period 1997-2004 using di¤erent versions of
Capital Asset Pricing Models (CAPM), which assume all …rm idiosyncratic risk
can be diversi…ed away. In addition, the paper tests the hypothesis of real
market integration (“home bias”), it examines whether COE is procyclical in
Latin American stock markets (i.e. lower COE in recession times) and …nally
assesses the breakdown between systematic (or CAPM-explained COE) and
idiosyncratic risk –the unexplained variance of COE.
The main conclusions drawn from this study are the following:

1. The positively sloped relationship between COE (expected returns) and

risk across …rms, sectors and countries is con…rmed. On average, the
highest COE estimates are found in Venezuela and Argentina (35% and
28% respectively) while the lowest COE are in Chile and Peru (roughly
16%). Pension Funds, Textiles and Agriculture & Fishing are the sectors
which display the lowest COE. On the other hand, Construction, Oil &
Gas and Telecommunications have the highest COE.

2. Lack of real market integration (home bias e¤ect), i.e. global portfolio
risk and real currency risk do not generally add explanatory power to
local portfolio market risk, thus domestic CAPM would be the "right "
model to price Latin American stocks and determine COE.

3. COE is statistically signi…cantly acyclical for a majority of countries. Bad

times do not mean lower COE.

4. For Latin America as a whole, on average 32% of the variability in COE

can be attributable to (domestic) systematic risk. This raises questions
about the remaining 68% which is accounted for by purely idiosyncratic
risk or other systematic risk factors not captured by traditional CAPM
nor explicited in this paper (see Fama and French, 1992 and 1997).

The paper is organized as follows. Section 2 surveys the literature on di¤er-

ent approaches to the measurement and determinants of COE, focusing on the
advantages and disadvantages of di¤erent CAPM versions. Section 3 presents

4
the database and introduces the econometric methods adopted by this study .
The econometric outcome and discussion follow in Section 4, including model
speci…cation tests, COE estimates and variance decomposition results. Section
5 puts forward some concluding remarks and some issues for further research.

2 Survey of the Literature

The main foundations of asset pricing theory were laid by Harry Markowitz
(1959), who developed the portfolio choice theory , widely known as mean-
variance approach. In his theory, risk adverse investors, with a one-period in-
vestment horizon and looking at di¤erent asset returns correlations will choose
mean-variance e¢ cient portfolios. E¢ cient portfolios are di¤erent combinations
of available assets which minimize the portfolio variance for a given portfolio re-
turn or maximize the portfolio return for a given portfolio variance. Perhaps the
main corollary of this theory is the so-called e¢ cient frontier of portfolios, along
which investors will select their optimal portfolio depending on their preferences
(i.e. their risk tolerance). Yet, Markowitz’s focus isn’t on how this portfolio is
priced on the market.
Building on Markowitz’s assumption of mean-variance investors and the ex-
istence of an e¢ cient frontier of portfolios, Sharpe (1964) and Lintner (1965)
developed the …rst asset pricing theory, namely the Capital Asset Pricing Model,
or CAPM. CAPM has become a milestone in asset pricing theory, not least be-
cause it has provided an intuitive and simple way of estimating the COE.
CAPM makes three critical assumptions: 1) investors have identical perceptions
of the future joint distribution of assets returns, 2) idiosyncratic risk is fully di-
versi…able and 3) investors can borrow and lend unlimitedly at a risk-free rate.
As a result, it follows that in equilibrium, all investors hold the same optimal
mean-variance portfolio of risky assets, which amounts to an equal fraction of
the market portfolio. The latter must be on the e¢ cient frontier for assets
market to clear.
The pricing relation of CAPM is displayed in Equation 1. This relationship
allows to determine the COE de…ned as the expected return on an asset, e.g.
a …rm stock. The pricing equation relates the excess return on an asset (the
return over the risk-free rate) to (only) the excess return on the market portfolio,
through a coe¢ cient beta which captures the covariance or systematic risk of
that speci…c asset (undiversi…able risk)2 .

E(Ri ) Rf = iM [E(RM ) Rf ] 8 i = 1; :::; N (1)

According to Equation 1, for a given …rm or asset COE can be calculated as
the risk-free rate plus a risk premium equal to the …rm’s asset systematic risk
2 One possible interpretation is that Beta coe¢ cient captures the risk that each dollar

invested in a particular asset contributes to the market portfolio.

5
multiplied by the market premium (or excess return on the market portfolio).
Intuitively, all investors will evaluate the risk of holding a security in terms
of how it contributes to the risk of the market portfolio, hence riskier securities
(and therefore …rms) will be associated with a higher COE. When implementing
this equation using actual data, the …rst question that arises is which could the
market portfolio be. The usual answer is that a proxy for this portfolio is given
by a local market index that tracks the most representative stocks in terms of
trading, capitalization, etc.3 We will come back to this issue below.
Later, Black (1972) showed that CAPM …ndings could also be replicated
by relaxing the free borrowing and lending assumption and instead assuming
that there is unlimited short sale of risky assets. In other words, in Black’s
framework investors are able to undertake short positions in risky assets, i.e.
they are able to borrow these assets, sell them on the market and repurchase
them at an (expected) lower price in the future.
In 1976, Ross (1976) developed the second milestone in the asset pricing
theory, namely The Arbitrage Pricing Theory (APT). This theory begins with a
less restrictive assumption. It assumes that there are no arbitrage opportunities
in the market, in the sense that assets prices will adjust to the level of its
expected prices.
APT focus is di¤erent than CAPM’s. While CAPM focuses on how investors
choose a portfolio from an existing available group of assets, APT focuses on
how the available investment opportunities in the market are a¤ected by ex-
ogenous factors4 . In particular, APT assumes that there are N factors which
a¤ect the systematic changes in expected returns. The pricing relation of APT
(Equation 2) associates the expected return on an asset, and hence COE with
an undetermined N number of exogenous factors, i.e. the determinants of COE.

Ri = E [Ri ] + i1 [F1 ] + i2 [F2 ] + ::: + iK [FK ] + i 8 i = 1; :::; N (2)

According to Equation 2, for a given …rm or asset COE can be calculated as

the expected risk-free interest rate plus several terms each equal to a factor
loading multiplied by the factor estimate itself. Now, the question becomes:
which factors, how many, why? APT has given rise to an emerging empiri-
cal literature that searches which and how many factors a¤ect stock returns.
Typically these factors are macroeconomic factors such as: innovations in in‡a-
tion expectations, innovations in the Gross National Product or GDP estimates,
unexpected changes in investor’s con…dence and unexpected shifts in the yield
curve.
3 Equation 1 is typically tested using the following linear econometric models: R
i;t =
i + i RM;t + i;t or Ri;t Rf;t = i RM;t Rf;t + i;t (depending on whether the
risk free rate is assumed to be constant or not), where i and i are estimated using time
series regressions for each individual stock.
4 Economists can think about this di¤erence as a demand side and a supply side approach.

6
 While both CAPM and APT are the main foundations of the Modern Asset
Pricing Theory, thus far the CAPM model appears as the model most widely
used by almost all practitioners in the world when valuating an investment
project5 .
Undoubtedly, the main theoretical weakness of the APT lies in the fact that
the N explanatory factors are not predetermined by the model. By contrast,
CAPM assumes a strong speci…cation of the relationship among asset returns,
yet straightforward and intuitive. Moreover, the stock prices and volumes used
by CAPM to compute the market portfolio are measured with very little error.
Notwithstanding this, Roll (1977) raised perhaps one the most important
theoretical critics to CAPM. He argued that CAPM could not ever be tested
because of the unobservability of the market portfolio. In principle, the market
portfolio should consider the stocks available in the capital market of our inter-
est. Therefore, the proxy to be used should be the stock market index of the
market in question. But, should the model include other than …nancial assets,
for instance real estate assets or human capital? If so, the elusive nature of the
market portfolio would make the model untestable and would generate inexact
and ine¢ cient COE estimates.
Confronted with Roll’s critic of CAPM, researchers have chosen a more prag-
matic view: wherever they …nd a proxy for the market portfolio that do have
certain properties predicted by CAPM, they will conclude that the underlying
model is true and they will use it for pricing, COE estimation and ultimately
for investment project valuation. That is why today the penetration of CAPM
into the business arena remains sizeable.
Important theoretical extensions were built on and followed CAPM frame-
work with the aim of making its assumptions more realistic. One of this ex-
tensions was Merton’s (1973) Intertemporal CAPM (ICAPM). The distinctive
feature in Merton (1973) is that, unlike a single-period maximizing investor who,
by de…nition does not consider events beyond the present period, an intertem-
poral maximizer in selecting his portfolio will take into account the relationship
between current and future returns6 . In other words, if the available invest-
ment opportunity set changes over time, there is some reason to believe that
investors will price this in their portfolio choice. As the market interest rate is
an element of the available investment opportunity set, the observation that the
interest rate changes stochastically over time represents evidence that the avail-
able opportunity set changes over time. As a result, in equilibrium investors
5 In a survey for 27 U.S. companies, Bruner et al. (1998) reported that 85% use regularly

CAPM for estimating the cost of capital. Looking into an emerging market, in a survey
for Argentina, Galli and Pereiro (2000) reported that 68% of corporations, 64% of …nancial
assessors and 67% of banks and insurance companies use regularly CAPM for estimating the
cost of capital.
6 Quoting Merton: Suppose that the current return on a particular asset is negatively

correlated with changes in yields (capitalization rates). Then, by holding the asset the investor
expects a higher return on the asset if, ex post, yield opportunities next period are lower than
were expected

7
are now not only compensated for bearing systematic risk but also for bearing
the risk of unfavorable (on the aggregate) shifts in the investment opportunity
set. This additional source of risk can be re‡ected through Equation (3), which
relates the excess return on an asset to the excess return on the market portfolio
and the excess return on an asset (or portfolio of assets7 ) that is supposed to
capture the shifts in the investment opportunity set.

E(Ri ) Rf = iM [E(RM ) Rf ] + N [E(RN ) Rf ] 8i = 1; :::; N (3)

Equation (3) states that, for a given …rm or asset COE can be calculated as the
risk-free rate plus two risk premia: 1) equal to the …rm’s asset systematic risk
multiplied by the market premium (or excess return on the market portfolio) as
in CAPM, and 2) equal to the …rm’s asset risk due to unfavorable shifts in the
investment opportunity set multiplied by a corresponding excess return factor.
Notice we have assumed that a single state variable is su¢ cient to describe
changes in the opportunity set. In general, Merton’s intertemporal CAPM states
that the expected excess return on any asset is given by a multi-beta version of
CAPM with the number of betas equal to one plus the number of state variables
needed to describe the relevant characteristics of the investment opportunity set.
In his innovative CCAPM (Consumption CAPM) model, Breeden (1979)
adopted the same assumptions as Merton (1973) and extended the latter model
by allowing for investment and consumption choices in an intertemporal set-
ting. Breeden’s contribution is supported by the observation that the dollar
value of an asset payo¤ and real aggregate consumption are always perfectly
negatively correlated. This observation arises because real aggregate consump-
tion is perfectly negatively correlated with the marginal utility of an additional
dollar of wealth invested. As a result, an asset’s covariance with aggregate real
consumption is all that is needed to price a …rm’s asset or to calculate its COE.
CCAPM involves a single beta equation, where the instantaneous expected re-
turn on any security is proportional to its beta (or covariance) with respect to
real aggregate consumption alone. In the new pricing equation (see Equation
(4), RC represents a security the return of which is perfectly correlated with
changes in aggregate consumption over the next instant. The main virtue of
this model is that it does not su¤er from a critic like Roll’s as the main variable,
real aggregate consumption, is in fact observable8 .
7 Merton suggested a long term bond portfolio. Empirical …ndings of Black and Scholes

(1972) suggested a long term bond portfolio which is highly correlated with a signi…cantly
positive portfolio, constructed such that there would be zero correlation with the market.
8 It is worth nothing that both Merton’s and Breeden’s models are powerful theoretical

tools, but they may be quite di¢ cult to implement. In the case of Merton’s ICAPM, the
model su¤ers from the same problem of APT: state variables are not easily identi…ed. Then,
while quite important from a theoretical point of view, it is neither tractable for empirical
testing, nor really useful for …nancial decision making. The case of Breeden’s CCAPM model
is di¤erent. While it is relatively easy to test, data avalability is scarse, especially in emerging
markets. Instantaneous consumption rates are not measured while weekly and monthly rates

8
 E(Ri ) Rf = iC [E(RC ) Rf ] 8 i = 1; :::; N (4)
Another important extension of CAPM owes to Solnik (1974), Sercu (1980),
Stulz (1981) and Adler-Dumas (1983) in what is known as the International
CAPM. As mentioned earlier, one of the main ideas behind CAPM was that beta
captures what each security contributes to the undiversifable risk of the market
portfolio. This relationship enables the pricing so long as the chosen stock
market index is indeed broadly perceived as the economy market portfolio. The
di¤erent versions of the International CAPM recognize that as a country opens
up its capital markets to foreign investors and let its residents invest abroad; the
residents of the country no longer had to bear all the risks associated with the
economic activities of that speci…c country 9 . It follows that in a freely mobile
capital world investors will hold an internationally diversi…ed portfolio of risky
assets and will regard the risky security choices by how (in terms of risk and
returns) they contribute to their internationally diversi…ed portfolio. This has
clear implications for the estimation of COE, as will be seen below.
The International CAPM recognizes an additional risk due to the di¤erent
currency denomination of …nancial assets held by global investors. Investors
holding a long position in a foreign stock have to short that currency to eliminate
foreign exchange risk. This means that foreign exchange risk can be priced. A
multifactor model that it is consistent with these assumptions would be one that
contains a risk premia based on the covariances of assets with exchange rates,
in addition to the traditional premium based on the covariance with the market
portfolio. The International CAPM pricing equation (see Equation (5)) relates
the expected excess return of an asset ( i ) with the expected excess return of a
global portfolio ( G ) and with the nominal exchange rate returns of the other
countries considered ( sj0 with j = 1; 2; ?; n 10 ). Summing up, Equation (5)
states that, for a given …rm or asset COE depends on the risk-free rate and two
systematic risk factors: 1) global market portfolio risk, and 2) currency risk (as
long as this risk is not fully diversi…able).

E(Ri ) r0 =[E(RG ) Rf ] iG + E [s10 + r r0 ] i1 + (5)

::: + E [sn0 + r r0 ] in

From a practitioner’s perspective, the question of whether these models pro-

vide substantially di¤erent COE estimates is straightforward. In the last years
are di¢ cult to obtain. Additionally, available data contain considerable measurement error
and include the consumption of nondurable goods, which is not compatible with the design
of the model.
9 As Stulz puts it “A country might have bad news on one day, but another might have good

news. Because of diversi…cation resulting from access to global markets, domestic investors
can construct a portfolio of equities that has less risk for the same expected return.”
1 0 Notice that all this variables are expressed respectively to a numeraire currency. Please

refer to the methodological section for a discussion over real exchange risk incorporation.

