International Asset Pricing under Mild Segmentation: Theory and Test

Abstract

This paper conducts a theoretical and empirical investigation of the pricing (and portfolio) implications of investment barriers in the context of international capital markets. The postulated market structure-labelled "mildly segmented"-leads to the existence of "super" risk premiums for a subset of securities and to a breakdown of the standard separation result. The empirical study uses an extended data base including LDC markets and provides tentative support for the mild segmentation hypothesis. THE QUESTION AS TO whether the international capital market is integrated or segmented appears particularly elusive. Indeed, the difficulties surrounding this important issue abound, as was made vividly clear by Solnik [20].At the risk of tackling too ambitious a task, we undertake here to build a model and develop an empirical methodology to provide at least a partial answer to the segmentation-integration issue. To do so, we follow one of Solnik's recommendations [20, p. 505]:The efficient way to test for segmentation would seem to be to specify the type of imperfection which might create it and study its specific impact on portfolio optimality and asset pricing. * Errunza is from McGill University and Losq is from McGill University and ESSEC, France. The authors wish to thank the International Finance Corporation, Washington, D.C. for funding the development of the LDC securities data bank. Research assistance of Prasad Padmanabhan and insightful comments of James Bicksler, Bernard Dumas, Dennis Logue, Lemma Senbet, Rene Stulz, Alex Whitmore, and Morty Yalovsky are greatly acknowledged. Financial support was provided by SSHRC and Faculty of Management, McGill University. l By way of contrast, such an explicit representation of the risk-return tradeoff is generally missing in most of the well-known models of market segmentation. For example, in a recent paper on international asset pricing with barriers to entry, Stulz [24] fails to specify the risk-return tradeoff for at least one class of assets (those which are not traded by all investors). As for the oft cited paper of Adler and Dumas [1], the purpose is not really to characterize the equilibrium relationship between 105 106 The Journal of Finance command a super risk premium that is proportional to the conditional market risk. 2. The model lends itself to the analysis of a continuum of market structures, with the two polar cases corresponding to complete (one-way) segmentation and complete integration, respectively. Although there exist a number of papers dealing with the segmentation-integration issue,2 few accommodate intermediate-and more realistic-structures where the markets are neither completely segmented nor completely integrated. The paradigm which follows was designed to deal with this more realistic problem, and thus follows the lead of Black [3] and, more specifically, Stulz [24].3 3. The kind of imperfection which constitutes the source of segmentation in the model appears quite prevalent in the international arena.4 Indeed, accessto the capital ma...

The Euro and European financial market dependence

“…5 In addition to foreign exchange rate risk, other barriers to international portfolio investment (including taxes on foreign security holdings and ownership restrictions) are crucial factors that prevent market integration. Consequently, in partially integrated economies, investors' portfolios may be biased towards home assets because the benefits of international diversification are not large enough to offset its costs (Errunza and Losq, 1985;Eun and Janakiramanan, 1986;Cooper and Kaplanis, 2000). Still, the launch of the common European currency was clearly associated with reduced exchange rate volatility and convergence of interest rates, lower cost of cross-country transactions, improved liquidity, breadth and depth of European capital markets, which have been noted as important drivers of integration in the Euro area (Danthine et al, 2001;Fratzscher, 2002).…”

Large Foreign Ownership and Firm-Level Stock Return Volatility in Emerging Markets

“…1 Theoretically, international asset pricing models such as those discussed in Errunza and Losq (1985), Eun and Janakiramanan (1986), and Bekaert and Harvey (1995) show that liberalization reduces the cost of equity capital. Empirical evidence on this and other benefits of liberalization is documented in studies such as Bekaert and Harvey (1997), (2000), Kim and Singal (2000), Henry (2000), (2003), Chari and Henry (2004), Bae, Bailey, and Mao (2006), Bekaert, Harvey, Lundblad, and Siegel (2007), Gupta and Yuan (2009), and so on.…”

Market structure and the cost of capital

“…Next, multiply equation (20) (22) Equation (22) can be simplified as follows: (23) This finally leads to our Partially Segmented CAPM: However, equation (24) says that because of stock market segmentation a part of this domestic risk is internationally priced. We call this part "undiversifiable domestic risk" which, as shown by equation (24), is measured by…”

“…However, there are no theoretical asset pricing models for partially segmented markets, except those developed in the vein of Black (1974) and Errunza and Losq (1985) in which a specific investment barrier is generally introduced and its effects on the equilibrium returns are derived. 1 The current paper aims to fill this gap by introducing a more flexible theoretical international CAPM in order to understand the complex mechanisms that move a national stock market from segmentation to integration and to investigate the effects of this transformation on the cost of capital of firms and on the prices of assets.…”