Pacific-Basin Finance Journal 1 (1993) 235-261. North-Holland Risk premia in Pacific-Basin cadal I markets* Stephen J. Brown’ and Toshiyuki Otsukib zyxwvutsrqponmlkjihgfedcbaZYXWVUTS ‘New York Unioersity, New York, NY. USA blnternational University of Japan, Niigata, Japan We study the extent to which exposure to global risk factors explains excess returns in Pacific-Basin capital markets. These risk premia are analyzed using a multiperiod asset pricing model of global equity markets. A feature of this model is that we allow risk premia to change through time in response to global macroeconomic factors. We find that factors that influence Pacific-Basin markets are similar to those operating in other capital markets. These risk premia reflect a systematic response to changes in global economic conditions. However, this region is more exposed to global risk factors than is the United States. Furthermore, the composition of the risk premium differs across capital markets of the Pacific-Basin. In particular, the Japanese market is more exposed to global market and currency factors than is any other market in the region. We argue that this is consistent with observed differences in average excess returns within the region. Key words: Risk premia; Asset pricing models: Arbitrage pricing theory; Pacific-Basin capital markets. 1. Introduction Popular wisdom. at least in the United States, has it that the Pacific-Basin equity markets are excessively volatile. ’ For evidence, we are encouraged to look no further than the recent increase and sharp decline in the Japanese markets. If this excess volatility is the result of irrational forces’ these Correspondence lo: S.J. Brown, Department of Finance, Stern School of Business, New York University, New York, NY 10012. USA. *We thank for their unusually constructive comments and support Warren Bailey, James Bodurtha. the editor S. Ghon Rhee, two referees, participants in presentations at Monash University, New York University. Australian Graduate School of Management, the Fourth Annual Pacific-Basin Conference in Hong Kong, 1992 and the Third Conference on Finance and Accounting at the Stern School of Business, New York University, 1991. Funding for the study was provided in part by Yamaichi Securities Company Limited, and we wish to thank M. Matsumoto and 0. Sadasue of that organization for their continuing encouragement and support. Remaining errors are our own. ‘Jones and Kaul (1992) find that the Japanese equity market significantly overreacts to oil price changes. However, Brown and Otsuki (1990) find that oil price changes represent a significant source of priced risk in this market. ‘This is certainly the popular view [Sterngold (1992)]. See also French and Poterba ( 1991). 0927-538X/93/%06.00 <! 199GEisevier Science Publishers B.V. AII rights reserved