9
a signi…cant number of studies tried to provide an answer. Stulz (1995) derived
two formulas for the di¤erence in the estimation of a …rm’s beta when the COE
is computed with the domestic CAPM as compared to the single factor Interna-
tional CAPM. He analyzed the case of the Swiss multinational Nestlé and found
a substantial pricing error. His study concludes that the International CAPM
should be used in small economies instead of the domestic CAPM version.
Koedijk et al (2002) derived a test to compute the pricing error between
the domestic CAPM and the multifactor International CAPM (i.e. an Interna-
tional CAPM adding multilateral currency risk to global market portfolio risk).
Equation (6) shows the resulting nested model.

Ri;t = i + iM [RM;t ] + iG [RG;t ] + iM N ER [RM N ER;t ] + i;t (6)

Unlike previous CAPM versions, the dependent variable is now expressed

in terms of assets returns instead of excess returns. The nested model relates
the stock return with a constant term (which captures the risk free rate), the
local and the international market portfolios returns at time t ( RM;t and RG;t )
and …nally RM N ER;t , which is the multilateral nominal exchange rate return
at time t. Using data from …rms with foreign equity listings, Koedijk et al
(2002) conclude that, although di¤erent COE estimates are signi…cant for only
12 percent of the sample, the size of the cost of capital di¤erential between
CAPM and the multifactor ICAPM goes up to 50 basis points for the US, 80
basis points for the UK and 100 basis points for France11 .
Irrespective of the speci…c CAPM version to be used for asset pricing and
for COE estimation, it is always important to have a measure of how much of
expected (excess) returns and consequently COE remain unexplained in these
models.
CAPM models share the assumption that the variability in expected returns
that fails to be explained by the market risk factor is not priced because it is
assumed to be diversi…ed away. This crucial hypothesis relies on the e¢ ciency
of the market portfolio. As should be clear at this point, multifactor e¢ cient
models such as Merton’s or Ross’APT show how, as some assumptions in the
CAPM setting are relaxed, the market portfolio turns out insu¢ cient to capture
all the variability in expected (excess) returns attributable to systematic risk.
It follows that introducing appropriate state variables in the CAPM pricing
equation may help account for some systematic risk that is not captured by the
market portfolio. The consequence of disregarding this additional information
1 1 Another example is Mishra and O’Brien (2001) who provided more evidence on the dif-

ference in estimation with these alternative models. Comparing the local CAPM with the
two versions of the international CAPM (the single market factor and the version allowing
currency risk) they estimate COE di¤erences of 48 and 61 basis points respectively for a US
sample of stock, di¤erences of 76 and 47 basis points respectively for a 70 developed mar-
kets sample of ADRs and di¤erences of 57 and 70 basis points respectively for a 48 emerging
markets sample of ADRs.

10
will be translated into a misspricing error, proportional to the weight of the
unexplained risk in the (total) variance of returns (or excess returns, depending
on model speci…cation).
Contributions to the empirical literature starting from the late 1970’s pointed
out that some …rm speci…c variables could account for misspricing errors. These
studies evidenced how when sorting stocks according to di¤erent …rms attributes
new estimates of future expected returns di¤er from the regular CAPM esti-
mates. Basu (1977) showed that stocks with high earnings-price ratios had
higher future returns than predicted by regular CAPM. Banz (1981) demon-
strated that the same happened with those stocks with lower market capitaliza-
tion. Bhandari (1988) used debt to equity ratios and found that stocks associated
with relatively high debt to equity ratios yielded higher returns than those es-
timated using standard CAPM. This is intuitive as higher debt to equity ratios
mean higher leverage, hence higher (default) risk as the …rm builds up debt.
Finally, Statman (1980) and Rosenberg, Reid and Landstein (1985) found iden-
tical results for returns on stocks with high book to market equity ratios, i.e. low
book-to-market value stocks displayed higher returns.
Fama and French (1992 and 1996) synthesized this approach within a COE
model, broadly known as the three factor model. Supported by the …nding of
higher average returns on small stocks (in terms of market capitalization) and
on high book to market value stocks in the US, they …gured out an additional
source of systematic risk not captured by previous CAPM frameworks through
local market beta. Therefore, in addition to local market portfolio risk they
included these attributes in a CAPM based equation, as displayed in Equation
(7). Speci…cally, Fama and French introduced diversi…ed portfolios associated
with the above mentioned attributes, and su¢ ciently di¤erent from the mar-
ket portfolio as new factors together with the market portfolio in the CAPM
equation. Equation 7 illustrates the three factor model.

E(Ri ) Rf = iM [E(RM ) Rf ] + iS [E(SM Bt )] + iH [E(HM Lt )] (7)

In the pricing equation, expected returns (and COE) are now explained by the
excess return on the market portfolio and two additional factors: SM B (small
minus big) is the di¤erence between the returns on diversi…ed portfolios of small
and big stocks. HM L (high minus low) is the di¤erence between the returns on
diversi…ed portfolios of high and low book to market stocks. The “new” betas
will indicate the sensitivity of the particular asset to the additional systematic
risk that is captured by each of the two new attributes.
Fama and French’s results suggested that US stock markets were not e¢ cient
(in the semi-strong sense) as there were additional sources of risk not priced in
by the local market portfolio. Later research extended this …nding to di¤erent
samples12 .
1 2 Using a sample of stocks from the Tokyo Stock Exchange from 1971 to 1988, Chan, Hamao,

11
 But in addition to the new sources of systematic risk found by Fama and
French (1992 and 1996), there can be a second reason why part of the expected
(excess) returns and consequently COE may remain unexplained by CAPM
idiosyncratic risk.
All CAPM versions share the common hypothesis that only systematic risk
is priced in the market because (…rm or country-speci…c) idiosyncratic risk can
completely be diversi…ed away. If this assumption were not true, idiosyncratic
risk should be explicitely priced by way of including appropriate variables re-
‡ecting this source of risk. As a result, disregarding these variables could cause
a potential misspricing error proportional to the weight of the unexplained risk
in the (total) variance of expected (excess) returns.
A wealth of recent studies have given rise to discussions about whether there
is a role for idiosyncratic risk in explaining returns or excess returns and ulti-
mately COE. The main questions raised by this literature are: why idiosyncrac-
tic risk matters? how much risk not priced in stock markets is idiosyncratic?
What variables are used to proxy for this source of risk?
In a recent paper, Goyal and Santa Clara (2003) have found evidence that
idiosyncratic risk is indeed priced in the market. Using CRSP stocks data for
the US, they show how idiosyncratic risk can be captured through a measure of
average stock risk13 and then how this measure successfully predicts the return
on the market in an econometric regression. Furthermore, in order to test the
robustness of these results, they use Fama-French three factor model residuals
and construct an alternative idiosyncratic variance measure. This measure is
also found to forecast the return on the market.
Additional recent evidence for the U.S. market highlights the fact of little
diversi…cation. Barber and Odean (2000) report that the mean household’s port-
folio in a large discount brokerage dataset held 4.3 stocks (worth 47,334 dollars),
and the median household held 2.61 stocks (worth 16,210 dollars). Goetzmann
and Kumar (2001) examined portfolios of more than 40,000 equity investment
accounts from a large discount brokerage. Their …ndings suggest little diversi…-
cation and a large amount of idiosyncratic risk undertaken by investors. They
also suggest that investors are aware of the bene…ts of diversi…cation but they
appear to adopt a "naïve" diversi…cation strategy where they form portfolios
without giving proper consideration to the correlations among stocks. Benartzi
and Thaler (2001) …ndings give further reasons to believe that diversi…cation
may be imperfect or incomplete. Their experimental and archival evidence
and Lakonishok (1991) explore Japanese stocks. They estimate predictive regression of returns
to the following variables: earning yield, size, book to market ratio and cash ‡ow yield. Their
cross-sectional regressions reveal a signi…cant relationship of the selected fundamental variables
and expected returns. Overall, of the four variables, the book to market ratio and cash ‡ow
yield have the most signi…cant impact on expected returns.
Capaul, Rowley, and Sharpe (1993) …nd similar e¤ects in four European stock markets and
in Japan.

1 3 We apply this measure to our sample in section 4.

12
for U.S. retirement saving plans also suggests naïve diversi…cation in investor’s
strategies. People are found to spread their contributions evenly across invest-
ment options (a n1 heuristic) irrespective of the particular mix of options they
face.
Theoretical fundaments for limited diversi…cation are neither new. Levy
(1978) and Merton (1987) had already built the …rst theoretical extensions of
CAPM where investors hold undiversi…ed portfolios. Merton stressed the in-
complete information problem that could lead to undiversi…ed portfolios. Levy,
probably inspired by the role of transaction costs and taxes that restrict port-
folio diversi…cation, assumed an imperfect market and imposed a constraint on
the number of securities that an individual could hold in his portfolio14 . The
empirical implications of these models support the role of idiosyncratic risk in
stock pricing and consequently in COE estimation15 .
Another possible reason for idiosyncratic risk pricing is that investors hold
nontraded assets which add background risk to their portfolio decisions. When
the risk of non traded assets increases, the investors are less willing to hold
other traded risky assets. Investors then require an increase in expected returns
(a higher COE) to be persuaded to hold the market portfolio of traded stocks.
Mayers (1976) introduces a human capital factor in a CAPM setting and obtains
similar implications to that of Merton and Levy16 .
Other models allow for investor heterogeneity (Constantinides and Du¢ e
(1996)). Here, individuals are subject to idiosyncratic income shocks. The result
is that, in equilibrium, risk premia depends on the cross-sectional variance of
consumption growth among investors.
Finally, the contigent claim analysis (Merton (1974) can also explain why
idiosyncratic risk may be priced. This approach consists in considering equity
and debt as contingent claims on the assets of a company. If equity is seen
1 4 For example, employee compensation plans often give workers stock in their …rms but

restrict their capacity to sell their holdings, thereby leading to a concentrated exposure.
1 5 Levy´ s model implementation isn’t straightforward. It requires information about the

number of securities that investors could hold and the wealth fraction they would be willing
to allocate in order to purchase those securities in the stock market. However, some additional
implications of the model allow Levy identify an impact of idiosyncratic risk. For example,
his model suggests that the variance of each security is a key factor for pricing, especially for
those securities that are less held. Levy exploits this relationship and incorporates a variance
_ ^
term together with the systemic risk (beta) in cross-section regression, namely: Ri = 1 1 +
2
2 i . The empirical results support the model predictions and the key role of idiosyncratic
risk.
In the case of Merton´ s model,the assumption of incomplete information implies that an
investor will face an additional cost for not knowing a security. This cost is translated into
the emergence of a new term in the pricing relation that captures the cost of incomplete
information over all securities. The implementation of this model can be associated with the
standard security market line test (see for example Roll (1977)): Ri RF = i [RM RF ]+ i
where the null hypothesis is i = 0 and i = 1 : : : n: Once again, as this model predicts, the
rejection of the null is consistent with an ine¢ cient market portfolio, as reported by Blume
and Friend (1973), Black Jensen and Scholes (1972), and Fama and Macbeth (1973)
1 6 Nontraded assets that have been studied extensively in the literature are private busi-

nesses.

13
as a call option on the …rms’s assets value, then as assets volatility heightens,
the value of equity goes up at the expense of the debtholders (i.e. debt prices
decline and default premia widens).

2.1 What do we know about emerging countries and in

particular about Latin America?
The literature on emerging-market stock pricing (and COE) has looked into a
handful of issues related to 1) how much correlation there is between developed
and emerging stock market (excess) returns or within emerging stock markets
(and individual securities) returns, 2) the extent to which this correlation is rel-
evant for portfolio diversi…cation and investors ’strategies. These issues include
a) some analyses of risk-return (and COE) trade-o¤s in developed and emerging
economies, b) the normality assumption of stock (excess) returns, c) the scope
for portfolio diversi…cation between emerging stock markets and d) how mul-
tifactor models such as Fama and French (1992, 1998) may explain emerging
stock market (excess) returns and (excess) returns correlations. Major empirical
…ndings on these issues are surveyed next.
Several authors have found that emerging stock market returns are higher
than developed ones (Harvey (1991) and (1995), Fama and French (1998)). For
instance, Fama and French (1998) report that for a sample of 13 developed
markets between 1975 and 1995 the annual dollar return in excess of U.S. T-Bill
rate is 9.6% on average, while for a sample of 16 emerging markets from 1987
to 199517 the average increases to 27.36%. A closer look at Fama and French ’s
tables shows annual dollar average excess returns of 42.2% in the case of 6 Latin
American countries covered by their study. These and other authors18 have also
realized that emerging stock markets are more volatile (see Bekaert and Harvey
(1997a)). Fama and French (1998) report that standard deviations of annual
dollar excess returns over the same periods were 15,67% and 67,87% in developed
and emerging stock markets respectively. Most remarkably, for those Latin
American countries included in their sample the standard deviation reached
97.34%. Even though the periods over which the …gures are computed are
not strictly comparable, the relationship between mean excess returns and risk
(measured as the standard deviation of annual dollar excess returns) carries a
meaningful implication: risk-adjusted returns (RAR) are lower in Latin America
(0,43) than in developed stock markets (0,6). Relatively low RAR on Latin
American (and other emerging-market) stocks may disincentivate the demand
for this asset class. We will discuss this further in Section 4.
In addition to the trade-o¤ between risk and returns (COE), another styl-
ized fact that has been con…rmed in several studies is the abnormal statistical
distribution of emerging stock market returns (see Wong Dávila (2003) for ev-
1 7 The sample period di¤er for some countries. See Fama and French (1998).
1 8 See Bekaert and Harvey (1997a) among others.

