Random or in Tandem?
IN PRINT ARCHIVE CIR Summer 2008
or In Tandem?
By Stephan Siegel, assistant professor of finance and business economics, Michael G. Foster School of Business
The removal of capital controls in both developed countries and emerging markets has led to unparalleled financial openness across the world. These important structural changes should have had a profound effect on the pricing of stocks across the globe, and hence on important economic issues such as the cost of capital, international diversification benefits, and international risk sharing. In particular, globalization may have increased the integration of equity markets across the world. Cross-border flows of capital most likely reduced the differences in discount rates and growth opportunities across different countries, especially when comparing countries at the industry level.
Nevertheless, quantifying the magnitude, the timing, and the sources of this increase of integration or decrease of segmentation is difficult. In recent work (joint with Geert Bekaert, Cam Harvey, and Chris Lundblad), we propose a weighted sum of the absolute value of industry-level valuation differentials as a measure of the degree of effective equity market segmentation for a country. For example, the average absolute differential in earnings yields for the set of developed countries between 2001 and 2005 is 1.9%, compared to 4.5% between 1980 and 1984. While significantly lower now than 20 years ago, the decrease itself does not inform us whether developed countries today can be viewed as integrated or not.
While this segmentation measure would be equal to zero in a completely integrated and frictionless world, differences in leverage, earnings volatility across countries and/or just plain measurement error will always yield a positive value even in relatively integrated markets. To account for these differences, we construct a benchmark using comparable U.S. data, for which measured segmentation cannot be ascribed to international market segmentation. Since about 1993, we reject segmentation for the set of developed countries. While levels of segmentation have decreased in emerging and frontier countries as well, the level of segmentation is still significantly above the U.S. benchmark (see Figure 1).
In a second step, we examine the factors that account for the variation in equity market segmentation both through time as well as across countries. Globalization, such as the openness of equity market to foreign investors, plays a pivotal role in explaining cross-country differences in market segmentation, but so does the institutional environment and local financial market development. Variables reflecting global risk conditions, such as the U.S. corporate bond spread, also account for a significant proportion of the variation in segmentation. These variables alongside equity market openness explain about 30% of the variation in segmentation. We find equity market openness to be the single most important economic explanatory variable, accounting for the largest share of the explained segmentation variance.
While our measure of market segmentation is helpful in quantifying the degree to which equity market valuations have converged, it can also be easily applied to other asset classes as well as regions of the world, including the study of valuation differentials within a given country.
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