Essays on international asset pricing under segmentation and PPP deviations

This dissertation comprises two essays. The first essay develops and tests a theoretical model that provides new insights when markets are partially segmented and the purchasing power parity (PPP) is violated which seems to be the case for the majority of national markets. The theoretical part derives closed form solutions for asset prices and portfolio holdings. Particularly, we show that deviations from PPP in mildly segmented markets induce a new form of systematic risk, termed segflation risk, and in equilibrium investors require compensation for this risk. A strong feature of the model is that it provides a theoretical framework for testing important issues; such as, pricing of foreign exchange risk and world market structure. The model also nests several existing international asset pricing models and thus provides a framework to distinguish empirically between competing models. The empirical part of the essay provides an empirical validation of the model for eight major emerging markets. The results give support to the model and point to the importance of the segflation risk which is statistically and economically significant.;The second essay uses our theoretical model to address the question of whether the IFC investable indices are priced globally or locally. Indeed S&P/IFC provides two emerging market indices: the IFC global index (IFCG) and its subset the IFC investable index (IFCI). Since the IFCI is fully investable, both the academic and practitioners implicitly assume that this subset of emerging markets is priced in the global context. This is a critical assumption for corporate finance decisions and portfolio management. Hence, this essay investigates the pricing behavior of the IFCI index returns using a conditional version of our model that allows for segmentation and PPP deviations. The results suggest that local factors are important in explaining returns of the IFC investable indices and that the return behavior of IFCI indices is similar to that of the IFCG.