14
idence on Latin America). In this regard, an interesting observation is that,
in order to account for downside risk (the risk of obtaining returns lower than
the mean), some authors have documented that while for some developed coun-
tries semi deviations are lower than standard deviations, for emerging countries
semi deviations are generally higher than standard deviations (see for example
Grootveld and Salomons (2002))
As mentioned earlier, one theoretical implication of …nancial market integra-
tion is the enlargement of the diversi…cation opportunities set. These additional
opportunities should enable investors to reduce portfolio risk for a given level of
expected (excess) returns (Stulz (1999)). A key feature of the study of diversi-
…cation bene…ts is the analysis of (excess) return correlations. As Stulz puts it
“little e¤ect of …nancial integration should be expected if the local market and
the world market are perfectly correlated.” In fact, several authors including
Bekaert et. al. (1998) and Harvey (1995) document low correlations between
emerging markets and developed market returns. Furthermore, an element that
increases the attractiveness of investing in emerging markets is that correla-
tions within these markets are also generally low (Wong Dávila (2003)). Harvey
(1991), for example, reports that the average cross-country correlation of de-
veloped markets returns during the 70’s and the 80’s was 41 percent, while for
emerging markets the correlation was only 12 percent. Moreover, in order to
compute more precisely the bene…ts of diversi…cation in emerging markets, Har-
vey tests whether adding emerging market assets to a mean-variance portfolio
problem signi…cantly shifts the investment opportunity set. He …nds that the
addition of emerging market assets signi…cantly enhances portfolio diversi…ca-
tion opportunities.
Some empirical studies have extended these correlation analyses to recent
years. In the case of Latin American markets correlations over the last decade,
Wong Dávila (2003) points out that, while the sub-periods 1991-1993, 1995
and 2000-2002 show statistically insigni…cant cross country-correlations, the lat-
ter became larger and statistically signi…cant during the sub-periods 1994-1996
(Mexican Crisis) and 1997-1999 (South East Asia, Russian and Brazilian Crises).
Other authors have focused on the impact of …nancial liberalizations, oc-
curred during the late 80’s and early 90’s, on emerging stock markets correla-
tions. The e¤ect of …nancial liberalization on cross market correlations is key
to measuring the bene…ts of portfolio diversi…cation because, as Bailey and Lim
(1992) and Bekaert and Urias (1996) put forward, correlations may increase as
a result of …nancial opening, therefore reducing the bene…ts of diversi…cation
and hence the scope for bringing down the cost of capital in emerging markets.
Using data from 1976 to 1995, Bekaert and Harvey (2000) …nd small correlations
between emerging and developed markets for the entire period but also a slight
tendency to increase in the wake of …nancial liberalization episodes. This last
observation suggests that the bene…ts of diversi…cation may still high.
The degree of international …nancial diversi…cation has direct implications

15
for the choice of the reference portfolio (market portfolio) as well as on the spec-
i…cation of the asset pricing model (and by way of this on COE estimation).
Evidence on this issue is presented in Bekaert and Harvey (2000). They …nd
that …nancial liberalization brought about a stronger impact (i.e. beta) of global
market portfolios on emerging markets (excess) returns: global betas jumped
from 0,06 to 0,105 in the post-liberalization period.
A similar example is found in Mishra and O’Brien (2004), where an “investabil-
ity” index is included to better di¤erentiate stocks which are fully open up to
global investors from those which are not. Using data from years 1990 to 2000,
in a regression of ex-ante19 COE estimates on global betas, they …nd that, for
those emerging market equities with a substantial share of equity capital legally
accessible to foreign investors, global CAPM betas do add some explanatory
power to domestic portfolio risk (local betas).
Rouwenhorst (1999) also looks into the realized increase in correlations
though resorting to a slightly di¤erent approach. First, when he introduces
portfolios sorted by size and book to market value into COE regressions for 20
emerging markets (including 6 from Latin America over the period 1982-1997) he
corroborates that the Fama and French three- factor model e¤ectively provides
a signi…cant explanation of returns20 : Second, he notices that the cross-country
correlations between these factor-based portfolios didn’t increase signi…cantly
in the last years. Finally, he concludes that the factors responsible for the
increase in emerging-market returns correlations are di¤erent from those that
drive di¤erences in returns within these markets.
The …ndings revealing that Latin American returns are not robustly corre-
lated with international portfolios are generally interpreted as signs of market
segmentation. In this respect, Bekaert and Harvey (1995) explain that in these
cases a stronger relationship should be observed between domestic stock returns
and local market volatility. In the case of Mishra, D. R., O’Brien, T. J. (2004)
this appears to be the case as they …nd a signi…cant relationship between ex-ante
COE estimates and stock return volatility (i.e.: total risk).

3 Stylized Facts, Data and Methodology

In this Section, we present the stylized facts for Latin American stock markets
over the period 1990-2004. Then we introduce the dataset and analyze some sta-
tistical properties of our data, and lastly we explain and discuss the econometric
estimation procedure conducive to CAPM COE estimates.
1 9 “Ex-ante” valuation models such as Gordon (1997) incorporate investor’s expectations

data on of stock prices in pricing formulas.

2 0 Fama and French (1998) show that value and size premia are also pervasive in emerging

market returns, including Latin America. They report that the average high minus low book
to market portfolio return is 16.9% (value weighed countries) and 14.13% (equally weighed
countries), while the average small minus large caps returns is 14.89% (value weighted coun-
tries) and 8.7% (equally weighted countries).

16
3.1 Stylized facts for Latin America
In Latin America, it has been typically the case that …rms have been reliant on
(short-term, sometimes dollar-denominated) banking …nance or own cash-‡ows
to fund their investment projects, the more so the smaller the …rm and the
less they had access to international capital markets. Local equity …nance, let
alone bond …nance, have represented a minor share in total …nance available
for domestic …rms. Yet local stock markets have experienced some positive
developments since the early 1990s.
For a while, the Brady debt swaps in the late 1980s and early 1990s alongside
massive privatizations programs carried out by several Latin American countries
in the early 1990s favoured the expansion and short-term development of domes-
tic stock markets. Still, long-term stock market development in most countries
analyzed in this study remain poor by developed-country standards. Figures 1
and 2 illustrate this observation plotting the stock market capitalization as a %
of GDP. This measure, which re‡ects the importance of stocks markets in an
economy, is computed for three groups of countries in Figure 1; while Figure 2
shows the same information for the seven Latin American countries studied in
this paper in 1990-2004.
The …rst fact is that Latin American stock markets capitalization in terms
of GDP do not stand comparison with Emerging Asian and G-7 stock market
capitalization, being Chile the only clear-cut exception (Figure 2). Indeed, Chile
displays capitalization ratios above the Asian average and near G-7 ones in some
years.
Second, the early growth in capitalization ratios recorded early in the nineties
–bolstered by the Brady plans, the privatization programs and successful macro-
economic stabilization plans- was short-lived. With the exception of Brazil,
whose relative stock market capitalization kept on growing over the whole
decade, the other countries’capitalization growth ‡attened (Argentina, Chile)
or even decreased (Colombia, Peru, Mexico and Venezuela).

In spite of the structural reforms21 carried out from the early nineties on-
wards, the development of Latin American stock markets has been dissapointing.
Evidence in this way is presented by De la Torre and Schmukler (2004). They
assess whether there is a gap between the extent of the reforms carried out in
these markets, on the one hand, and the actual outcomes, on the other. Running
panel regressions for 82 countries where the dependent variable are two alterna-
tive measures of stock market development, namely stock market capitalization
and volume traded, against a set of economic fundamentals they …nd that the
predicted levels of development for Latin American countries are signi…cantly
2 1 These included domestic …nancial liberalization, the opening of the capital account, so-

cial security regimes reform (from the pay-as-you go to a private capitalization system), the
creation of exchange commissions and improvements of the regulatory and supervisory frame-
work, such as laws intended to protect minority shareholder rights.

17
 160%

140%

120%

100%

80%

60%

40%

20%

0%
1990 1992 1994 1996 1998 2000 2002 2004

Latin America Emerging Asia Developed Markets

Figure 1: Aggregated Stock Market Capitalization as Share of Ag-

gregated GDP by Selected Groups. Latin America is Argentina, Brazil,
Chile, Colombia, Mexico . Emerging Asia is Korea, Malaysia, Singapore and Thai-
land. Developed Markets are Canada, Germany, Italy, Japan, UK and US. Consid-
ered Exchanges: Buenos Aires, Sao Paulo, Santiago, Bogota, Mexico, Lima, Seul,
Kuala Lumpur, Singapore, Bangkok, Borsa Italiana, Deutsche Börse, London, Amex,
Nasdaq, NYSE and Tokyo. Source: World Federation of Exchanges, IFS-IMF and
SourceOECD.

18
 120%

100%

80%

60%

40%

20%

0%
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Argentina Brazil Chile Mexico

Peru Colombia Venezuela

Figure 2: Domestic Companies Stock Market Capitalization as Share

of GDP for Selected Latin Amercian Economies. Note: Colombia and
Venezuela include foreign companies. Source: FIAB and World Federation of Ex-
changes

higher than the levels actually attained as seen, for instance, in Figure 2.
Third, an alternative measure of stock market development, namely the
number of listed …rms, has declined in almost all Latin American markets in
our sample, as shown in Figure 3. This …nding is also supported by De la Torre
and Schmukler (2004). They show evidence pointing to an increasing interna-
tionalization trend in Latin American …rms publicly traded in stock markets22 .
By the year 2000, 18.2% of Latin American traded …rms had gone interna-
tional whereas only 11.6% and 7.7% of its G-7 and East Asian counterparts,
respectively, had internationalized. An observer may wonder if the delisting
phenomenon in Latin American markets is in fact associated with an interna-
tionalization process ending in a migration to developed markets, as sometimes
happens, for example, when …rms substitute their domestic share issuances for
American Deposits Receipts.
Fourth, liquidity in Latin American stock markets is another issue of concern.
The consequences of shallow and illiquid stock markets are well known (Levine
1997 and others). A common measure of liquidity is the total (nominal) trading
volume as a percentage of GDP. Figure 4 depicts this indicator spanning 1990-
2004. Market liquidity for the countries in our sample grew until 1995-1996 and
2 2 According to De la Torre and Schmukler (2004), international …rms are those identi…ed as

having at least one active depositary receipt program at any time in the year, or having raised
capital in international markets in the current or previous years, or trading in the London
Stock Exchange, New York Stock Exchange, or NASDAQ.

19
 700

600

500

400

300

200

100

0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Argentina Brazil Chile Colombia

Mexico Peru Venezuela

Figure 3: Number of Listed Companies in Selected Latin American

Stock Markets. Note: Excluding Pension Funds. Sources: FIAB and World
Federation of Exchanges.

then dropped to levels sometimes similar to those observed in 1990.

Further evidence supporting the illiquidity phenomena in Latin America is
shown in Table 1. For a sample23 of more than 127000 observations, we calculate
for each country the percentage of observations without trade, a usual proxy for
illiquidity.24 Figures averaging 20% suggest that illiquidity in these markets is
signi…cant and therefore diversi…cation might become problematic.
Typical practices in Latin American markets make diversi…cation trouble-
some. From a supply side perspective, the diversi…cation problem is worsened
by ownership concentration and the limited share of publicly traded stocks as
a percentage of the …rm’s capital. From a demand side perspective, the prob-
lem is exacerbated by common buy and hold investment strategies pursued by
institutional investors.
2 3 Andescription of the data is presented in next section
2 4 See
…gure 14 in the appendix for a comparison between volume and nontrading observation
measures. While overall the patterns displayed by the two measures are consistent, Brazil
appears to be the odds.

20
 25%

20%

15%

10%

5%

0%
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Argentina Brazil Chile

Mexico Peru Colombia
Venezuela, Rep. Bol.

Figure 4: Total Value of Share Trading in Percentage of GDP for

Selected Latin American Economies

year AR BR CL CO MX PE VE
1993 3.6 4.8 17.9 6.0 4.1 5.6 13.6
1994 4.2 8.6 16.8 16.0 4.9 3.9 32.0
1995 10.8 14.1 15.5 31.0 12.0 7.9 30.2
1996 4.5 13.8 15.6 23.8 8.4 12.2 25.6
1997 5.1 17.7 16.0 16.6 5.7 15.2 16.6
1998 12.5 26.1 20.6 21.4 8.4 24.1 20.3
1999 20.1 22.7 21.9 33.7 10.0 38.3 26.6
2000 26.1 20.4 20.8 33.9 12.5 33.4 28.3
2001 35.8 22.8 21.1 33.9 13.7 44.9 31.8
2002 28.1 24.9 22.8 28.7 15.0 40.4 36.9
2003 14.0 20.5 20.4 24.1 14.1 36.0 38.7
2004 8.4 14.1 15.0 13.9 6.5 25.9 26.8
TOTAL 15.6 18.3 18.8 24.7 10.4 26.7 27.3

Table 1: Percentage of Observations without Trade. Source: Economatica.

Fifth, Latin American stock markets are more volatile than mature ones.
Limited (actual) diversi…cation opportunities and illiquidity could be among
the main factors driving stock return volatility (we will come back to this in
Section 4). Figure 5 displays annualized average dollar stocks returns over
the period 1990-2004. Comparing Latin American stock market returns with
developed markets returns (e.g. US stocks tracked by the Dow Jones index),
it turns out that Latin American stocks are substantially more volatile than
their US counterparts. A further observation is that Latin American stock
market returns exhibit some degree of comovement though with a few exceptions
pairwise market return correlations are generally low but positive (see Table 13
in the appendix). These relatively low correlations support the argument for

21
portfolio diversi…cation between developed and emerging countries securities
(Bekaert et al.(1998) and Harvey (1995)) or across emerging market securities
(Wong Dávila (2003), see Section 2.1).
Table 2 summarizes total returns statistics. Total market return volatility
is visibly higher for Latin American indexes than Dow Jones’s volatility. As
economic theory predicts, Latin American stock returns consistently display
higher mean return values.
Another typical stylized fact regarding …nancial and stock market returns
in particular is that returns are not normally distributed, i.e. stock market
returns are skewed and high leptokurtic. Moreover, normality tests reject the
null hypothesis of normal distribution in all cases (also observed in estimated
kernel densities of Figure 6 in the appendix). Finally, on the whole, Latin
American stock market returns do not appear to be highly auto-correlated. For
the cases of Chile, Colombia and Mexico, however, positive auto-correlation
coe¢ cients are signi…cantly di¤erent from zero.

22
 6
5
4
3
2
1
0
-1

1990m1 1995m1 2000m1 2005m1

date
Dow Jones MERVAL Argentina
IBC Venezuela IGBC Colombia
6
5
4
3
2
1
0
-1

1990m1 1995m1 2000m1 2005m1

date
IPSA Chile IPyC Mexico
IGBVL Peru BOVESPA Brazil

Figure 5: Across-country comparison of local market annualized total

returns (12 month moving average, in USD). Source: Economatica.

