Introduction

As part of the process of increasing international financial integration, countries have experienced in recent years a migration of stock market activity from domestic markets to international markets. By now, many countries have several firms simultaneously trading equity in domestic stock markets and international financial centers. The growth of international markets as a source for financing and trading is generating a wedge within countries between large, liquid firms and the rest, and is influencing domestic stock market development around the world. Emerging economies have been particularly affected by this process.¹

In this paper, we take advantage of this migration of stocks to international financial centers and the fact that two identical assets trade in domestic and international stock markets to study the degree of international financial integration and how it is affected by liquidity and the imposition of capital controls. To do so, we measure international financial integration through the lens of the law of one price (LOOP). This law stipulates that two markets are integrated when identical goods or assets are priced equally across borders. We analyze the percentage price difference displayed by the (underlying) shares in domestic markets and the corresponding depositary receipts (DR) in international markets (henceforth, the crossmarket premium), controlling and testing for the presence of non-linearities.

The behavior of the cross-market premium provides a useful price-based measure of integration. If there are no restrictions to trading, the possibility of arbitrage implies that the prices of the depositary receipt and the underlying share would be equal, after adjusting for exchange rate and transaction costs. It follows that, in a fully integrated market, the crossmarket premium should be approximately zero.² However, full integration of capital markets can be disrupted by several factors. Two of them are studied in this paper. First, liquidity affects the ability to perform arbitrage. For example, stocks may not be traded in all markets on a daily basis (i.e., stocks might be infrequently traded), or stock prices might be sensitive to the trading activity of particular investors because the market is not deep enough. Therefore, arbitrage activity might be hampered in the case of these non-liquid companies. Second, government controls on cross-country capital movement are also expected to affect the cross-market premium. To the extent that these controls are effective in limiting the ability to transfer funds (not securities) across borders, the cross-market premium would reflect the desire of investors to purchase the securities inside or outside the country, depending on the type of control.³ For example, controls on capital outflows would exert pressure on the underlying stock relative to the depositary receipt, since investors can purchase the security domestically and sell it (at a discount) in the international market, but without paying the tax to move funds outside the country. Conversely, controls on capital inflows would push up the relative price of the depositary receipts, as investors buy them abroad and sell them domestically, avoiding the tax to enter funds into the country. As such, the cross-market premium would reflect the effectiveness of capital controls and the price investors are willing to pay to hold a security that can be freely transferred across borders, when other restrictions are in place.⁴ While the analysis of differentials in the pricing of DRs and the underlying shares has received attention for a while (see, among others, Eun et al. 1995, Alaganar and Bhar, 2001, and Gagnon and Karolyi, 2004), a systematic analysis of LOOP and its link to liquidity and capital controls, as studied in this paper, has been missing.

In our empirical estimations, we analyze systematically the distribution of daily cross-market premia since 1990 for a large set of stocks (98 in total) from nine emerging economies: Argentina, Brazil, Chile, Indonesia, Republic of Korea (hereafter Korea), Mexico, Russia, South Africa, and Venezuela. The paper uses two methodologies to examine financial integration through the convergence to LOOP by two identical assets trading in domestic stock markets and at the New York Stock Exchange. First, we use the more traditional autoregressive (AR) models to estimate the convergence speed of a shock to the crossmarket premium. Higher convergence speeds reflect a quicker convergence to LOOP by the underlying stocks and the DR, and hence stronger financial integration. Second, we use non-linear threshold autoregressive (TAR) models. Typical transaction costs such as brokerage fees, or control induced costs such as Chilean-type unremunerated reserve requirements (or, more generally, any tax-like control on capital flows), can be expressed as a percentage of the amount invested, that is, a discount that requires a compensating premium. TAR models implicitly characterize this premium by estimating at what point it is profitable to engage in arbitrage. Therefore, they provide a natural way to measure transaction costs-based segmentation in financial markets, and constitute a clear alternative for the more traditional AR models.

