Financial Integration and the Cost of Capital: A Study of the Brazilian Equity Market

Abstract

This study analyzes the effect of financial integration on the cost of equity capital of Brazilian listed firms. According to the relevant literature, foreign capital flows are expected to increase stock returns, the so-called revaluation effect. For standard valuation models, higher stock prices imply a lower cost of equity capital, as expected returns fall as stock prices rise. Two analyses are conducted: first, a statistical analysis based on a partial general equilibrium model as suggested by Henry (2003) and Stulz (1999) provides insights that the cost of equity capital in Brazil reduced following the integration with the Global equity market in the period between 1996 and 2013, as expected returns decreased over time. In the second part of the study, a regression analysis is conducted, by estimating the effect of foreign portfolio capital flows on the Brazilian stock market returns using a Global CAPM with an additional parameter for foreign portfolio capital flows. The results of the regression analysis provide evidence that foreign portfolio capital flows are associated to an increase in excess returns on the Brazilian stock market (after controlling for systematic risk). Also, in a second regression estimated between the dividend yield (a direct measure of the cost of equity) and net foreign portfolio capitals, the partial effect of net foreign capitals on the Dividend Yield was negative. These findings are in line with the revaluation effect hypothesis and also support the argument that financial globalization reduces the cost of capital for a previously segmented equity market.