23
 Stock Market Index N Min Max Mean Median Std Mean/Std Skewness Kurtosis Norm. Pr First O. AC

MERVAL Argentina 170 -0.423 1.190 0.017 0.022 0.158 0.105 2.5 20.6 0.000 0.09

BOVESPA Brazil 170 -0.411 0.741 0.029 0.014 0.157 0.188 0.7 5.5 0.000 0.06

IPSA Chile 170 -0.309 0.207 0.017 0.016 0.077 0.221 -0.2 4.1 0.038 0.21*

IGBC Colombia 170 -0.223 0.379 0.017 0.011 0.096 0.180 0.8 5.0 0.000 0.40*

IPyC Mexico 170 -0.402 0.241 0.015 0.024 0.099 0.155 -0.9 5.4 0.000 0.14*

IGBVL Peru 170 -0.286 0.604 0.023 0.011 0.116 0.200 1.5 9.3 0.000 0.08

IBC Venezuela 170 -0.419 0.483 0.010 -0.006 0.128 0.075 0.5 4.4 0.003 -0.02

24
DOW JONES USA 170 -0.151 0.106 0.010 0.013 0.042 0.230 -0.5 4.1 0.003 -0.09

Table 2: Descriptive Statistics of USD Total Returns from US and selected Latin American Stock Markets (1990-2004). Note: * stands for
significant autocorrelation coefficients at 0.05. Source: Economatica.
3.2 Dataset
Our dataset is an unbalanced panel spanning monthly observations for 921 pub-
licly traded …rms in 1986-2004 -127,000 observations- from the largest Latin
American stock markets: Argentina, Brazil, Chile, Colombia, Mexico, Peru and
Venezuela (Table 5 below illustrates this fact). However, as we will see later
on, the estimation of CAPM COE will be performed on the basis of a restricted
sample (1997-2004) in order to come up with comparable …gures.
We gather data from Datastream, Economatica, Morgan Stanley, and re-
gional central banks. The dataset includes individual stock variables such as
share prices, total annualized returns, volume and the number of traded shares,
as well as related macroeconomic or global variables. The latter are: the 30-year
US Treasury bond yield to maturity, sovereign spreads -JP Morgan EMBI+25 -,
MSCI26 total returns, local market total returns27 and multilateral real exchange
rates. For the sake of comparison, all data but the number of traded shares and
the rate of depreciation of the multilateral real exchange rate are expressed in
current US dollars.
From Table s 3 and 4, we can see that Brazilian stocks account for a third
of the total number of stocks and near 40% of the total number of non-missing
observations. Di¤erences between Figures in Table s 3 and 4, i.e. stock number
and observation number distributions across countries and sectors, owe to the
unbalanced nature of our panel database (see Table 5). For instance, while some
Brazilian stocks have non-missing data since 1986, Colombian stock information
is not available prior to 1993.
Regarding across sectors distributions (Table 4), we observe that Finance &
Insurance, Food & Beverages, Steal & Metal Products and those stocks labeled
as "Others" explain more than 35% of the total number of observations.
2 5 Because J.P. Morgan EMBI+ data are not available for the whole sample period, we com-

plement available information with country speci…c parametric estimations following Druck
and Morón (2001). Further details about the econometric speci…cation are provided in the
following sub-section (3-3).
2 6 As usual, the Morgan Stanley Capital International index is used as a proxy of the global

market portfolio.
2 7 For Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela local market total re-

turns are obtained using MERVAL, BOVESPA, IPSA, IGBC, IPyC, IGBVL and IBC indexes,
respectively.

25
 AR BR CL CO MX PE VE TOTAL
Agriculture & Fishing 5 1 16 3 10 1 36
Chemicals & Chemical Products 6 19 8 1 2 5 3 44
Construction 3 14 3 9 3 32
Electrical Equipment & Electronic Products 2 9 1 3 15
Electricity 4 36 19 2 6 2 69
Finance & Insurance 8 25 15 16 15 11 11 101
Food & Beverages 5 18 16 3 16 13 2 73
Machinery & Equipment 1 10 2 5 18
Mining 3 6 2 3 15 1 30
Motor Vehicles & Related 3 16 1 20
Non-Metallic Mineral Products 4 4 5 6 7 6 3 35
Non-specified 4 4
Oil & Gas 10 8 2 2 1 23
Others 13 44 36 6 18 16 5 138
Paper & Paper Products 4 9 2 2 3 2 22
Pension Funds 36 3 39
Software & Data 1 1 2
Steal & Metal Products 4 29 7 7 4 4 55
Telecommunications 3 21 7 2 7 2 2 44
Textiles 3 26 5 2 3 9 3 51
Transportation & Storage 1 5 7 3 1 17
Wholesale & Retail Trade 1 10 16 2 21 3 53
TOTAL 81 307 211 47 120 115 40 921

Table 3: Number of listed stocks included in the sample by country and sector (unbalanced
database, 1986-2004)

26
Sector AR BR CL CO MX PE VE TOTAL
Agriculture & Fishing 682 67 2630 342 796 144 4661
Chemicals & Chemical Products 912 3284 1007 144 256 578 482 6663
Construction 426 2248 157 745 215 3791
Electrical Equipment & Electronic Products 296 1757 192 404 2649
Electricity 447 3742 3382 102 573 220 8466
Finance & Insurance 896 4129 1793 1597 1601 1457 1499 12972
Food & Beverages 653 3169 2676 334 1941 1439 312 10524
Machinery & Equipment 148 1907 314 648 3017
Mining 637 1051 261 390 1785 84 4208
Motor Vehicles & Related 434 3163 127 3724
Non specified 508
Non-Metallic Mineral Products 533 607 895 634 920 895 467
4951
Oil & Gas 1008 1416 372 288 3 3087
Others 1322 5784 5182 771
1779 1835
728 17401
Paper & Paper Products 598 1768 382 277
382 270 3677
Pension Funds 5413 288 5701
Software & Data 131 117 248
Steal & Metal Products 393 5473 1147 924 568 472 8977
Telecommunications 364 1928 1042 116 604 294 99 4447
Textiles 427 4828 575 228 261 1091 402 7812
Transportation & Storage 50 564 1244 312 150 2320
Wholesale & Retail Trade 148 1313 2173 217 2248 303 6402
TOTAL 9868 47784 31821 5086 13146 13172 5329 126206

Table 4: Number of non-missing observations by country and sector (unbalanced database,

1986-2004)

Year AR BR CL CO MX PE VE TOTAL
1986 1097 1097
1987 1327 1327
1988 1579 1579
1989 1815 1108 2923
1990 1909 1399 46 3354
1991 1950 1513 21 48 3532
1992 335 2000 1661 344 419 309 5068
1993 527 2165 1820 233 388 514 352 5999
1994 648 2395 1933 306 587 726 372 6967
1995 696 2529 2037 336 733 845 368 7544
1996 726 2651 2097 332 824 984 387 8001
1997 743 2781 2231 385 986 1128 429 8683
1998 786 2984 2300 457 1210 1240 453 9430
1999 816 3256 2328 484 1286 1247 448 9865
2000 884 3429 2341 492 1301 1256 452 10155
2001 937 3510 2349 511 1332 1286 444 10369
2002 931 3524 2314 527 1376 1268 425 10365
2003 931 3489 2243 519 1385 1191 408 10166
2004 908 3394 2147 504 1373 1068 388 9782
TOTAL 9868 47784 31821 5086 13146 13172 5329 126206
Table 5: Number of observations by country and year

27
 Additional variables such as CAPM rolling parameters (betas, alphas, R
squared, t-values, Wald p-values, etc.), Vasicek adjusted values, COE estimates,
etc., where including using the following econometric and statistical procedures.

3.3 Econometric and statistical methodology to estimate

the CAPM COE
In this Section, we deal with a number of “model estimation and speci…cation”
issues associated with the CAPM framework already discussed in Section 228 :

1. Data frequency,

2. Optimal sample size,

3. The assumption of real market integration or "home bias e¤ect" in stock

princing,

4. Sovereign spreads calculation and pricing,

5. Risk-free interest rate and emerging market bond yield stability,

6. Corrections for illiquidity,

7. "Beta" (systematic risk loading) robustness and instability,

8. Heterocedasticity and serial correlation in regression residuals,

9. The presence of outliers,

10. Treatment of negative COE estimates

11. Weighting strategies.

3.3.1 Data frequency

There is one fundamental reason to grasp why we use monthly instead of daily
stock return observations. First, in the case of emerging markets daily obser-
vations are particularly characterized by illiquidity (non-trading).29 Should we
use such data, both beta coe¢ cients and consequently CAPM-COE would be
under-estimated because an illiquidity downside bias in the estimated covari-
ances -between illiquid stock and local market excess returns- would come out.
2 8 We suggest the non-dedicated reader to skip this section without any loss of generality

and move on to section 4

2 9 In the case of developed-country stock returns, Daves et al. (2000) show that high fre-

quency data (daily returns) "provide a smaller standard error of the estimated beta than do
weekly, two-weekly, or monthly return ". However, this is fully explained by the higher number
of observations they use in daily-return estimations and not by frequency choices. Further-
more, Daves et al (2000) prove that a larger return interval (low frequency data) smooths
out some of the noise a¤ecting the return generating process. In other words, they suggest a
trade o¤ between degrees of freedom (smaller standard deviation of betas) and noise (larger
standard deviation of betas)

28
Assuming that the lower the frequency the lower the expected number of ob-
servations without trade, it is clear that the illiquidity downside bias can be
strongly reduced by using monthly returns, without a signi…cant loss in terms
of degrees of freedom (which could be the case when using quarterly or annual
data).

3.3.2 Optimal sample size

The sample size choice is a controversial issue on its own. There is no clear
consensus concerning the optimal sample size on the basis of which CAPM
betas should be estimated because of the potential trade-o¤ between e¢ ciency
and the likelihood of structural breaks (i.e. parameter instability). The larger
the sample size the lower the variance of beta estimates given the higher degrees
of freedom, but the higher the probability of biased betas so long as the earliest
observations turn out irrelevant for expectational purposes. Altman, Jacquillet,
and Levasseur (1974), Baesel (1974), Gonedes (1973), Roenfeldt, Griepentrof,
and P‡aun (1978), Smith (1980), Alexander and Chervany (1980), and Daves
et al. (2000) conclude that the optimal estimation period ranges from four to
nine years.
Like in Fama and MacBeth (1973), we use a four-year rolling window sample
because it is consistent with the average length of the business cycle in the
largest Latin American countries (see Carrera et al., 1998). Therefore, we use
48-months rolling windows to estimate CAPM betas and subsequently CAPM
COE for the countries in our sample.

3.3.3 The assumption of real market integration

To test the null hypothesis of "real" market integration, we follow Koedijk et

al. (2002) who derive a nested (domestic-global) CAPM equation à la Stultz
(1995) from which we are able to perform the test. Before presenting the nested
equation, a caveat is in order. Real market integration is not a synomym of
…nancial market integration or …nancial opening. By real market integration we
mean that global factors such as international portfolio returns or multilateral
exchange rate returns are relevant to price domestic stock returns. Put di¤er-
ently, if the null hypothesis of real market integration is accepted, there is some
risk diversi…able in the local market which contains a global risk component
which is systematic. By contrast, …nancial market integration is associated
with full capital mobility, i.e. the inexistence of barriers to …nancial in‡ows
and out‡ows (capital controls, foreign exchange regulations, dual exchange rate
regimes, taxation on capital ‡ows, etc). That is, while markets may be …nan-
cially integrated (absence of barriers to capital ‡ows) investors could still price
local stocks disregarding global factors, i.e. international portfolio returns or
multilateral exchange rate returns will not add signi…cant information to the
domestic market portfolio when computing local stock returns ("home equity

29
bias")
As noted in the literature survey, Koedijk et al. (2002) derive their nested
equation from a generalization of Stultz (1995), combining the multifactor In-
ternational CAPM equation of Solnik (1983) and Sercu (1980)

Ri;t = i + iG [RG;t ] + iM ER [RM ER;t ] + i;t (8)

(where Ri;t , RG;t and RM ER;t stand for asset i , global portfolio and multilateral
nominal exchange rate returns, respectively) with the standard Sharpe-Lintner’s
domestic CAPM equation

Ri;t = i + iM [RM;t ] + i;t (9)

(where RM;t is the return of the local market portfolio).

Using 8 to price the local market portfolio, we get:

RM;t = M + MG [RG;t ] + M M ER [RM ER;t ] + ei;t (10)

Then, plugging 10 in 9 yields a modi…ed CAPM which takes into account
the global factors set out in ICAPM:

Ri;t = i+ M iM + M G iM [RG;t ]+ iM ER iM [RM ER;t ]+ iM ei;t + i;t (11)

Equalizing 11 and 8 yields the testable hypothesis, namely: H0 : M G iM =

iG and iM ER iM = iM ER which, in the case of acceptance would imply
that domestic CAPM alone would su¢ ce to price any stock i or that i;t is
ortogonal to RG;t and RM ER;t i.e. global factors (see Section 2, Equation 6) are
not correlated with the residuals backed out from a domestic CAPM equation.
Koedijk et al. (2002) demonstrate that testing the latter is equivalent to run
the nested model presented earlier in Section 2:

Ri;t = i + iM [RM;t ] + iG [RG;t ] + iM N ER [RM N ER;t ] + i;t (12)

to test the null hypothesis H0 : iM RER = iG = 0 (using standard Wald or

Log-likelihood tests). This enable us to to assess the likelihood of the global
factors orthogonality condition,
The non-rejection of H0 would mean that global factors are irrelevant for
pricing purposes because all the risk that could be diversi…able domestically
could also be diversi…able globally. In such a case, there would be no miss-
pricing error in the CAPM domestic speci…cation. This would yield evidence
in favor of the lack of real capital market integration or home bias puzzle (see
Gri¢ n and Karolyi, 1998).
In this paper we apply a slightly modi…ed version of Equation 12. Instead
of using nominal exchange rate returns, we use multilateral real exchange rate

30
returns, assuming a) deviation from the PPP (as in Adler and Dumas, 1983) and
b) that asset returns (in local currency) are partially correlated with in‡ation
rates.

Ri;t = i + iM [RM;t ] + iG [RG;t ] + iM RER [RM RER;t ] + i;t (13)

where RM RER;t stands for the rate of change in the multilateral real exchange
rate.

3.3.4 Sovereign spreads calculation and pricing into the CAPM frame-
work

In emerging countries, COE estimates are strongly dependent on sovereign

spread calculation and pricing.
Since major …nancial institutions provide widely accepted data on emerging
markets sovereign spreads in hard currency–typically in the form of bond spread
or total returns indexes, most practitioners make use of it in order to estimate
“modi…ed” domestic CAPM betas. However, this data has been only recently
available in some Latin American countries for two reasons. First, secondary
government bond markets for long maturities were nearly inexistent before the
Brady Plans. Second, comprehensive indexes are only available since 1993 (e.g.
JP Morgan EMBI+). Moreover, some Latin American countries like Chile have
not had benchmark government bonds in hard currency until 1998.
Given the constraint on sovereing spread data availability, we proceed to
complete the actual dataset, namely JP Morgan EMBI+ indexes for Argentina,
Brazil, Colombia, Mexico, Peru and Venezuela and JP Morgan EMBI Global
indexes for Chile, with parametric estimations based on Druck and Morón’s
(2001) single equation model.
Druck and Moron (2001) set out a "con…scation risk model" from which they
derive a sovereign spread equation with four types of covariates: "(1) those that
re‡ect the safe asset return, (2) those that are idiosyncratic to each particular
economy, (3) those a¤ ecting the probability of an adverse shock, and the gov-
ernment’s decision to whom should be con…scated in case the bad shock arises,
and 4) those variables measuring the balance sheet e¤ ect". As proxies of these
covariates they use (1) the yield to maturity on the 30-year US government
bond, (2) the return of the domestic stock exchange measured in dollar terms
and lagged one period, (3) the ratio M2 to foreign reserves as well as the vari-
ation of foreign exchange reserves; the lagged endogenous variable and (4) the
ratio of Foreign Liabilities over the sum of Demand Deposits, Time, Savings
and Foreign Currency Deposits. More formally:

0
SSj;t = j + j Xj + j SSj;t 1 + j;t (14)

31
where j ; j and j are the parameters for country j , SSj;t and SSj;t 1 stand
for actual and lagged sovereign spreads, j;t represents estimated residuals in t
and Xj0 is a vector of covariates including the 4 groups of variables introduced
above.
Depending on data availability in each country we may use a slightly mod-
i…ed version of Equation 14 excluding the lagged dependent variable from the
speci…cation.
We …rst estimate parameter vectors j ; j and j using standard OLS regres-
sions. Then, we use these parameters as well as the covariates series represented
by Xj0 to …ll all gaps in sovereign spreads since 1986 and until the …rst actual
observation of sovereign spread available for each country.
Figure 6 shows that Latin American sovereign spreads are well …tted by
Druck and Moron’s single equation model, with an average R-squared of 0.8.
Finally, we apply an unseasonal two-parameter Holt-Winter exponential
smoothing algorithm to reduce excessive noise in the …tted sovereign spread
series.
The extent to which sovereign spreads are actually priced in stock markets
returns (or excess returns) has also been discussed in the academic literature.
Modi…ed versions of domestic CAPM applied to emerging markets often include
sovereign spreads in COE estimates (see, for instance, Mariscal and Lee, 1993).
However, there is no general agreement on how much of this "government bond
risk" is already priced in local market indices. Most practitioners assume that
government bond excess returns (sovereign spreads) are not priced in local stock
markets. Therefore, sovereign spreads should be additive. In this case, the
following CAPM-COE speci…cation obtains30 :

a
COEi;t = Rf;t + i [RM;t Rf;t ] + SSj;t (15)
where COEi;t is the …rm i ’s estimated COE at t , Rf;t is the risk-free interest
rate (30 year US government bond yield to maturity), ai stands for the …rm
i ’s Beta parameter obtained from a standard Black’s version of the domestic
CAPM31 , [RM;t Rf;t ] is the local market excess return (over the risk free
interest rate) and SSj;t is the country j sovereign spread in t.
Notice that if sovereign spreads are not priced in local stock markets, Equa-
tion 15 will overestimate COE.32 In other words, if sovereign spreads are already
priced in RM;t , they are also priced but twice in COEi;t .
Here, we assume that RM;t includes SSj;t and then, a proper estimation of
COE should be conducted by subtracting the sovereign spread from the local
market excess return and adding it to the latter plus the risk free rate as shown
in Equation 16:
3 0 Fornero (2002) equation 10 or Rodriguez Pardina (2005) pp. 15.
3 1 Using the following equation: Ri;t Rf;t = a i RM;t Rf;t + i;t :
3 2 See Erb, Harvey and Viskanta (1995).

