The importance of human capital for asset pricing has been long recognized at least since Mayers (1972) and Fama and Schwert (1977). Recent domestic asset pricing literature shows that information about returns on human capital, or more precisely, labor income growth, is important for explaining both time series and cross sectional variations of expected stock returns. For example, Campbell (1996) and Jagannathan and Wang (1996) find that the risk premium associated with aggregate labor income growth helps explain the cross section of expected stock returns.
Lettau and Ludvigson (2001a, 2001b, 2005) and Santos and Veronesi (2006) document that fluctuation of aggregate labor income or aggregate wealth including labor income relative to aggregate consumption has remarkable predictive power for stock returns. In this article I show that labor income acting as both returns from human capital and a dominant component of consumption for domestic or foreign investor can help explain the time series variation of the risk premium and volatility of domestic and foreign stock returns.
In international markets, investors are faced with investment opportunities from domestic and foreign financial markets traded across countries as well as nonfinancial assets such as human capital which is not traded across countries. In this article I assume that human capital is not traded across national boarders for at least two reasons. First, while labor markets exist within each country, immigration visa restrictions make work permits in another country difficult to obtain. Second, although investments in public educational institutions and job training programs are widespread and available to residents within each country, there is little evidence of investments in human capital such as education across countries.
According to modern finance theory, the subset of assets held by domestic investors should be priced by one minimum-variance discount factor formed by a payoff from the subset of assets. Similarly, another subset of assets held by foreign investors should be priced by another minimum-variance discount factor formed by a payoff from the other subset of assets. The minimum-variance discount factor for a given subset of assets also represents projections of marginal utility growth of investors, whose investment opportunity sets entail the subset of assets, onto the subset of assets (see, e.g., Hansen and Richard (1997), Hansen and Jagnnathan (1991), Cochrane (2001)).
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