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This article considers a panel framework to test consumption based asset pricing models driven by a US stock market reference for a number of developed economies. Specifically, we focus on a linearized form of what might be seen as a consumption-based capital asset pricing model in a pooled cross section panel with two-way error components. The empirical findings of this multifactor model using a range of specifications indicate that there is a significant unobserved heterogeneity captured by cross-country fixed effects when consumption growth is treated as a common factor. However, the cross-sectional impact of home consumption growth can vary over the countries, where unobserved heterogeneity in the rate of risk aversion can also be addressed by random effects.

There is evidence from empirical studies that shows that the conditional covariances between the Intertemporal Marginal Rate of Substitution (IMRS) in consumption and returns cannot satisfy the equilibrium restrictions imposed by the representative agent Consumption-based Capital Asset Pricing Model (C-CAPM) for a range different countries (Kocherlakota, 1996). This has led to a great deal of interest in the capacity of the C-CAPM to take account of heterogeneity and idiosyncratic risk (Lund and Engsted, 1996). The issue of heterogeneous risk in asset pricing was first addressed by Miller (1977), and then revisited by Constantinides and Duffie (1996) and Jacobs and Wang (2004). It has been concluded that heterogeneous risk has a better chance of explaining the data than standard representative-agent C-CAPM models (Jacobs and Wang, 2004). Gregoriou et al. (2009) using monthly data for the US and Hunter and Wu (2009) using similar data for the UK find that via some form of augmentation, consumption growth can be seen as one of the drivers of the riskier component of asset valuation. Gregoriou et al. (2009) develop a fully formulated Vector Autoregressive (VAR) model of US asset prices where excess returns are simultaneously explained by consumption growth, real money growth and inflation with income growth as a single exogenous variable. The results across the system are controlled where appropriate for Autoregressive Conditional Heteroscedasticity (ARCH) and the major financial shocks to the economy. A key explanatory variable in the VAR is US consumption growth. Hunter and Wu (2009) address the importance for the UK market of simultaneous heterogeneity proxied by a US stock market reference. The analysis in Hunter and Wu (2009) considered similar monthly data for the UK in a limited information context and found that UK excess returns were explained by two primary factors consumption growth and US excess returns. The second factor in the case of the UK study appears to capture the volatility in the return series and once this feature of the data is captured then consumption growth captures the underlying fundamental feature driving the UK stock market. The multifactor form of this model implies that financial risk as computed by the excess return, derives from two primary sources, aggregate consumption growth and US excess returns that are a measure of the state of the global market. This would still appear pertinent in the light of the financial crisis that stemmed from the failure of Lehman Brothers in the Autumn of 2008. The primary role of Lehman Brothers in the credit default swap market and the resulting impact on the counterparties to this risk sent a shock wave across the world's financial markets. This suggests that home stock prices are driven by the world view on asset prices and local fundamentals as represented by a measure of growth either income, consumption or output. Some recent empirical evidence provides further support for the notion that stock prices are inter-related (see Bekaert et al., 2009, D'Ecclesia and Costantini, 2006 and Rua and Nunes, 2009). In this article, a similar approach is applied to data on excess stock returns for a number of developed economies to see whether the primary multifactor nature of the explanation of economies' assets extends beyond the economies based on the Anglo Saxon financial model. The wealth reference is important to improve the explanation of systematic risk in pricing countries' assets. US excess returns are used in a number of different specifications of a two-way error component panel model to study whether there is any measurable heterogeneity or idiosyncratic risk related to excess returns and consumption growth either across countries or over time. The rest of this article is organized as follows. A brief review of the literature is given in Section 2. 3 and 4 describe the data properties and the methodology applied in this paper, respectively. Section 5 reports the empirical results. Finally, Section 6 contains some concluding remarks.

