Where βiw denotes firm i ’s beta with the world market, E(Rw) denotes the required rate of
return on the world equity market portfolio, σ2w denotes the variance of the return of the
world portfolio andrf*the world risk-free rate. In other words, expected local returnsE(Ri) in
a fully integrated market depend solely on non-diversifiable international factors. The extent
of integration of capital markets into global finance has various economic and financial
effects, which can be derived from an asset pricing model. These include a decrease in the
cost of capital for local firms, a decrease in portfolio diversification opportunities, and an
increase in financial vulnerability.
2.2 Implications
2.2.1 Market integration and the cost of capital
The CAPM implies that the expected return required by the market on a risky security is equal
to the risk free rate plus a risk premium equal to the beta coefficient of the security times the
world market’s’s risk premium. In other words, the investment’s present value for the
shareholders is equivalent to the expected cash flows discounted by their required rate of
return, as determined by the CAPM. Therefore, a decrease in the market’s risk premium
makes all projects which have a positive covariance with the market portfolio look more
advantageous for investors. From the firm’s point of view, this is equivalent to a decrease in
the cost of capital.
The relationship was formally analyzed by Stulz (1999). The model makes the assumption of
a homogenous degree of risk aversion for investors. Consequently, the price per unit of risk is
a constant T, which can be defined as the ratio of risk premium on variance of the return:
T=
[E(R)-r]
σ2
(1)