Equity Markets and Economic Development: What Do We Know

2. Equity market integration

The issue of the integration of equity markets into global finance and its relationship with
economic development arised during the last two decades of significant flows of capital to
emerging markets. However, the impact of financial globalization has often been analyzed
within a macoeconomic framework, which has considered the financial sector as a whole. In
what follows, we show that equity market integration has specific welfare implications which
can be derived from an asset pricing perspective.

2.1 Definition

Within the generic definition, the integration of financial markets (credit, bond, money and
equity markets) means that all potential market participants with the same characteristics (i)
face a single set of rules when they decide to deal with financial instruments, (ii) have equal
access to these financial instruments, and (iii) are treated equally when they are active in the
market (Baele et.al (2004)). Turning to equity markets, integration means that cross-market
arbitrage opportunities disappear (Gjersem, 2003). In such a situation, portfolios having the
same payoffs tend to be priced equally regardless of their geographic origin (Frankel, 1994).
This implies not only the absence of barriers to capital flows, but also that investors undertake
capital transactions to eliminate arbitrage opportunities that arise (Fratzscher, 2002). The
extent of cross-market integration is thus a positive function of the degree of comovement
between investment returns. The process culminates into the law of one price (Kearney and
Lucey, 2004). At a theoretical level, asset pricing models are useful for conceptualizing the
integration of capital markets (Stulz, 1999). These models can be classified into three
categories: segmented markets, integrated markets and mildly-segmented markets (Bekaert
and Harvey, 1995).

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