with respect to the small country market, financial integration can lead to a substantial fall in
the risk premium and in the cost of capital. By contrast, if firm i has a low beta with the small
market portfolio and a high beta with the world market portfolio, and is small enough that it
does not affect the distribution of the returns in the small market portfolio, financial
globalization can increase the risk premium. However, such firms constitute exceptions in a
domestic market. Overall, the model shows that financial integration has the potential to
diminish the firm-level cost of capital, and thereby allow increasing the domestic rate of
investment in capital-scarce economies.
For illustration, Patro and Wald (2005) investigated a panel of 18 emerging markets and made
three important observations. First, they found an average decrease in returns of 2.88% per
month during the 36 month period starting three and a half year after the liberalization date,
suggesting a decrease in the cost of capital. Second, they constructed asset pricing models and
observed an average increase in global beta of 0.199 after liberalisation. As predicted by
models of international asset pricing, this indicates that increased global risk sharing is the
source of the perceived decline in the cost of capital. Third, they measured the extent to which
risk sharing drives the revaluation of stock prices that actually occurs following liberalisation.
To do so, they investigated the impact of firm-level characteristics and found that the decrease
in the cost of capital is more pronounced for firms with a higher local market beta, which tend
to display lower long term returns. The latter result echoes Chari and Henry (2004), who used
a similar dataset in international asset pricing modeling framework, and found that firm-
specific risk sharing characteristics as measured by the differential between local and global
covariances account for two fifth of the revaluation of investible stocks. Empirical studies
hence highlight a decrease in the cost of capital in the period following financial
liberalization, which seems to be related to firm level characteristics. The differential between