return volatility of the world portfolio is higher than the correlation coefficient between the
small country market and the world markets. In other words, the small country risk premium
decreases if an investor that has all his wealth invested in the small country can construct a
lower variance portfolio by selling some of his assets in the small country and make a positive
investment in the world market portfolio. By contrast, integration may increase the risk
premium and the cost of capital if the covariance with the world market is too high. In this
case, the small country market is risky relative to the world market and therefore requires a
higher risk premium. The same phenomenon occurs if the volatility of the world market is
much higher than the small market’s volatility. Therefore, a country that liberalizes its capital
market can experience a decrease in the cost of capital provided that the correlation of its
market portfolio with the world portfolio is not too large or if its volatility is larger than the
volatility of the world market portfolio (Stulz, 1999). The impact of financial integration of
capital markets on the cost of capital is thus strongly related to diversification opportunities
arising from the integration process. Besides, this impact varies according to firm
characteristics (Chari and Henry, 2004). This can be shown by subtracting equation (2) from
equation (1):
∆E(Ri)=E(Ri)-E(Ri*)=(rf -rf*)+γDIFCOV (5)
Where DIFCOV = [Cov(Ri,Rm)- Cov(Ri, Rw)]. Equation (5) highlights the two channels
through which integration may affect the firm-level required rate of return. The first effect
occurs through a change in the risk-free rate and is common to all firms. The second effect is
firm-specific and depends on the covariance of firm i’s stock return with the domestic market
minus the covariance of firm i ’s stock return with the global market. Intuitively, two
situations may arise. If firm i has a low beta with respect to the world market and a high beta