ANNALS OF ECONOMICS AND FINANCE 3, 249–298 (2002) What Determines Expected International Asset Returns? * Campbell R. Harvey Duke University, Durham, NC 27706, USA National Bureau of Economic Research, Cambridge, MA 02138, USA Bruno Solnik HEC-School of Management, Jouyen Josas, 78350, FRANCE and Guofu Zhou Washington University, St. Louis, MO 63130, USA This paper characterizes the forces that determine time-variation in ex- pected international asset returns. We offer a number of innovations. By using the latent factor technique, we do not have to prespecify the sources of risk. We solve for the latent premiums and characterize their time-variation. We find evidence that the first factor premium resembles the expected return on the world market porfolio. However, the inclusion of this premium alone is not sufficient to explain the conditional variation in the returns. We find evidence of a second factor premium which is related to foreign exchange risk. Our sample includes new data on both international industry portfolios and international fixed income portfolios. We find that the two latent factor model performs better in explaining the conditional variation in asset returns than a prespecified two factor model. Finally, we show that differences in the risk loadings are important in accounting for the cross-sectional variation in the international returns. c  2002 Peking University Press Key Words : International investment; Asset pricing; Latent variables; Exchange rate risk; Factor models. JEL Classification Numbers : G15, C13, F21. * Part of this paper was written while the first author was visiting the Graduate School of Business at the University of Chicago. We are grateful for comments received from seminar participants at Cornell and Rochester as well as the comments of Wayne Ferson. Harvey’s research is supported by the Batterymarch Fellowship. 249 1529-7373/2002 Copyright c  2002 by Peking University Press All rights of reproduction in any form reserved.