32
 8000 2500
Argentina Brazil
2000
R2: 0.97 6000 R2: 0.72
1500
4000
1000
1000
1500 2000
500
1000
0 500 0
500

0 0
-500

-1000 -500
94 95 96 97 98 99 00 01 02 03 04 94 95 96 97 98 99 00 01 02 03 04

250 Residual (left scale) Fitted (right scale) 1200

Residual (left scale) Fitted (rigth scale)
Actual (right scale) Chile Actual (right scale) Colombia
2 R2: 0.74 1000
R : 0.85 200
800
150 400
80 600
300
40 100 400
200

50 100 200
0
0
-40 -100
-200
-80 1999 2000 2001 2002 2003 2004
1999 2000 2001 2002 2003 2004

1600 Residual (left scale) Fitted (right scale) 1000

Residual (left scale) Fitted (right scale) Actual (right scale)
Actual (right scale) Mexico Peru
R2: 0.89 1200 R2: 0.71 800

800 600 600

600
400
400 400 400
0
200 200 200
0
0
-200

-400 -200
94 95 96 97 98 99 00 01 02 03 04 1997 1998 1999 2000 2001 2002 2003 2004

Residual (left scale) Fitted (right scale) Residual (left3000

scale) Fitted (right scale)
Actual (right scale) Actual (right scale)
Venezuela 2500
2
R : 0.72
2000
1500
1000
2000
500
1500
0
1000
500
0
-500
-1000
94 95 96 97 98 99 00 01 02 03 04

Residual (left scale) Fitted (right scale)

Actual (right scale)

Figure 6: Latin American sovereign spreads: Actual values from Datas-

tream. Fitted and residual values from Druck and Moron (2001)’s
single equation model. Note: All series but Chilean ones are JPM EMBI+
values. Chilean sovereign spreads comes from the JPM Global index. Sources:
Datastream and Central Banks.

33
 b
COEi;t = Rf;t + i [RM;t Rf;t SSj;t ] + SSj;t (16)
Note that bi is obtained from a modi…ed Black’s version of the domestic CAPM
equation, namely:

b
(Ri;t Rf;t SSj;t ) = i [RM;t Rf;t SSj;t ] + i;t (17)
Intermediate alternatives propose that only a share (ranging from 0.3 to 0.7)
of the sovereign spread is actually priced in local stock markets. Along these
lines, authors as Godfrey and Espinosa (1996) propose to include a correction
factor in (15) to avoid the "double pricing bias" in COE. Unfortunately, there are
no previous studies on Latin American countries allowing a proper identi…cation
of the share of sovereign spreads that is actually priced in these markets. For
this reason, we …nally use Equations 16 and 17 to obtain our COE estimates.

3.3.5 Risk-free interest rate and emerging market bond yield stabil-
ity

The question about how much the sovereign spread is already priced in stock
market indices could have been dismissed should we have used Sharpe-Lintner’s
CAPM speci…cation. Assuming that sovereign spreads are constant over time
(at least for a given sub-sample or moving window), it is possible to derive COE
estimates by using the following equations:

c
Ri;t = i + i [RM;t ] + i;t (18)
where i ' Rf + SSj is a regression intercept comprising both the risk-free
interest rate ( Rf ) and the share of the sovereign spread that is actually priced
in the local market ( SSj ).

c
COEi;t = E (Ri;t ) = i + i [RM;t ] (19)
Notwithstanding this simpli…cation, the constant government bond yields
hypothesis can be safely and clearly rejected in our sample. As shown in Table
6 most Latin American countries have extremely volatile values. These results
strenghten the case for using Black’s version(s) of CAPM, where both, the
sovereign spread and the risk free rate are stochastic and variable over time.

34
 Country Mean Std. Dev. Min Max
Argentina 0.16 0.087 0.09 0.65
Brazil 0.15 0.040 0.08 0.29
Chile 0.08 0.018 0.05 0.12
Colombia 0.13 0.027 0.08 0.19
Mexico 0.10 0.028 0.06 0.23
Peru 0.11 0.014 0.06 0.15
Venezuela 0.16 0.043 0.08 0.31
US 0.06 0.012 0.03 0.08
Table 6: Descriptive statistics of Government Bonds
annualized yields (in USD, 1990-2004)

3.3.6 Corrections for illiquidity

In 3.3.1 we pointed out that low frequency data (e.g. monthly data) tend to
reduce the incidence of the "illiquidity downside bias" in CAPM-Beta estimates.
In spite of this, there are so many non-trading days in our database that many
Latin American stocks have several observations with no recorded trading even
on a monthly basis. Following Damodaran (2002), this non-trading problem can
be addressed in one of two ways. One way is to work with even larger return
intervals. However, quarterly and annual returns strongly reduce the number
of observations and therefore the sample size. The second way is to estimate
betas using monthly returns, and then adjusting these betas for the extent of
the non-trading.
Regarding the second way, there are two well-known adjustment mechanisms
to deal with the problem of non-trading observations. The …rst, put forward by
Scholes and Williams (1977) propose the following adjustment equation:

k=1
X i;t+k
S W = (20)
(1 + 2 )
k= 1

where S W is the …rm i’s adjusted CAPM Beta, is the …rst order autocor-
relation coe¢ cient of local market returns and i;t+k are the slope coe¢ cients
from three separate regressions,

Ri;t = i;t 1 + i;t 1 [RM;t 1] + i;t (21)

Ri;t = i;t + i;t [RM;t ] + i;t

Ri;t = i;t+1 + i;t+1 [RM;t+1 ] + i;t

Damodaran (1996) suggests that this procedure allows the beta estimate "to
re‡ect the spill over of returns that often occurs around non-trading".
The second adjustment mechanism is the "Dimson Beta adjustment" (see
Dimson and Marsh, 1983). This adjustment consists in summing the slope

35
coe¢ cients on the …ve lagged, …ve leading and contemporaneous returns on a
stock market index in the following regression:

k=5
X
Ri;t = i+ i;t+k [RM;t+k ] + i;t (22)
k= 5

and then

k=5
X
D = i;t+k (23)
k= 5

Both adjustment mechanisms have been intended for high frequency data (daily
data). However, as they are applied to low frequency data they become less
e¢ cient because of two di¤erent reasons. The Dimson’s adjustment is too de-
manding in terms of degrees of freedom. There are 12 parameters in Equation
22 and we have only 48 monthly observations for each rolling window. On the
other hand, Scholes and Williams’approach su¤ers from "frequency-dependent
autocorrelation". The lower the frequency, the lower the expected autocor-
relation coe¢ cient of local market returns because of a higher probability of
"momentum" changes. When autocorrelation coe¢ cients becomes negligible or
even negatives, the "spill over e¤ect" of returns around non-trading is unlikely
to happen and beta adjustments based on "spill over e¤ects" become much less
e¤ective.
In this paper, we use a third alternative adjustment process. We assume
that investors form expectations using a simple and single rule: factor loadings
on systematic risk (beta parameters) are better represented by high-trading
observations. If we equally weight high and low-trading (including non-trading)
observations we would add noise on beta expectations because we would have
a higher probability of hazardous returns in low-trading days. Therefore, we
need a weighting matrix to correct for illiquid stocks. The chosen matrix is
one where the number of monthly traded shares is the weighting variable. In
this way, liquid observations (associated with non-hazardous returns) drive beta
estimates reducing the "illiquidity downside bias".

3.3.7 Beta (systematic risk loading) robustness or instability

The instability of beta estimates is another critical problem we encounter when

estimating CAPM COE for Latin American …rms. Individual stock illiquidity,
changes in the market indexes (owing to delisting, mergers & acquisitions, etc.)
and macroeconomic uncertainty result in highly volatile CAPM Beta estimates.
Extremely unstable betas cannot be used to derive robust COE estimates.
In the Appendix, we show average CAPM betas time series by country and
sector (Figures 16 to 22). It is worth noting that these estimates are more robust
in low-volatility countries such as Chile, Mexico or Peru (less volatile countries

36
since 1997, our benchmark period) than in Argentina, Colombia, Brazil33 or
Venezuela. The di¤erences look sharper at the …rm level due to segmented
liquidity. High-volume …rms display less volatile betas and largely represent the
average estimates by sector. On the contrary, low-volume stocks (a majority
in Latin America) are associated with noisy betas because of disproportionate
nontrading observations.
Vasicek (1973) proposed an estimator to deal with this shortcoming. Basi-
cally, this estimator improves the mean reversion trend of individual betas al-
lowing for both individual and sectoral beta dispersion. When the uncertainty
about the estimate of the individual beta is high compared to the uncertainty
about the average beta estimate, the beta forecast is adjusted strongly towards
the average beta (e.g. average beta by sector). On the other hand, when the
uncertainty about the estimate of the individual Beta is small compared to
the uncertainty in the estimate of the average beta, then the beta forecast is
adjusted strongly towards the individual beta.
Formally, Vasicek’s (1973) adjusted beta is a weighted average between in-
dividual and sector betas where beta variances (the measure of the uncertainty
about betas) are the weights:

VA
i = i
s
+ s
i
(24)
s
+ i s
+ i

where Vi A is the …rm i ’s Vasicek’s adjusted beta, i is the …rm i ’s CAPM

standard beta, s is the sector s ’s across-…rm average beta (with …rm i belong-
ing to sector s ), i is the …rm i’s standard deviation of beta estimate and s
is the sector s’s across-…rm standard deviation of betas. We use this approach
instead of other often used ad-hoc corrections toward one.

3.3.8 The econometric method

The classical estimator for beta is the well-known ordinary least squares (OLS).
However, it has been documented that in studies of …nancial assets returns
the OLS estimator su¤ers from several de…ciencies: it has a mean reversion
3 3 Note that most Brazilian Betas are particularly low. This is not surprising because

Bovespa index is mostly explained by Telebras. Damodaran (2002) show that "Telebras is
40% or more of the Bovespa, and this has some strange consequences. The …rst is that the
beta estimates for all other Brazilian stocks essentially become regressions of those stocks
against Telebras, rather than a diversi…ed stock index. The second is that more than 90%
of all stocks on the Brazilian index were reporting betas less than one at the time of this
regression. Since it is the weighted average beta that is one, and Telebras has a beta greater
than one, this asymmetry in beta estimates becomes possible. The third and most troubling
consequence is that it is the smallest, riskiest companies in the Brazilian market that have
the lowest betas, while the largest and most estabilished …rms have the highest betas. There
are still many who argue that this is, in fact, the best measure of risk in these …rms, and that
the marginal investor’s portfolio in Brazil is likely to be weighted heavily with Telebras. This
argument may have resonance in markets where investors invest only in domestic stocks....".
Moreover, because none of our regional stock market indices is a weighted portfolio of all local
stocks, even weigthed average Betas could be either higher or lower than one.

37
 100
Kernel Density
80
60
40
20
0

0 .02 .04 .06 .08 .1

Unit Root Probability from ADF tests with 12 lags

Figure 7: Kernel density of Unit Root probabilities from ADF tests

(applied …rm by …rm) with 12 lags in the ADL (autorregresive dis-
tributed lags) speci…cation.

tendency, it is ine¢ cient when returns (or excess returns) distributions are ab-
normal, and also introduces signi…cant biases when shares are poorly and thinly
traded34 . To overcome these shortcomings, GMM speci…cations have become
popular as they do not rely on the normality, homoskedasticity, or the lack of
serial correlation assumptions held by OLS.
Indeed, GMM estimators35 can a¤ord distribution of returns which are het-
eroskedastic, serially dependent and non-gaussian. The only required assump-
tions are that returns are stationary with …nite fourth moments (see Ferson and
Jagannathan, 1996 and Fernandes, 2004).
Table 2 above, shows that all Latin American stock market returns but Colom-
bian ones have very small …rst order autocorrelation coe¢ cients and none of
them appear to be close to the unit root. Furthermore, we show in Figure 7
that the results of the Augmented Dickey-Fuller (ADF) tests (without using
structural breaks in order to allow for a higher probability of non rejection of
the unit root hypothesis) do not support the null hypothesis of the existence of
a unit root. Indeed, 90 to 95 per cent of these results (depending on whether
we use 12 or 4 lags in the ADF test) rejects the null hypothesis as GMM as-
sumptions prescribe.
Lastly, given the lack of a widely-accepted underlying theory supporting a
conditional GMM equation (a GMM equation with instrumental variables for
local market excess returns), we use the unconditional equation yielding GMM
3 4 See Lam (1999), Lally (1998), or Boabang (1996).
3 5 See Hansen (1982).

38
estimators that are the same as the OLS estimators. Nevertheless, GMM proce-
dures leads to heteroskedasticity and autocorrelation consistent standard devi-
ations, which is particularly important for speci…cation purposes. Furthermore,
GMM estimates were improved by ruling out outliers at the country level. Ob-
servations in the upper and bottom tails (2 percent) of total return distributions
(by country) were treated as outliers.

