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Financial Integration and Asset Returns

The paper investigates the impact of financial integration on asset return, risk diversification and breadth of financial markets. We analyse a three-country macroeconomic model in which (i) the number of financial assets is endogenous; (ii) assets are imperfect substitutes; (iii) cross-border asset trade entails some transaction costs; (iv) the investment technology is indivisible. In such an environment, lower transaction costs between two financial markets translate to higher demand for assets issued on those markets, higher asset price and greater diversification. For the country left outside the integrated area, the welfare impact is ambiguous: it enjoys better risk diversification but faces an adverse movement in its financial terms of trade. When we endogenise financial market location, we find that financial integration benefits the largest economy of the integrated area. Only when transaction costs become very small does financial integration lead to relocation of markets in the smallest economy.

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Paper provided by Centre for Economic Performance, LSE in its series CEP Discussion Papers with number dp0451.

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Date of creation: Feb 2000
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Handle: RePEc:cep:cepdps:dp0451
Contact details of provider: Web page: http://cep.lse.ac.uk/_new/publications/series.asp?prog=CEP

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