DP4027 Financial Integration: A New Methodology and an Illustration

Author(s): Robert P Flood , Andrew K Rose

Publication Date: August 2003

Keyword(s): risk-free , rate , intertemporal , asset , market , expected , price , stock , conditional

JEL(s): F32 , G15

Programme Areas: Financial Economics , International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP4027.asp

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.