3.3.9 Negative COE estimates

In developed countries, negative COE estimates are rare (e.g. some cases of
negative betas in a sample period with high local market excess returns and low
risk-free interest rates). In emerging economies, negative COE estimates can be
a more regular output from CAPM regressions.
Most Latin American countries negative COE estimates owe to medium-
term sizeable negative excess returns. True, it is always possible to extend the
sample in order to obtain rolling windows with strictly positive average excess
returns. However, it is well-known that the higher the sample size the higher
the probability of non-representative betas because of changing fundamentals
over time.
A way to deal with negative COE estimates has been put forward by Barnes
and Lopez (2005) and Hail and Leuz (2004). According to this literature, it
su¢ ces to apply a simple trimming rule setting at 0 all negative COE estimates.
Because of the systematic origin of Latin American negative COE values, this
trimming rule ensures that relative COE estimates (e.g. across sectors) will not
be signi…cantly modi…ed (even when the country level average COE signi…cantly
increases with the number of trimmed observations).

3.3.10 Weighting strategies

Unlike the bulk of empirical contributions to stock pricing and COE estimation,
we use volume (in US current dollars) instead of market capitalization as across-
…rm weighting variable (e.g. to obtain weighted average COE estimates by sector
or country )36 . In this way, weighted averages become market representative
in a proper sense. Big …rms with high market capitalization but low trading
activity (low volume) must be highly weighted when stock variables are taken
into account but only high volume …rms (irrespective of whether they are big
or small in terms of market capitalization) should be highly weighted when
‡ow variables are analyzed. Because COE estimates are obtained from a ‡ow
of traded shares, volume-weighted strategies improve both sector and country
average reliability.
3 6 The standard distinction is between equal and market value-weighted averages. See for

example Bennet and Sias (2004),Cao, Simin and Zhao (2005) or Lettau and Ludvigson (2002).

39
3.4 Variance Decomposition
Almost all previous methodological issues focus on COE estimates without pay-
ing especial attention to variance decomposition procedures. The breakdown of
the total variance of (excess) returns is important to assess how much risk is
systematic. systematic risk should be the only source risk priced in CAPM. To
analyse the variance of (excess) returns we follow Goyal and Santa Clara (2003).
Consider the following measure of total risk in a country. First, compute the
variance of a stock (or collection of stocks) p using a 12 months moving window
as:

11
X
2
Vpt = rpt i (25)
i=0

Where rp;t i is stock p return in month t. Then compute the average stock
variance as the arithmetic average of the N 12-month window variances of each
stock return.
" 11
Nt X
#
1 X 2
Vt = r (26)
Nt i=1 i=0 pt i

Where Nt is the number of stocks in the country of interest at each t .37 This
is a measure of total risk, including systematic and idiosyncratic components.
Now consider a portfolio that equally weights all stocks for a speci…c country at
each moment in time t. Call this portfolio the equally weighted portfolio (ew).
This portfolio, by construction, will capture the systematic risk of the market.
Using (25) we can compute a time series for the variance of this portfolio (Vew ).
Formally:
X11 N
1 X 2
Vew = r (27)
i=0
Nt i=0 p;t i
Analyzing together both measures, we obtain the share of the total variance
of returns explained by idiosyncratic risk, namely 1 VVew t
. With the size of
this "residual" variable we get a measure of the potential miss-pricing error in
CAPM models if underlying assumptions do not hold.

4 Empirical results for Latin American markets

Before estimating the contribution of systematic risk (betas) to account for
asset returns (or excess returns) and hence be able to obtain COE estimates, it is
necessary to identify the appropriate econometric speci…cation of the underlying
asset pricing model.
3 7 Note that this measure is not, strictly speaking, a variance measure since returns are not

demeaned. However, the impact of subtracting the mean is minimal, or you can safely assume
mean returns normalized to zero.. As Goyal and Santa Clara (2003) suggest, the expected
squared return overstates the variance by less than one percent of its level.

40
4.1 Asset pricing model speci…cation
Following Stultz (1995) and Koedijk et al (2002), we use a nested International
CAPM-Domestic CAPM equation in order to test whether global portfolio risk
and (multilateral) real exchange rate ‡uctuations add some signi…cant informa-
tion to the domestic CAPM model (see Section 3.3.3). Recall Equation 28 below
which suggests that a …rm’s asset return (i.e. its COE) can be accounted for by:
the risk-free rate, local market portfolio risk, global market portfolio risk, and
multilateral real exchange rate returns (or "real" currency risk, as long as this
risk is not fully diversi…able or hedged against currency exposures are limited).

Ri;t = i + iM [RM;t ] + iG [RG;t ] + iM RER [RM RER;t ] + i;t (28)

In order to …gure out which model speci…cation should be adopted to estimate

expected (excess) returns and COE, we perform di¤erent individual and joint
statistical tests under the null hypothesis that either global market portfolio risk
(Global Returns) or multilateral (real) exchange rate returns (RER), or both
are statistically insigni…cant in Equation (28); in other words, we are testing
the null hypothesis that Domestic CAPM is the right model.
Table 7 displays the results of these tests: we can conclude that both Global
Returns and RER are almost never signi…cant and therefore Domestic CAPM
overwhelmingly turns out to be the relevant econometric speci…cation we should
adopt.
Global Returns RER returns Join test
Period
Country (1) (2) (1) (2) (1) (2)
AR 0.12 0.06 0.19 0.15 0.22 0.16 1990-2004
BR 0.21 0.14 0.27 0.23 0.38 0.28 1986-2004
CL 0.15 0.05 0.18 0.15 0.24 0.14 1989-2004
CO 0.08 0.07 0.12 0.08 0.18 0.11 1993-2004
MX 0.11 0.06 0.29 0.23 0.28 0.18 1991-2004
PE 0.14 0.07 0.11 0.07 0.19 0.08 1992-2004
VE 0.18 0.08 0.12 0.10 0.20 0.14 1989-2004
Latin America 0.17 0.09 0.22 0.18 0.29 0.20 1986-2005
Table 7: Percentage of Wald Test rejecting the null of non significant
global instruments

Running more than 140.000 nested equations (84359 for unweighted GMM
speci…cations and 65145 for weighted GMM models, using monthly traded shares
as weights) we …nd the rejection percentages in the case of the joint test –under
the null hypothesis that: both Global Returns and RER coe¢ cients are non
signi…cant in the nested equation) are always below 40%. Moreover, taking Latin
America as a whole these percentages decrease up to 19 and 28%, depending on
the econometric speci…cation38 .
3 8 In Columns (1) of Table 7 percentages are taken from non weighted GMM speci…cations

41
 0.6 Weigthed GMM
Non-Weighted GMM
0.5

0.4

0.3

0.2
Critical value for rejection
0.1

0
Jan- May- Sep- Jan- May- Sep- Jan- May- Sep- Jan- May- Sep-
90 91 92 94 95 96 98 99 00 02 03 04

Figure 8: Average Wald test p-values in Latin America for the null Hy-
pothesis: Global returns and RER returns do not explain individual
stock total returns. Note: weighted GMM econometric speci…cation uses traded
shares as within …rm weights for each rolling window of 48 monthly observations.

Regarding the Wald Test dynamic properties, we …nd that Latin American
average p-values (i.e. the probability that the null hypothesis is rejected) are
slightly decreasing over time but they always remain well above the usual 0.05
critical value for rejection (see Figure 42).
For most Latin American stock markets we …nd increasing rejection percent-
ages since 2000 (see Table 8). Notwithstanding this fact, none of these values
is on average higher than 0.5. Therefore, and taking into account that a single
econometric speci…cation is required in order to produce both time-series and
cross-section comparable COE estimates, we …nally reject the null hypothesis
that global components (i.e. Global Returns and RER) are statistically signi…-
cant in the ICAPM-CAPM nested equation. In other words, the only relevant
factor to account for variations in expected (excess) returns –the COE- in our
sample of Latin American countries is local market portfolio risk (and sovereign
spreads), like in the single factor or Domestic-CAPM (Equation 1 above).
while in Columns (2) values have been obtained from weighted GMM models using monthly
traded shares as within weights.

42
 Arg. Bra. Chile Col. Mex. Peru Ven.
1986
1987
1988
1989
1990 0.04
1991 0.15
1992 0.13
1993 0.13 0.10 0.17
1994 0.13 0.18 0.08 0.00
1995 0.10 0.16 0.09 0.24 0.25
1996 0.11 0.16 0.10 0.27 0.03 0.08
1997 0.04 0.26 0.10 0.05 0.25 0.05 0.10
1998 0.08 0.25 0.09 0.12 0.17 0.07 0.17
1999 0.13 0.27 0.13 0.11 0.20 0.09 0.26
2000 0.12 0.31 0.12 0.14 0.13 0.07 0.09
2001 0.13 0.32 0.16 0.14 0.21 0.11 0.04
2002 0.29 0.42 0.21 0.13 0.22 0.10 0.10
2003 0.22 0.47 0.18 0.08 0.17 0.07 0.18
2004 0.22 0.48 0.20 0.08 0.14 0.09 0.23
Whole Sample 0.16 0.28 0.14 0.11 0.18 0.08 0.14
Table 8: Percentage of Wald Test rejecting the null of non significant global
instruments. Yearly averages by country obtained from non weighted GMM
specifications

Using within …rm weighted GMM instead of unweighted versions of the

nested equation, we obtain similar results as we can see from Figure 23.

4.2 The COE Derived from Black’s CAPM Beta estimates

Using the Black’s CAPM beta estimates (Equation 29, reproduced below) we
have got from GMM rolling regressions, we compute alternative estimates of the
COE.

b
(Ri;t Rf;t SSj;t ) = i [RM;t Rf;t SSj;t ] + i;t (29)
Indeed, we calculate 8 di¤erent COE estimates depending on whether the
Vasicek adjustment39 is allowed for, and on the di¤erent weighting mechanism
in both the GMM rolling regressions (with or without within-…rm weights -
the weight being the number of traded shares in each observation) and cross-
sectional averages (with or without between-…rm weights, the latter being the
(nominal) monthly volume40 ). Each COE estimate is the result of summing
the risk-free rate, the appropriate sovereign spread (see Section 3.3.4) and a
term equal to Black’s CAPM beta multiplied by the local market portfolio
premium (or excess return on the market portfolio). In Table 9 and Figure
3 9 See Equation 24 in Section 3.3.
4 0 See Section 3.3.

43
 40
Average COE by sector (1997-2004)
35 VE

30
AR

25 CO BR
MX
20
PE
15 CL

10
10 20 30 40 50 60 70

COE std by sector (1997-2004)

Figure 9: COE in Latin America. Cross-plot of average COE and

standard deviation by country (annualized values, in percentages)

9, we present the annualized average COE by country (and their associated

standard deviations) for the period 1997-2004.

Overall averages
Country
Mean Std
AR 28.33 45.36
BR 25.31 33.89
CL 15.84 17.70
CO 25.32 28.76
MX 22.13 27.44
PE 16.39 24.08
VE 35.10 59.41

Table 9: Black's Model Cost of Equity estimates

by country (in percentage). Overall averages for
the whole sample period (1997 to 2004)

Not surprisingly, the riskiest stock markets (Venezuela and Argentina) are
also those with higher average COE estimates, while the less risky country, Chile,
exhibit the lowest rates of stock returns and hence COE estimates. Notwith-
standing this …nding, the risk-return (COE) relationship found in the case of
Peru deserve further discussion. Peruvian COE estimates are lower than ex-
pected -after all Peru is an speculative grade country, and its stock market
remains underdeveloped/illiquid and the average COE observation is below the

44
…tting curve. However, the Peruvian macroeconomic outlook has been steadily
improving since 1997. Indeed, average in‡ation in 1997-2004 is the lowest in
Latin America and the average real GDP volatility in Peru is also relative small
since 1997 and well below those of Argentina, Venezuela, Colombia, and even
Mexico. Why should then rational (but to some extent backward-looking) in-
vestors require higher returns on a Peruvian stock? This remains an open
question to debate and further research.
Figure 9 depicts a mean-variance COE trade-o¤ which is quite in line with
Markowitz’s predictions. Average COE estimates seem to be relatively high
on an absolute basis41 . However, this is not surprising because of the sample
period and methodological features. Most Latin American …nancial crisis takes
place in this period (including the Mexican one -Tequila-42 ). Furthermore, it
is worth noting that setting at 0 all negative COE estimates (the standard
criterion43 ) yields higher average COE values (because Latin American stocks
show many observations with negative COE estimates in this period). Allowing
for negative observations reduces Latin America average COE estimates by 25%
(on average), but do not qualitatively changes the relative structure of data
(neither across countries nor across sectors).
From a time series perspective, our CAPM COE estimates share some com-
mon features with regional stock markets returns: high return volatility and
some degree of co-movement (compare Figures 10 and 5). In spite of these com-
monalities, when we look at COE over time we realize two di¤erent patterns
emerge. On the one hand, Argentina, Brazil and Venezuela share a high overall
volatility alongside higher but decreasing COE estimates since January 2004.
On the other hand, more stable patterns in the evolution of COE arise in the
cases of Chile, Colombia, Mexico and Peru. Although COE estimates remain
lower than those of the …rst group, they have been steadily increasing since
2003.
It is interesting to notice that Latin American COE are a-cyclical (see Fig-
ure 11) and not pro-cyclical as is generally the case in developed, mature stock
markets. This is because GDP growth is negatively correlated with sovereign
spreads which only play a role in emerging markets. When the sovereign spread
GDP-elasticity is higher than that of total market returns, COE estimates can
even be counter-cyclical (e.g. Argentina or Colombia). Looking at the country
level, only Mexican COE estimates are signi…cantly pro-cyclical (with a corre-
lation coe¢ cient of 0.48).
A critical question arises from the previous results: Why should Latin Amer-
ican …rms increase their use of equity …nance if it is very expensive (as usual)
4 1 For the sake of comparison with developed-country stocks, see for example Khothari et

al. (1995), Fama and French (1997) or Hauptman and Natella (1997). Also see section 2.1.
4 2 Remember that cross-country comparable COE estimates start in 1997, but were obtained

using information from 1993 to 2004 (i.e. a minimum of 48- month or 4-year moving window
is required to estimate beta and COE).
4 3 See the methodological section.

45
 0.8 AR
BR
0.7 VE

0.6

0.5

0.4

0.3

0.2

0.1

0.0
Jan-97 Mar-98 May-99 Jul-00 Sep-01 Nov-02 Jan-04

0.8 CL
CO
0.7 MX
PE
0.6

0.5

0.4

0.3

0.2

0.1

0.0
Jan-97 Mar-98 May-99 Jul-00 Sep-01 Nov-02 Jan-04

Figure 10: Evolution of the COE by country (Black’s model 12-month

rolling moving overall-averages)

46
 0.7 COE = 0.0004*GDP growth + 0.22
R2 = 0.0004
Correlation Coeff.
Average COE (annualized values)

0.6
Country
(COE-GDP growth)
0.5 Argentina -0.12
Brazil 0.03
0.4 Chile -0.11
Colombia -0.09
0.3 Mexico 0.46*
Peru 0.19
0.2 Venezuela 0.25
Note: * stands for significant
0.1 correlation coefficients at 5%.

