According to (8), the gains from international diversification are a negative function of the
conditional correlation coefficient between the domestic portfolio and the global portfolio.
The power of portfolio diversification is magnified in segmented markets, where returns tend
to be predominantly determined by the systematic risk of each security in the context of the
national portfolio (Bartram & Dunfey, 2001). By contrast, the gains from international
diversification are equal to zero under perfect integration; ie when the domestic portfolio is
perfectly positively correlated to the global portfolio (piw,t-1=1). Taking this into account,
equity market liberalization may have a mixed impact on portfolio inflows. Market
segmentation may first lead to a sharp increase in capital flows in the immediate aftermath of
financial liberalization. As an illustration, Bekaert & Harvey (2000) investigated a sample of
16 emerging markets and observed that american holdings increased on average from 6.2% to
9.4% of market capitalization from five years before liberalization to five years after
liberalization. Empirical studies have suggested that these capital flows are self-sustained on
the short run due to the induced pressure on local prices which results in significant ‘returns to
integration’ (Bohn&Tesar, 1996; Clark&Berko, 1997). However, the subsequent increase in
international correlation leads to dynamic rebalancing of international portfolios, ultimately
resulting in the adjustment of capital inflows (Bacchetta and Wincoop, 2000; Stulz 1999;
Griffin, Nardari&Stulz, 2002). This phenomenon is illustrated in figure 2, which shows an
increase in capital flows between in the time between liberalization and integration, and a
diminution of the same flows in the following years (Barhoumi, 2005).
Overall, theoretical models suggest that financial integration diminishes the cost of capital,
increases financial vulnerability and has a mixed impact on capital flows. From an economic
perspective, equity market integration seems to depend on an arbitrage between international
accessibility and domestic stability.