Are financial assets priced locally or globally?

We review the international finance literature to assess the extent to which international factors affect financial asset demands and prices. International asset pricing models with mean-variance investors predict that an asset’s risk premium depends on its covariance with the world market portfolio and, possibly, with exchange rate changes. The existing empirical evidence shows that a country’s risk premium depends on its covariance with the world market portfolio and that there is some evidence that exchange rate risk affects expected returns. However, the theoretical asset pricing literature relying on mean-variance optimizing investors fails in explaining the portfolio holdings of investors, equity flows, and the time-varying properties of correlations across countries. The home bias has the effect of increasing local influences on asset prices, while equity flows and cross-country correlations increase global influences on asset prices. Prepared for the Handbook of the Economics of Finance, George Constantinides, Milton Harris, and René M. Stulz, eds., North-Holland. * Respectively, Professor of Finance and Reese Chair of Banking and Monetary Economics, Fisher College of Business, Ohio State University. René Stulz is also a Research Associate at the National Bureau of Economic Research. We are grateful to Dong Lee and Boyce Watkins for research assistance, and to Michael Adler, Kee-Hong Bae, Warren Bailey, Soehnke Bartram, Laura Bottazzi, Magnus Dahlquist, Craig Doidge, Cheol Eun, Vihang Errunza, Jeff Frankel, Thomas Gehrig, John Griffin, Cam Harvey, Mervyn King, Paul O’Connell, Sergio Schmukler, Ravi Schukla, Enrique Sentana, Bruno Solnik, Christof Stahel, Lars Svensson, Linda Tesar, Frank Warnock, and Simon Wheatley for comments.