0
-40 -30 -20 -10 0 10 20 30 40
Real GDP growth (YoY, as %)

Figure 11: The acyclical pattern of the COE in Latin American coun-
tries. Cross-Plot and across country comparison of average correla-
tion between COE and GDP growth (1997-2004, Quarterly data)

and does not provide a "bene…cial" pro-cyclical pattern? Risk-averse man-

agers would be willing to pay a market premium to obtain equity …nance if
COE estimates were pro-cyclical (because of the pro…t-smoothing properties
of such a behavior). But it is no longer true when COE estimates become a-
cyclical. Therefore, Latin American stock market underdevelopment can also
be explained by this feature.
When examining the average COE estimates by sector, we …nd that Pension
Funds and Agriculture & Fishing stocks have the lowest estimates in the sample
while Oil & Gas, Telecommunication, Electricity and Construction …rms display
the highest values across sectors (see the last column in Table 10).
Pension Funds have the lowest COE because they hold more diversi…ed in-
vestment portfolios than other sectors. Low COE estimates for Agriculture &
Fishing are due to the relatively low return volatility of this sector (sales -in
US current dollars- of this tradable sector are much more stable than those
of non-tradable ones). On the contrary, Construction …rms are highly volatile
(and thus risky) because of their high sensitivities to the business cycle (which
is priced in higher expected returns and then relatively higher COE).
COE estimates for Telecommunication and Electricity …rms are surprisingly
high because these …rms have relatively stable sales (in domestic currency).
However, expected pro…ts in US current dollars are particularly uncertain be-
cause of country speci…c regulations and high exchange rate volatility in most
Latin American countries.
Oil & Gas COE results could have a di¤erent nature. Impressive COE esti-
mates would be explained by gradually increasing pro…t expectations rather

47
 0.28 Oil & Gas
Average COE by sector (1997-2004)
0.26 Telecommunications

0.24
Construction
0.22 Finance &
Insurance
0.20

0.18
Agriculture
0.16 & Fishing

0.14
Pension Funds
0.12
0.15 0.20 0.25 0.30 0.35 0.40 0.45 0.50 0.55

COE std by sector (1997-2004)

Figure 12: COE in Latin America. Cross-plot of across-country overall

averages and standard deviations by sector (annualized values)

than by excessive pro…t uncertainty. Put it di¤erently, high COE estimates owe
to progressive upward corrections and not to symmetric volatility.
The mean-variance trade-o¤ observed across-countries is also reported across-
sectors (see Figure 12 and Figure 31 in the appendix), with Oil & Gas, Telecom-
munications and Construction being representative to the upper-right panel
(high mean - high variance) and Pension Funds and Agriculture & Fishing
(amongst others) belonging to the lower-left one.
The majority of sectors report the lowest COE estimates in Peru and, mainly,
in Chile, while the highest are almost always associated with Venezuelean …rms.
Venezuela and Colombia display the highest cross-sector COE dispersion
while Chile and Mexico show the lowest ones.

48
Sector AR BR CL CO MX PE VE Average
Agriculture & Fishing 0.20 0.34 0.14 0.17 0.17 0.13 0.18
(0.27) (0.30) (0.15) (0.20) (0.19) (0.17) (0.22)
Chemicals & Chemical Products 0.22 0.26 0.09 0.18 0.19 0.14 0.23 0.23
(0.33) (0.34) (0.12) (0.18) (0.21) (0.23) (0.47) (0.32)
Construction 0.26 0.17 0.14 0.23 0.48 0.24
(0.39) (0.43) (0.17) (0.27) (0.62) (0.50)
Electrical Equipment & Electronic Products 0.24 0.25 0.22 0.22 0.24
(0.27) (0.35) (0.25) (0.40) (0.34)
Electricity 0.29 0.30 0.15 0.29 0.11 0.58 0.25
(0.43) (0.44) (0.21) (0.29) (0.10) (1.20) (0.44)
Finance & Insurance 0.33 0.23 0.12 0.22 0.23 0.15 0.23 0.23
(0.61) (0.36) (0.15) (0.30) (0.35) (0.21) (0.47) (0.39)
Food & Beverages 0.26 0.21 0.17 0.31 0.21 0.19 0.16 0.21
(0.37) (0.25) (0.19) (0.46) (0.27) (0.31) (0.16) (0.28)
Machinery & Equipment 0.20 0.21 0.22 0.12 0.22
(0.22) (0.27) (0.28) (0.13) (0.29)
Mining 0.20 0.17 0.24 0.19 0.22 0.18 0.19
(0.23) (0.21) (0.32) (0.20) (0.37) (0.14) (0.26)
Motor Vehicles & Related 0.29 0.22 0.16 0.23
(0.59) (0.26) (0.23) (0.32)
Non-Metallic Mineral Products 0.27 0.21 0.15 0.28 0.25 0.17 0.30 0.24
(0.44) (0.31) (0.15) (0.38) (0.33) (0.28) (0.58) (0.34)
Oil & Gas 0.26 0.28 0.18 0.40 0.27
(0.42) (0.42) (0.21) (0.55) (0.42)
Others 0.29 0.23 0.14 0.23 0.25 0.13 0.19 0.23
(0.44) (0.31) (0.17) (0.32) (0.32) (0.20) (0.34) (0.32)
Paper & Paper Products 0.21 0.21 0.20 0.11 0.22 0.27 0.21
(0.20) (0.28) (0.24) (0.09) (0.27) (0.55) (0.29)
Pension Funds 0.14 0.10 0.14
(0.18) (0.02) (0.18)
Software & Data 0.23 0.11 0.19
(0.28) (0.05) (0.24)
Steal & Metal Products 0.40 0.26 0.27 0.24 0.26 0.42 0.26
(0.86) (0.35) (0.35) (0.30) (0.40) (0.90) (0.41)
Telecommunications 0.38 0.32 0.21 0.07 0.20 0.16 0.30 0.27
(0.69) (0.41) (0.30) (0.11) (0.28) (0.25) (0.66) (0.43)
Textiles 0.20 0.20 0.08 0.23 0.08 0.13 0.38 0.20
(0.21) (0.24) (0.07) (0.22) (0.12) (0.16) (0.75) (0.27)
Transportation & Storage 0.09 0.15 0.18 0.19 0.27 0.19
(0.04) (0.16) (0.19) (0.17) (0.60) (0.27)
Wholesale & Retail Trade 0.21 0.29 0.23 0.16 0.21 0.19 0.22
(0.33) (0.40) (0.27) (0.16) (0.27) (0.31) (0.30)

Table 10: Overall Average Cost of Equity by country and sector (annualized values for the
whole sample period: 1997-2004)

The highest across-country COE dispersion is obtained for Construction and

Electricity stocks, while Mining and Electrical Equipment & Electronic Products
stocks appear to have very similar COE in all Latin American countries studied
in our sample.
Finally, we observe that extreme values of COE by country are very di¤er-
ent44 . In Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela, the
sectors with the highest COE estimates are Steal & Metal, Agriculture & Fish-
4 4 More details on COE estimates by country and sector are presented in …gures 22 to 28 in

the appendix.

49
ing, Steal & Metal, Oil & Gas, Non-Metallic Mineral Products, Construction and
Electricity respectively. Conversely, Transportation & Storage, Transportation
& Storage, Textiles, Telecommunications, Textiles, Pension Funds, and Agricul-
ture & Fishing exhibit the lowest COE estimates in Argentina, Brazil, Chile,
Colombia, Mexico, Peru and Venezuela, respectively.

4.3 The explanatory power of CAPM

How well does Black-CAPM regressions …t (excess) returns? How much of
(excess) returns remain to explain? Are Black-CAPM beta and COE estimates
mispricing systematic risk? To answer these questions we will …rst take a look
at how much of the stock (excess) returns variance remains unaccounted for by
Black-CAPM regressions.
Should Black-CAPM regressions provide a poor explanation of (excess) re-
turns variability, it could be the case that CAPM assumptions are wrong and
hence misspricing errors huge. For instance, investors may not be able to fully
diversify portfolios and idiosyncratic variables may in fact matter. It is clear at
this point that understanding how large idiosyncratic relative to systematic risk
is in each country is a key issue. In Section 4.4 we provide an alternative mea-
sure of the variance decomposition that may be useful to determine the relative
importance of these sources of risk.
Econometric techniques enable us to isolate the percentage of the risk which
is not accounted for by the explanatory-variable set. In our study, these are
the proxies for the domestic market portfolio (see Section 3.3 and 4.1). As
mentioned earlier, if these market portfolios are e¢ cient (something that we are
not testing here), they should (fully) capture the systematic component of risk.
It follows that Black-CAPM regressions allow us to isolate the percentage of the
total variance of (excess) returns explained by systematic risk, what amounts
to computing the R-squared or goodness of …t.
Figure 13 shows the R-squared which averages out all individual R-squared
obtained through the 8 di¤erent econometric speci…cations as set out in Sec-
tion 3.3. The sample covers all stock returns on Latin American …rms in the
selected countries over 1997-2004. The black solid line indicates the overall
(across-econometric model) average R-squared while the dotted lines depict the
individual R-squared values at +- 1 standard deviation away from the mean.45
Figures 32 to 35 in the Appendix report average R-squared values on a
country basis. Like in the full sample case, these measures of the goodness of …t
4 5 Out of 8 possible CAPM econometric speci…cations, the highest individual R-squared

obtains where within and between …rm weights are used (Vacisek-adjusted betas). In principle,
the result that weighting …rms by their average traded volume increases the explanatory power
of the market portfolio, and therefore the stock return variability accounted for by systematic
risk, is not surprising. This happens as in our sample there is an apparent correlation between
market capitalization and the average traded volume. Market capitalization is generally well
tracked by the market portfolio or its proxy. A chart displaying the best …t and other R-square
values is available upon request.

50
 1.0
CAPM R2 (across model overall mean) for Latin America
0.9 +/- 1 std

0.8

0.7

0.6

0.5
0.4

0.3

0.2

0.1

0.0
Jan-97 Mar-98 May-99 Jul-00 Sep-01 Nov-02 Jan-04

Figure 13: R-Squared overall mean across di¤erent CAPM-GMM spec-

i…cations. L.A. sample 1997-2004

correspond to Black-CAPM regressions where within and between …rm weights

are used (Vacisek-adjusted betas). The country reporting the highest average
R-squared is Argentina (44,4%), followed by Mexico (43.9%), Venezuela (40%),
Colombia (39,7%), Peru (29,4%), Chile (32,2%) and Brazil (22,6%).
The best Black-CAPM model speci…cation accounts for, on average, 32% of
the variance of (excess) returns for the whole sample of Latin American coun-
tries. Why the remaining 68% is not explained by the best model speci…cation is
subject to discussion. If all Black-CAPM assumptions held true, then, for Latin
America, 32% of the variance of returns would be attributable to systematic
risk, and 68% to idiosyncratic, fully diversi…able risk. However, it may be the
case that Black-CAPM assumptions could be wrong, for example, if there were
intertemporal investment choices not captured by the domestic market portfolio
(as Merton´s (1973) model suggested), or if investors were not able to fully diver-
sify portfolios (as Levy (1978) or Merton (1987), among others, demonstrated).
In any of these cases, the important 68% of (excess) return (and COE) volatil-
ity that remains unexplained represents a huge potential misspricing error of
the cost of capital. Either additional systematic risk factors (Fama and French
1992, 1996 and 1997) or …rm-idiosyncratic variables, or both, could be added to
Black-CAPM so as to reduce the potential misspricing error.46
An interesting question related to the foregoing analysis is how large idiosyn-
cratic relative to systematic risk turns out in each country. Our Black-CAPM
4 6 This is subject of ongoing research by the authors.

51
 regressions suggest that idiosyncratic risk accounts for a percentage close to
68% of total (excess) returns variance, i.e. the average R-squared is 0.32. There
are some disadvantages to the use of R-squared though. The …rst is that it
is model dependent. Another disadvantage of R-squared is that it is only a
relative measure, so it does not say anything about the absolute magnitude of
the variance. It may re‡ect whether systematic risk is relatively higher than
idiosyncratic risk in a country with respect to another country, but it does not
say anything about the absolute magnitude of systematic risk in either country.
Next Section presents an alternative approach to deal with these disadvantages.

4.4 Variance Decomposition Results

An alternative approach to breaking down total risk (i.e. the total variance
of (excess) returns and COE)) consists in, …rst, estimating the cross-sectional
variance of stock (excess) returns in a given country at time t (Section 3.4)
to capture the systematic component of stock (excess) return volatility, and,
second, to divide the latter by the average total stock risk. Table 11 presents
some descriptive statistics of these two measures, i.e. total and systematic risk.
Recall that these are 12-month rolling window standard deviations. Figures 36
to 39 in the appendix plot the evolution of those variances by country, over
the period 1996-2005. Table 12 compares the R-squared obtained from Black-
CAPM regressions as discussed in Section 4.3 with the share of systematic risk
in total risk measured according to the methodology laid out in Section 3.4.

Total Risk (Vt) Systematic Risk (Vew)

Country
Mean Median Std Dev Mean Median Std Dev
Argentina 0.24 0.22 0.07 0.16 0.14 0.08
Brazil 0.32 0.31 0.08 0.18 0.16 0.08
Chile 0.16 0.16 0.03 0.08 0.08 0.03
Colombia 0.14 0.16 0.07 0.07 0.07 0.05
Mexico 0.18 0.17 0.03 0.10 0.09 0.03
Peru 0.20 0.19 0.06 0.09 0.07 0.05
Venezuela 0.23 0.23 0.04 0.14 0.14 0.06
Table 11: Standard Deviations on Total Returns by country for the whole
sample period: 1997-2004.

Table 1247 shows that, on average, systematic risk accounts for 30% of the
total variance in (excess) returns. This …gure is actually close to the average
R-squared -32%- we have got from the best Black-CAPM econometric speci…-
cations. Also, consistent with the …ndings from the Black-CAPM regressions,
the share of systematic risk increases in the cases of Argentina and Venezuela,
this time to 41% and 37%, respectively.
4 7 Note that Column 1 in table 12 is the result of dividing the square of the …gures in column

4 by the square of the …gures in column 1 in table 11.

52
 Country Systematic Risk / Total Risk Overall average R2
Argentina 0.41 0.44
Brazil 0.33 0.23
Chile 0.28 0.32
Colombia 0.25 0.40
Mexico 0.30 0.44
Peru 0.21 0.29
Venezuela 0.37 0.41
Table 12: Alternative Systematic Risk Measures. Overall
averages for the whole sample period: 1997-2004

It is interesting to note that the country displaying the lowest R-squared

in Black-CAPM regressions (23%), Brazil, has nevertheless the higher absolute
systematic standard deviation with a value of 18.22% (see Table 4.4) . Brazil
has also the largest absolute total variance measure. In relative terms, Brazil’s
systematic risk share (33%) is not the highest and has a comparable level to
that of Mexico(29%) or Chile(28%).

