Equity Markets and Economic Development: What Do We Know

Asset pricing theory states 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 reference market’s risk premium. Assuming E(R_m ) to be the domestic market
equilibrium rate of return and rm to be the domestic risk-free rate, we have:

■ E (R} = r, + βm [E (R )-r, ]
' E(R,*)= r_r* + βw[E(R.)-r_f ]

(2)

β_iw , the beta of the small country portfolio with respect to the world’s portfolio; is equivalent

to ^{ρσ s σ w} , where σ. is the variance of the return in the global portfolio and ρ is the
σ _w²

correlation coefficient between the return of the small country portfolio and the world
portfolio. In addition, risk premiums can be rewritten as the product of the variance times the
constant risk aversion T. Segmention and integration risk premiums can be rewritten as:

■RP = σ²T

I ^{s s}

RP_i = ρσsσwT

(3)

By substitution, the necessary and sufficient condition for financial integration to diminish the
risk premium (ie, RP_i < RP_s ) in the small market is that:

>ρ

(4)

According to (4), globalization decreases the risk premium - and thus the cost of capital - in
the small country provided that return volatility of the small country portfolio relative to