K.U.Leuven - Faculty of Economics and Applied Economics
DTEW - AFI_0615 pages:1-32
The starting point of this paper is the Heston and Rouwenhorst (1994) methodology, which decomposes stock returns into four factors: market factor, country factor, sector factor and idiosyncratic factor; all with unit exposures. First, we explain why discarding small firms may overstate the relative importance of sector effects in international stock returns: small caps turn out to have an above average variability (after controlling for sector and country effects) and to be less exposed to their global sector index than large caps. Secondly, we show that the unit exposure assumption in Heston and Rouwenhorst (1994) is empirically not valid, and we accordingly generalize the HR-methodology by taking into account the unequal distribution of exposures along countries and sectors. Thirdly, we decompose the stacked variance of exposures and factors into his moments and correct it for estimation error in the xposures. We show that ignoring exposures and estimation error in the exposures may also overstate the impact of sector effects on international stock returns. Lastly, we show that there is no necessary link between the outcome of the HR-methodology and benefits of international risk diversification.