DIVERSIFICATION OF MACROECONOMIC RISK AND INTERNATIONAL INTEGRATION OF CAPITAL-MARKETS - THE CASE OF MEXICO

This article tests the arbitrage pricing theory in the context of the unstable macroeconomic years in Mexico, 1977-87. Using information on returns on assets available to domestic investors-primarily stocks traded at the local stock exchange-an attempt is made to ascertain the extent to which these assets have offered premia for a set of proposed sources of risk. The pervasive factors that play an important role in asset pricing in Mexico are unexpected inflation, unexpected money growth, innovations in the Standard & Poor's 500 price series, and innovations in the dollar oil price. A residual market factor is obtained, using the McElroy and Burmeister model. Given that these risks get premia over and above the riskless rate, expected rates of return in Mexico have been higher during the years of erratic macroeconomic conditions. Mexico is not considered to be well integrated with the international capital markets because local sources of risk-such as inflation-are not priced in the United States, whereas international sources of uncertainty-such as oil price shocks-are priced locally but not in the United States. © 1991 The International Bank for Reconstruction and Development / THE WORLD BANK.