5 Conclusions
This paper provides a unique dataset of comparable COE estimates for Latin
America. The dataset includes 921 …rms listed in 7 stock markets (Argentina,
Brazil, Chile, Colombia, Mexico, Peru and Venezuela) and looks at the inter-
temporal (1997-2004), cross-country and cross-sectoral dimensions of COE.
In order to obtain homogeneous (and robust) CAPM-COE estimates for
these Latin American publicly-traded …rms, we introduce a number of method-
ological considerations, some of which are "innovative" in the literature of
emerging-market stock pricing (test of real market integration or "home bias
e¤ect" in stock princing, an alternative method to price sovereign spreads into
COE, adjustment for illiquidity, beta robustness and instability, treatment of
negative COE estimates and weighting strategies; see Section 3.3),
Our main results can be summarized as follows:

1. Risk-adjusted returns on Latin American stocks are signi…cantly lower

than those observed in developed countries. However, Latin American
COE estimates (CAPM required returns) are much higher than those in
mature markets, reaching an annualized regional average of 24.06% (in US
dollars).

2. These results are mainly explained by the underlying extreme uncertainty

in Latin American stock markets, in turn related to periods of heightened
macroeconomic volatility.

3. Despite the recent increase in …nancial globalization, we …nd a lack of

real market integration ("home bias e¤ect") in the case of Latin American

53
 stocks. Therefore, COE estimates should be derived from domestic CAPM
speci…cations instead of international versions.Notwithstanding the impli-
cations of the latter, we found that "home bias" in stock pricing is slightly
decreasing over time.

4. In line with Markowitz’s predictions, there is a clear-cut risk-return (stan-

dard deviation-mean) positive trade-o¤ in COE estimates. This is not
surprising because a strong relationship between returns and local port-
folio risk should be expected when markets are segmented. As a result,
the riskiest stock markets (Venezuela and Argentina) are also those asso-
ciated with higher average COE estimates, while Chile (the Latin Amer-
ican "paradigm" in terms of capital market development and stability)
exhibits the lowest risk/return values. The positive risk-return trade-o¤
is also reported across-sectors, with Oil & Gas, Telecommunications and
Construction displaying the highest COE means and standard deviations
and Pension Funds and Agriculture & Fishing the lowest.

5. Latin American COE estimates are not generally pro-cyclical, which comes
in sharp contradiction with the theoretical insights in the literature on de-
veloped countries. This is because GDP growth is negatively correlated
with sovereign spreads which are an important component of total …nanc-
ing costs in emerging markets. If sovereign spread GDP-elasticities are
higher in absolute value than those of local market (excess) returns, COE
estimates can even be counter-cyclical (e.g. Argentina or Colombia). Put
di¤erently, when there is a recession in Latin American countries, the re-
duction in the local market premium is o¤set by a rise in the sovereign
spread, yielding a-cyclical COE estimates.

6. Using two di¤erent measures of variance decomposition we …nd that indi-

vidual returns, and hence COE are mainly driven by idiosyncratic shocks
(even in Venezuela or Argentina, the countries with the largest shares
of systematic risk in total risk). Consequently, CAPM-COE estimates
should be cautiously interpreted because 60% to 70% of the total variance
is not explained by the model. In a context of low probability of complete
diversi…cation, this may lead to signi…cant misspricing errors.

Our main results may shed light on the causes of Latin American stock
market underdevelopment.
On the demand side, excessive systematic risk reduces the risk-adjusted re-
turn on Latin American stocks below the level of developed markets. Therefore,
why should risk-averse investors hold Latin American stocks in their portfolios
if they o¤er relatively small risk-adjusted returns?.
On the supply side, excessive macroeconomic volatility drives high and a-
cyclical COE estimates. Then, why should Latin American private sector man-

54
agers tap stock markets to raise equity …nance if COE estimates are neither low
nor ‡exible?.
In the light of the foregoing results, a policy concern should be to dampen
the excessive macroeconomic volatility -typically associated with country risk-
observed in some Latin American countries studied in this paper, thereby re-
ducing the systematic component of risk and ultimately COE. This would make
more advantageous for investors to hold Latin American stocks as their risk-
adjusted returns would increase and for …rms to raise cheaper equity …nance
as COE might fall. Lower COE is a necessary condition for higher investment,
sustained long-term growth and poverty-reduction enhancing.
As said before, however, systematic risk in the context of our Black (domes-
tic) CAPM regressions only accounts for 30% to 40% of total risk, i.e. it only
explains less than half of COE. Other potential sources of systematic risk deal-
ing with size (capitalization) and book to market value ratios (Fama and French
1992, 1996 and 1997) or …rm-speci…c variables (idiosyncratic risk not priced in
Black-CAPM COE estimates) or both could help explain the remaining 60% to
70% of total variability in COE. An ongoing extension of this research project
is looking into the latter potential sources of misspricing.

55
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6 Appendix

Argentina Brazil
Percentage of Observations

Percentage of Observations
Without Trade (Iliquidity

0,4 0,3

Without Trade (Iliquidity

0,35
0,25
0,3
Measure)

0,25 0,2

Measure)
0,2
0,15
0,15
0,1 0,1
0,05 0,05
0
0
0 0,05 0,1 0,15 0,2 0,25
0 0,05 0,1 0,15 0,2 0,25
Total Trading Volume as Percentage of Total Trading Volume as Percentage of
GDP (Liquidity Measure) GDP (Liquidity Measure)

Chile Mexico

Without Trade (Iliquidity Measure)

0,25
Percentage of Observations

0,16
Without Trade (Iliquidity

0,2
Percentage of Observations 0,14

0,12
Measure)

0,15 0,1

0,08
0,1
0,06
0,05 0,04
0,02
0
0 0,05 0,1 0,15 0,2 0
0 0,05 0,1 0,15 0,2 0,25
Total Trading Volume as Percentage of GDP
(Liquidity Measure) Total Trading Volume as Percentage of GDP
(Liquidity Measure)
Colombia
Percentage of Observations Without Trade

Peru
Without Trade (Iliquidity Measure)

0,5
0,4
Percentage of Observations

0,4 0,35
(Iliquidity Measure)

0,3
0,3 0,25
0,2
0,2
0,15
0,1 0,1
0,05
0 0
0 0,02 0,04 0,06 0,08 0,00 0,01 0,01 0,02 0,02
Total Trading Volume as Percentage of GDP Total Trading Volume as Percentage of GDP (Liquidity
(Liquidity Measure) Measure)

Venezuela, Rep. Bol.

Percentage of Observations
Without Trade (Iliquidity

0,5
0,4
Measure)

0,3
0,2
0,1
0
0,00 0,02 0,04 0,06

Total Trading Volume as Percentage of GDP

(Liquidity Measure)

Figure 14: Liquidity Measures Comparison (1997-2004)

63
Stock Market Index (1) (2) (3) (4) (5) (6) (7) (8)
MERVAL Argentina (1)
1.00
BOVESPA Brazil (2)
0.27* 1.00
IPSA Chile (3)
0.37* 0.45* 1.00
IGBC Colombia (4)
0.22* 0.05 0.18* 1.00
IPyC Mexico (5)
0.45* 0.41* 0.49* 0.14 1.00
IGBVL Peru (6)
0.23* 0.24* 0.35* 0.23* 0.44* 1.00
IBC Venezuela (7)
0.27* 0.21* 0.22* 0.25* 0.24* 0.13 1.00
DOW JONES USA (8)
0.27* 0.44* 0.47* 0.12 0.47* 0.16* 0.21* 1.00

Table 13: Stock Market correlation matrix (1990-2004). Note:* stands for
significant autocorrelation coefficients at 0.05.

64
 10
DOWN JONES US
MERVAL Argentina
IBC Venezuela
8

IGBC Colombia
Kernel De nsity
6 4
2
0

-.5 0 .5
USD Monthly Total Returns
10

BOVESPA Brazil
IPSA Chile
IGBVL Peru
8

IPyC Mexico
Kernel Density
6 4
2
0

-.5 0 .5
USD Monthly Total Returns

Figure 15: Gaussian Kernel Densities of Total

Returns by Country (1990-2004)

65
Figure 16: Beta estimates by sector in Argentina from 1996-I to 2004-IV

66
Figure 17: Beta estimates by sector in Brazil from 1996-I to 2004-IV

67
Figure 18: Beta estimates by sector in Chile from 1996-I to 2004-IV

68
Figure 19: Beta estimates by sector in Colombia from 1996-I to 2004-IV

69
Figure 20: Beta estimates by sector in Mexico from 1996-I to 2004-IV

70
Figure 21: Beta estimates by sector in Peru from 1996-I to 2004-IV

71
Figure 22: Beta estimates by sector in Venezuela from 1996-I to 2004-IV

72
0.6 AR BR CL CO
MX PE VE

0.5

0.4

0.3

0.2

0.1
Critical value for rejection

0
Jan-97 Mar-98 May-99 Jul-00 Sep-01 Nov-02 Jan-04

Figure 23: Average Wald test p-values by country (using traded

shares as weights in the GMM econometric specification) for the
null H0: Global returns and RER returns do not explain individual
stock total returns

73
Figure 24: 12-month moving averages Black’s model COE estimates for Argentina

74
Figure 25: 12-month moving averages Black’s model COE estimates for Brazil

75
Figure 26: 12-month moving averages Black’s model COE estimates for Chile

76
Figure 27: 12-month moving averages Black’s model COE estimates for Colombia

77
Figure 28: 12-month moving averages Black’s model COE estimates for Mexico

78
Figure 29: 12-month moving averages Black’s model COE estimates for Peru

79
Figure 30: 12-month moving averages Black’s model COE estimates for Venezuela

80
 Argentina Brazil

0.60 0.60

Average COE by sector (1997-2004)

Average COE by sector (1997-2004)

0.50 0.50

0.40 Steal & 0.40

Telecommunications
Metal
Agriculture
& Fishing
0.30 0.30 Electricity

0.20 0.20 Textiles

Construction
Textiles
Transportation
0.10 0.10
& Storage
Transportation
& Storage
0.00 0.00
0.00 0.20 0.40 0.60 0.80 1.00 1.20 0.00 0.20 0.40 0.60 0.80 1.00 1.20
COE std by sector (1997-2004) COE std by sector (199 7-2004)

Chile Co l om bi a

0.60 0.60

Average COE by sector (1997-2004)

Average COE by sector (1997-2004)

0.50 0.50

Oil & Gas

0.40 0.40

Chemicals
0.30 & Chemical Steal & Metal 0.30
Products Products
Textiles
0.20 0.20

0.10 0.10
Telecommunic.
0.00 0.00
0.00 0.20 0.40 0.60 0.80 1.00 1.20 0.00 0.20 0.40 0.60 0.80 1.00 1.20
Textiles COE std by sector (1997-2004) COE std by sector (199 7-2004)

Mexico Pe ru

0.60 0.60
Average COE by sector (1997-2004)

Average COE by sector (1997-20 04)

0.50 0.50 Construction

0.40 0.40

Construction
0.30 0.30
Steal & Metal Products
Finance & Insurance
0.20 0.20

Electricity
0.10 0.10

0.00 0.00 Pension Funds

Textiles0.20
0.00 0.40 0.60 0.80 1.00 1.20 0.00 0.20 0.40 0.60 0.80 1.00 1.20
COE std by sector (1997-2004) COE std by sector (199 7-2004)

Venezuela

0.60 Electricity
Average COE by sector (1997-20 04)

0.50

Steal & Metal Products

0.40

0.30

0.20
Food & Beverages
0.10 Agriculture & Fishing

0.00
0.00 0.20 0.40 0.60 0.80 1.00 1.20
COE std by sector (1997-2004)

Figure 31: Mean-Variance Trade-O¤ in Latin American COE

estimates. Cross-plot of average and std by country and sector
(annualized values)

82
 1.0 LA overall mean
Argentina +/- 1 std
0.9 Argentina
0.8

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0.0
Jan-97 Mar-98 May-99 Jul-00 Sep-01 Nov-02 Jan-04

1.0 LA overall mean

Brazil +/- 1 std
0.9
Brazil
0.8

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0.0
Jan-97 Mar-98 May-99 Jul-00 Sep-01 Nov-02 Jan-04

Figure 32: CAPM models Explanatory Power: Overall average

R-Squared (across di¤erent model speci…cations) in Argentina and
Brazil

83
 1.0 LA overall mean
Chile +/- 1 std
0.9
Chile
0.8

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0.0
Jan-97 Mar-98 May-99 Jul-00 Sep-01 Nov-02 Jan-04

1.0 LA overall mean

Colombia +/- 1 std
0.9
Colombia
0.8

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0.0
Jan-97 Mar-98 May-99 Jul-00 Sep-01 Nov-02 Jan-04

Figure 33: CAPM models Explanatory Power: Overall average

R-Squared (across di¤erent model speci…cations) in Chile and
Colombia

84
 1.0 LA overall mean
Mexico +/- 1 std
0.9
Mexico
0.8

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0.0
Jan-97 Mar-98 May-99 Jul-00 Sep-01 Nov-02 Jan-04

1.0 LA overall mean

Peru +/- 1 std
0.9
Peru
0.8

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0.0
Jan-97 Mar-98 May-99 Jul-00 Sep-01 Nov-02 Jan-04

Figure 34: CAPM models Explanatory Power: Overall average

R-Squared (across di¤erent model speci…cations) in Mexico and
Peru

85
 1.0 LA overall mean
Venezuela +/- 1 std
0.9
Venezuela
0.8

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0.0
Jan-97 Mar-98 May-99 Jul-00 Sep-01 Nov-02 Jan-04

Figure 35: CAPM models Explanatory Power: Overall average

R-Squared (across di¤erent model speci…cations) in Venezuela

86
 Standard Deviation Measures
Argentina
30
Total Risk Measure (V)
Systematic (EW)

25

20
Percent

15

10

5
Jan2000 Jan2005
Date

Standard Deviation Measures

Brazil
35
Total Risk Measure (V)
Systematic (EW)
30

25

20
Percent

15

10

0
Jan2000 Jan2005
Date

Figure 36: Variance Decomposition Results by Country

87
 Standard Deviation Measures
Chile
18
Total Risk Measure (V)
Systematic (EW)
16

14

12
Percent

10

2
Jan2000 Jan2005
Date

Standard Deviation Measures

Colombia
25
Total Risk Measure (V)
Systematic (EW)

20

15
Percent

10

0
Jan2000 Jan2005
Date

Figure 37: Variance Decomposition Results by Country (cont.)

88
 Standard Deviation Measures
Mexico
24
Total Risk Measure (V)
22 Systematic (EW)

20

18

16
Percent

14

12

10

4
Jan2000 Jan2005
Date
Standard Deviation Measures
Peru
25
Total Risk Measure (V)
Systematic (EW)

20

15
Percent

10

0
Jan2000 Jan2005
Date

Figure 38: Variance Decomposition Results by Country (cont.)

89
 Standard Deviation Measures
Venezuela
30
Total Risk Measure (V)
Systematic (EW)
25

20
Percent

15

10

0
Jan2000 Jan2005
Date

Figure 39: Variance Decomposition Results by Country (cont.)

90