The view that a minimum return differential is required to induce arbitrage (hence, the nonlinearities in cross-market premia) dates back, at least, to the work of Einzig (1937, p. 25).⁵ Einzig’s point has been empirically tested by Peel and Taylor (2002), who apply the TAR methodology to the weekly dollar-sterling covered return differentials during the interwar period. Obstfeld and Taylor (2002) replicate the exercise using monthly data. Obstfeld and Taylor (1997) use similar models to document the presence of non-linearities in the convergence process of international prices. In this paper, we calibrate TAR models to estimate no-arbitrage bands (that is, zones where deviations between depositary receipt and stock prices are not arbitraged away) and convergence speeds outside the band. We interpret both the band-width and the convergence speed as (inverse) measures of integration.⁶

The main results of this paper are the following. First, we show evidence of strong financial integration: the cross-market premium is close to zero, with rapid convergence to zero and very narrow no-arbitrage bands. Second, non-linear models seem to capture well the behavior of the premium, in line with the hypothesis of a no-arbitrage band due to transaction costs. Moreover, convergence speeds are slower when estimated by an AR model, and the difference with respect to the speed estimated by the TAR model is proportional to the band-width, as expected. Third, convergence speed is more rapid and the no-arbitrage bands are narrower, the more liquid a stock is. This suggests that large companies, the ones that typically have liquid stocks, are well integrated with the international financial system. Fourth, regulations on cross-border capital movement effectively segment stock markets, weakening arbitrage across markets. The presence of controls is directly reflected in the intensity of integration, in the form of wider bands and more persistent deviations (less rapid convergence when outside the band), except where controls are not binding. In all, the results show that arbitrage works well for liquid (typically large) companies from emerging economies that are fully integrated with the international financial system, but that this integration is easily disrupted as stocks become less liquid or governments introduce restrictions on capital movements.

Some additional contributions to the literature are worth mentioning here. The cross-market premium used in this paper offers a number of advantages as a measure of financial integration over many other measures proposed in the literature. First, it allows testing LOOP based on two truly identical assets, avoiding the problems generated by different index composition across countries. For example, stock market indexes are composed of assets with different degrees of liquidity and from different sectors, for which effective integration (and, as a result, the speed of convergence of prices in different locations) may differ. Second, the cross-market premium is free from the idiosyncratic risk related to default risk. In other words, depositary receipts do not involve different securities, but rather claims on the same stock of shares traded in the local market issued by the same company. The underlying shares move between the domestic market and the international market following arbitrage activity. Since the depositary receipt is a claim on the underlying share, holders of depositary receipts have the same legal rights as holders of equity and are entitled to the same cash flows. Third, because it is a market-based measure, no empirical model needs to be imposed on the data. Fourth, the measure is continuous and spans the range between complete segmentation and complete integration, capturing variations in the degree of integration that can arise, for example, from the introduction or lifting of investment barriers. Fifth, the measure is amenable to the use of TAR models. Linear models tend to understate the convergence speed when there are non-linearities in the data (the more so the wider the no-arbitrage bands).⁷ Finally, the use of individual identical assets avoids any potential aggregation bias that working with indexes might induce.⁸

By using the cross-market premium, this paper also extends the literature on price-based measures of international financial integration, which can be broadly divided into two strands.⁹ A first one analyzes integration by estimating return correlations across markets. Although very useful to understand the scope for international risk diversification, this work is often based on a comparison of price indexes, which can be problematic (as discussed above). Furthermore, when based on capital asset-pricing models the studies of return correlations test simultaneously the extent of integration as well as the applicability of a particular model.¹⁰ A second strand of the literature studies financial integration by testing LOOP in capital markets in various ways.¹¹ In response to the composition problem associated with price indexes, some papers specifically focus on the evolution of the premium of emerging market closed-end country funds over the value of their underlying portfolio. While free from the composition bias, these attempts fall short of comparing identical assets, as the restrictions and management of closed-end funds distinguishes them from their underlying portfolio.¹² Alternatively, Froot and Dabora (1999) examine the price behavior of pairs of stocks of large Siamese twins (corporates that pool cash flows and fix their distribution) traded in different countries, and find that price deviations of these “nearly identical” stocks are habitat dependent.¹³

The remainder of the paper is organized as follows. Section 2 discusses the link between the cross-market premium and financial integration. Sections 3 and 4 discuss the data and methodology. Section 5 characterizes the behavior of the cross-market premium and studies how the premium is related to liquidity. Section 6 examines how controls on cross-border capital movement affect financial integration and to what degree the cross-market premium provides a good measure of integration. Section 7 offers some concluding remarks.

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