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Global Pricing of Large-capitalization Stocks?

April 28, 2006 • Posted in Size Effect

As worldwide economic participation broadens and deepens, are large companies (more than small companies) becoming internationally owned and therefore priced? In other words, are large companies subject to a worldwide equity risk premium while small companies remain moored to local risk premiums? In his paper entitled “Financial Integration and the Price of World Covariance Risk: Large vs. Small-cap Stocks” (forthcoming in the Journal of International Money and Finance), Wei Huang investigates whether global pricing is peculiar to large-capitalization stocks. Using three size-based stock portfolios for nine developed countries (Australia, Netherlands, Canada, France, Germany, Italy, Japan, U.K. and U.S.) over the period 1980-2004, he concludes that:

  • Nearly all (hardly any) of the foreign companies cross-listed in the U.S. are in the top (bottom) 20% by size in their home markets.
  • Large-capitalization stocks show significantly greater comovement across countries than do small-capitalization stocks. The average correlations between the large-cap / mid-cap / small-cap portfolio returns and the world market portfolio return are 67% / 50% / 36%, respectively.
  • Global financial integration increased in recent years primarily for large-capitalization stocks. In other words, investors are increasingly pricing large-capitalization stocks, but not small-capitalization stocks, globally.
  • The diversification benefits of small-capitalization foreign stocks are therefore greater than those of large-capitalization foreign stocks.
  • The behavior of small-capitalization stocks worldwide is more predictable, based on fundamentals, than that of large-capitalization stocks. This greater predictability derives from a (one-way) lead-lag relationship between large-capitalization and small-capitalization stocks and from the stronger calendar effects for the small-capitalization stocks.

In summary, investors in large capitalization stocks are likely accepting a worldwide equity premium. Local (and identifiable) pockets of reward-for-risk involve small capitalization stocks.

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