Global Pricing of Equity

Global equity management has historically been structured around country asset allocation. This approach was supported by the observations that the country factor is the major source of influence on stock-price behavior and that the correlation between equity and currency is close to zero and unstable. If a corporation is regarded as a portfolio of international activities, however, its stock price should be influenced by international factors in relation to the geographical breakdown of its activities rather than where its headquarters is located or its stock is traded. We examined a large cross-section of security prices and found that regional factors and currency factors have a strong influence on asset returns beyond that of domestic factors. Moreover, the sensitivity of individual company returns to nondomestic factors is closely related to the extent of their international activities, as proxied by the relative importance of foreign sales to total sales. We review the implications of these findings for the asset management profession. Global equity management has historically been structured primarily around country asset allocation. This approach was supported by the common observations that the country factor is the major influence on stock-price behavior and that the correlation between equity and currency is close to zero and unstable, so country exposure matches currency exposure. This logic breaks down, however, in a world where companies work and compete on a global basis and are recognized as doing so by investors when they price securities.As companies expand and diversify their international activities, the relative importance of domestic factors for the companies should decline. If a corporation is regarded as a portfolio of international activities, its stock price should be influenced by international factors in relation to the geographical breakdown of its activities. Similarly, the currency exposure should be influenced by the geographical distribution of the company's activities, rather than by the domicile of incorporation or by where the stock is mainly traded. In such integrated or “global” pricing, the market recognizes the value and changes to value of the foreign activities of the company. In essence, a French company with foreign activities can expect investors to value each stream of “national” earnings at the relevant national discount rate adjusted for the company's specific risk characteristics.We examined a large cross-section of security prices for companies in eight developed countries from mid-1989 through 1998 and found that regional factors and currency factors have a strong influence on asset returns beyond the influence of domestic factors. We found a relationship between the degree of domestic (international) stock exposure, as inferred from return data, and the company's domestic (international) sales. This finding corroborates our theoretical model of the value of the company: The greater the proportion of international sales, the greater the likelihood that the stock responds to foreign stock-price movements. (These results were less pronounced for U.S. companies.) We also found that foreign stock market exposures exceed foreign currency exposures, which suggests that some currency hedging takes place within the companies. Because the stock prices of some international companies are exposed to foreign currencies, when investors fully hedge their accounting currency exposures back to their home currencies, they risk overhedging.Our findings suggest that conventional methods of market and currency allocation used in asset management are problematic and biased. For instance, our analytical framework, in contrast to the traditional accounting-based portfolio measures of market exposure, demonstrates that a portfolio of the constituents of the Swiss market provides significant exposure to foreign factors. More importantly, this portfolio illustrates how home-biased allocations are poorly diversified from a global perspective; the lack of exposure to several major global industries is noteworthy.Global asset management has become a more complex task than in the past—and a task that cannot be addressed through simple shortcuts, such as stratifying the world into multinational and national companies. Analysis of the individual company and its diversity is critical; thus, analysts need a sound understanding of the geographical breakdown and currency practices of the company as well as the country and industry factors that affect its performance. This complexity provides opportunities to those with a good understanding of the global and domestic influences on stock pricing to achieve superior return and risk management.