This article focuses on a linearized form of the Consumption-based CAPM in a pooled cross section panel model with two-way error components. Specifically, we assert that each country appears to have its own fixed effect. The panel model is designed to extend the time series framework of Hunter and Wu (2009) that explains UK excess returns by UK consumption growth and US predicted excess returns. The panel model covers nine major developed stock markets with quarterly data over the period 1992:2–2008:4. The empirical findings of the panel models based on a range of specifications that capture fixed and random effects all indicate that there is some significant heterogeneity and heteroscedasticity but no apparent autocorrelation across the nine countries. This might suggest that the US market has the effect of capturing any prospective inefficiency. Any unobserved heterogeneity described by fixed effects offsets the impact of the US stock market. While an average risk aversion coefficient of 2.393 across the sample, corresponds closely to the results that arise in the case where the heterogeneity is purely captured by fixed effects at 2.17. It can be observed from this analysis that important aspects of the world banking crisis in 2007–8 are reflected in the response to financial asset movements across the globe. Economies not sensitive to the direct impact of the failure of liquidity that arose from the breakdown of the credit default swap (CDS) market in August 2007 and the resulting bank failure that culminated in the failure of the US Government to act on the collapse of a wholesale bank, Lehman Brothers (Milne, 2009). The multifactor model presented here and estimated before the crisis implies that stock returns will be squeezed by the failure of liquidity and resultant increase in interbank rates in 2007. Something not acted on for more than twelve months in the UK by the Bank of England. It is evident from the analysis in Gregoriou et al. (2009) that the normal response of the Federal Reserve Bank of the US to Stock Market crises was to introduce liquidity into the market via a real monetary injection. This occurred in the UK and the US following the stock market crash in 1987, and in the US in response to the Asian Crisis and 9/11. However, this response was unfortunately muted in the case of the monetary authorities in the US and the UK in relation to the Banking crisis in 2007–8. The serious nature of the crisis seems to have crept up on them with the initial position of the Governor of the Bank of England being that the crisis related to poor bank practice and that led to a period of inaction in terms of interest rate reduction and expanding liquidity sufficiently. It would appear from the analysis conducted here that a rapid global response would have greatly ameliorated the latter and the subsequent ripples that have then without any consensus on Macro policy had the potential to give rise to a subsequent crisis in the Euro zone. The next factor whose effect is estimated by the model relates to the direct financial effect of the failure of Lehman brothers. The failure of this wholesale bank was a catalyst for a global crisis in the financial markets that became embedded in the value of stock indices across the world. As can be observed from the model, asset values even in countries such as Spain and Italy without a primary connection to the underlying drivers of the crisis are impacted by the collapse of US asset values. This arises even with countries whose banks did not have significant holdings in the CDS and Mortgage Backed Securities (MBS) markets (Milne, 2009). The results show that US stock prices have an effect close to unity on UK excess returns and the other major European Economies plus Australia and less surprisingly Canada. A secondary effect of such crises is corporate failure and it can be shown for the UK (Hunter and Isachenkova, 2006) and for other economies (Hunter and Isachenkova, 2001), that a key aspect of corporate failure is liquidity. In terms of macro variables, high nominal interest rates and real exchange rates in the case of the UK are a key failure predictor more than one year in advance. This was a feature of the incapacity of monetary authorities and the Monetary Policy Committee in the UK to focus on what was happening in the financial markets as even in July 2008 they were fixated on inflation and not on the risk of corporate failure as the crises started to bite. The collapse in asset values induces increased problems with debt that are invidiously linked with Basel II and the capacity of corporations to find liquidity in an already difficult market when debt to equity ratios are moving in the wrong direction (Hunter and Isachenkova, 2006). This feeds into the final factor in the pricing of the assets, the fundamental relationship between stock performance and growth in the economy as captured by the consumption term in the model. The likely consequence of a failure of growth is to reduce asset values and this is further compounded by falling corporate sales turnover that is a well known determinant of corporate failure. Hence, the local and global return, nexus controlled for interest rates and growth, captured in the model considered here, explains key aspects of pricing the stock indices of the economies of Australia, Canada, Denmark, France, Germany, Italy, Spain, Switzerland and the UK. The model also shows how the volatile nature of asset prices is embedded in the global market place as captured by US excess returns and this component of risk is required to deliver more appropriate rates of risk aversion and a significant impact of consumption growth on asset prices. A major component of the underlying volatility feed through is captured by the behaviour of global stock prices as manifested in US excess returns and interest rates.