Equity Markets and Economic Development: What Do We Know

local market and global betas thus appear to be driving the main theoretical advantage of
equity market integration.

2.1.2 Market integration and financial vulnerability

The concept of financial contagion refers to a possible unexpected transmission of volatility
across markets. There are several co-existing definitions for contagion, all highlighting the
destabilization risk brought along by financial liberalization. Fundamental contagion refers
to the transmission of shocks resulting from real interdependencies between economies. Pure-
contagion is the transmission of local shocks to another country or market, resulting in an
increase in correlation during periods of financial crisis in excess of fundamental linkages
(Forbes and Rigobon, 2002). Nonetheless, whatever the chosen definition, financial contagion
refers to shocks in a market resulting from the international transmission of price movement
(Kodres and Pritsker, 2001). The linkage between market integration and this generic
definition of contagion has been underlined by Bekaert, Harvey and Ng (2003). Their
approach proceeded by extending the traditional CAPM from a one-factor to a two-factor
setting. In doing so, they divided the world market into the U.S. and a particular region, and
allow for local factors to be priced. Consider a financially integrated country i. Under the
CAPM, expected excess returns in US dollars have the following form:

Rit = ^γiZi,t-1 ^{+ β}iUS,t-1 * ^μUS,t-1 ^{+ β}iREG,t-1 * ^μREG,t-1 ^{+ S}i,t

In (1), μ_uS_t-1 and μRE_ot-1 represent the conditional expected excess returns on the US and
regional portfolios, based on informations available in (t - 1) . The vector Z_i,t-1 contains a
constant and the local dividend yield, which help estimate the expected return of market i.

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