Assessing the Impacts of Global Financial Integration

National Bureau Of Economic Research Inc, Cambridge MA

Investigators

Abstract

The trend toward international financial market integration has accelerated over the past decade. The effects of global market integration on asset prices is obviously an important issue for both policy-making and research reasons. Are equity prices being priced more as an asset in a single world market or are they still priced according to benchmarks from their own domestic country? And if equity markets are evolving towards a common integrated market, what do the effects on asset prices imply about traditional assumptions about the diversification potential of foreign assets? These general questions are the focus of a large literature spanning both macroeconomic and financial research. This project intends to take a different approach to these questions, however. It is commonly argued that the higher costs of foreign stocks interfere with global market integration. These costs are usually argued to be one of two kinds: (1) direct transactions costs of going to foreign markets and paying possibly higher taxes and fees; or (2) informational costs of learning about a foreign firm and its growth potential. This project examines a set of foreign stocks that are largely devoid of significantly higher costs along these two dimensions. The investigator builds a unique data set with information about foreign companies that cross-list their stocks in the U.S. through so-called ADR (American Depositary Receipt) programs. Acquiring these foreign stocks is no more costly than acquiring domestic stocks. Moreover, foreign firms that list these stocks on the NYSE must go through the same disclosure requirements as a domestic US firm, including following the same accounting standards. Therefore, these foreign stocks on domestic markets provide a unique opportunity to directly study the effects of global market integration on asset pricing and on the potentials for gains from international diversification. The data set is unique because it provides a full time series for the price of the foreign companies both at home and in the U.S. This project consists of three parts. The first part of the project focuses upon the effects of financial integration on asset pricing relationships. The issue of foreign stocks in the US market has been associated with a casual empirical observation: the stock price of the parent company tends to covary more positively with the US market after cross-listing. If these anecdotal stories are true, they are important for understanding international equity pricing, and thereby bear on most policy issues concerning international financial markets. This part of the project examines the question of whether greater international financial integration in the form of cross-listings of stocks has affected international equity pricing. It also calculates the welfare gains for international equity markets before and after integration. The second part of the project focuses more directly on the scope for diversification in the face of greater integration. This question is important for policy issues ranging from retirement and its associated social security questions to international allocation of capital issues. The project uses a time series of about 2000 foreign firms' cross-listed stock price in the US and match these with their counterparts on their own markets. This allows a comparison of asset pricing behavior before and after cross-listing. A Bayesian approach is used that allows the calculation of what investors would choose once these stocks are issued in the U.S. and thereby address two different fundamental questions. First, comparing the degree of integration between the US and a given foreign market before and after cross-listing, what are the diversification gains from the increased integration? This question is important because the existing literature has generally compared gains only relative to perfect integration. Second, would US investors who hold cross-listed foreign stocks still choose to hold additional foreign stocks that are not cross-listed? Obviously, answering this question is important for determining whether domestic investors really need to hold assets obtained directly from foreign stock exchanges to be optimally diversified. The third part of the project asks: Has global integration through cross-listing improved the domestic resident's ability to hedge consumption risk? It addresses this issue by testing whether the variability of consumption growth that is explained by these stocks is significantly higher than the variability of the general foreign index. Addressing these issues is important since studies of international diversification from a macroeconomic viewpoint have focused upon the sharing of consumption risks. To the extent that international portfolio allocation has been considered, it has been to ask what assets would support the sharing of consumption risks. No study to date has examined the direct effects of market integration through cross-listing on the ability to insure consumption risk.