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Financial Integration: A New Methodology and an Illustration

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Author Info
Robert P. Flood
Andrew K. Rose

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Abstract

This paper develops a simple methodology to test for asset integration, and applies it within and between American stock markets. Our technique relies on estimating and comparing expected risk-free rates across assets. Expected risk-free rates are allowed to vary freely over time, constrained only by the fact that they must be equal across (risk-adjusted) assets in well integrated markets. Assets are allowed to have standard risk characteristics, and are constrained by a factor model of covariances over short time periods. We find that implied expected risk-free rates vary dramatically over time, unlike short interest rates. Further, internal integration in the S&P 500 market is never rejected and is generally not rejected in the NASDAQ. Integration between the NASDAQ and the S&P, however, is always rejected dramatically.

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Paper provided by International Monetary Fund in its series IMF Working Papers with number 04/110.

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Date of creation: 20 Jul 2004
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Handle: RePEc:imf:imfwpa:04/110

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Keywords: Financial assets United States Stock markets Risk premium Asset prices Economic models

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  1. Hansen, Lars Peter & Jagannathan, Ravi, 1991. "Implications of Security Market Data for Models of Dynamic Economies," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 225-62, April. [Downloadable!] (restricted)
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  2. Bekaert, Geert & Harvey, Campbell R, 1995. " Time-Varying World Market Integration," Journal of Finance, American Finance Association, vol. 50(2), pages 403-44, June. [Downloadable!] (restricted)
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  3. Chen, Zhiwu & Knez, Peter J, 1995. "Measurement of Market Integration and Arbitrage," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 8(2), pages 287-325. [Downloadable!] (restricted)
  4. Roll, Richard & Ross, Stephen A, 1980. " An Empirical Investigation of the Arbitrage Pricing Theory," Journal of Finance, American Finance Association, vol. 35(5), pages 1073-1103, December. [Downloadable!] (restricted)
  5. Fama, Eugene F & French, Kenneth R, 1996. " Multifactor Explanations of Asset Pricing Anomalies," Journal of Finance, American Finance Association, vol. 51(1), pages 55-84, March. [Downloadable!] (restricted)
  6. G. Andrew Karolyi & Rene M. Stulz, 2002. "Are Financial Assets Priced Locally or Globally?," NBER Working Papers 8994, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  1. Rose, Andrew-K, 2004. "Equity Integration in Japan: An Application of a New Method," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, vol. 22(2), pages 1-17, May. [Downloadable!]
  2. Levy Yeyati, Eduardo & Schmukler, Sergio L. & Van Horen, Neeltje, 2006. "International financial integration through the law of one price," Policy Research Working Paper Series 3897, The World Bank. [Downloadable!]
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  3. P N Smith & S Sorensen & M R Wickens, . "An Asset Market Integration Test Based on Observable Macroeconomic Stochastic Discount Factors," Discussion Papers 03/14, Department of Economics, University of York. [Downloadable!]
  4. Robert P. Flood & Andrew K. Rose, 2004. "Estimating the Expected Marginal Rate of Substitution: Exploiting Idiosyncratic Risk," NBER Working Papers 10805, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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