DP4027 Financial Integration: A New Methodology and an Illustration

Author(s): Robert P Flood, Andrew K Rose
Publication Date: August 2003
Keyword(s): asset, conditional, expected, intertemporal, market, price, rate, risk-free, stock
JEL(s): F32, G15
Programme Areas: International Macroeconomics, Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=4027

This Paper develops a simple new methodology to test for asset integration and applies it within and between American stock markets. Our technique is tightly based on a general intertemporal asset-pricing model, and relies on estimating and comparing expected risk-free rates across assets. Expected risk-free rates are allowed to vary freely over time, constrained only by the fact that they are equal across (risk-adjusted) assets. Assets are allowed to have general risk characteristics, and are constrained only by a factor model of covariances over short time periods. The technique is undemanding in terms of both data and estimation. We find that expected risk-free rates vary dramatically over time, unlike short interest rates. Further, the S&P 500 market seems to be well integrated, and the NASDAQ is generally (but not always) integrated. The NASDAQ, however, is poorly integrated with the S&P 500.