Equity Markets and Economic Development: What Do We Know

for foreign investors. In other words, the pricing of investible securities under mild
segmentation will continue to be given by: E(R_i)= r_f +β_im[E(R_m)-r_f ]. By contrast, the
pricing of non-investible securities includes a ‘super risk premium’, which compensates
domestic investors for bearing the risk associated with holding all of the non investible stocks.
For any individual restricted stock we have:

E (Ri) = r, + γ(W )COV ( R, R, )+ γ (W )COV (R, R,∣R )                           (2)

In equation (2), R_, and R_I are the returns on the portfolio investible and non-investible
securities, respectively. The variable COV (Ri, R_nR₇ ) is the covariance of firm i’s return with
the return on the portfolio of non-investible stocks, taking the return on the investible
securities as given. γ and γu are the coefficient of risk aversion for restricted international
investors and unrestricted domestic investors, respectively.

2.1.3 Market integration

The international version of the CAPM was proposed by Solnik (1974), in which risk is
measured by asset contribution to the world portfolio. Under financial integration, the
domestic equity market becomes part of the global equity market. As a consequence,
domestic assets are rewarded in function of their covariance with the world portfolio, as the
risk premium on any asset is proportional to its world beta. For any local firm, we thus have:
' E (R * ) = r_f * + β, [E (R, )-r_f * ]

<[^{e (r}, )^-rf ]=γ(W^{σ 2 w                                                              (3)}

_ E (R₁ * ) = rf * + γCOV (Ri*, R, )

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