This paper explores risk and return relations in six Asian equity markets affected by the 1997 Asian financial crisis. After the start of the crisis, national equity betas increased and average returns fell substantially. Beta increases due to leverage linked to exchange rates. The increase in expected return needed to accompany this rise in beta is made possible through the creation of capital losses that lower average returns. We propose a new probability-based asset pricing model that captures leverage effects using valuation ratios. Results show the role of leverage in explaining the likelihood of the financial crises. Crosssectional evidence supports time-series findings.

We consider consumer responsiveness to changes in the macroeconomic environment (i.e. product demand sensitivity) to be a systematic industry characteristic useful to studying how industrial diversification adds value. We argue that diversified firms, with the advantages of their internal capital market and the imperfectly correlated cash flows of their segments, will perform better than focused firms when the demand sensitivity of a product increases. Our empirical evidence reveals a significant diversification premium associated with an increase in sensitivity. Moreover, such premium predominantly exists during recessionary periods, disappearing in the presence of low coinsurance and inefficient use of the internal capital market. Our results are robust to alternative measures of sensitivity and performance metrics, different empirical model specifications, and to the concern of possibly biased estimations associated with the sample of diversified and focused firms.