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With the creation of the European Economic and Monetary Union (EMU), European monetary policy has converged, and consequently a similar price for similar stocks in all EMU stock markets was an expected outcome. Since there exist a series of doubts regarding such evidence, it is important to identify and analyze which markets are benefitting the most from the EMU. The suspicion that the larger markets in the EMU, such as Germany and France, are becoming centralized, since they are prime recipients of capital, whilst the others, particularly the smaller markets—such as Austria, Belgium, and Portugal—are becoming peripheral, is the primary concern of this study. Consequently, firms from smaller markets will have an incentive to quote their stocks in large markets, since the cost of capital will be lower, thus benefitting from market integration (see for example, Karolyi, 1998; and Errunza and Miller, 2000).
In order to test the hypothesis, this study compares the Capital Asset Pricing Model (CAPM) of Sharpe (1964) and Lintner (1965) with the Fama and French (1993) model (FFM) results, following the procedures of Griffin (2002), in order to evaluate the EMU financial integration as well as to assess which model is more useful for practitioners.
There are many reasons for the local capital markets from the EMU to be integrated. Important among them being macroeconomic convergence, fiscal policy rules and regulations and the emergence of the single currency. There also exists many impediments to the financial integration. For example, the existence of many stock exchanges in Europe, as well as different central securities depositaries, which duplicate instructions and require a continuing development in banking financial services keeps the cost of cross-border settlements higher than desirable (Carvalho, 2004). Home bias—the proportion of investment in domestic assets in comparison to the value of the local market—is also arguably a source of market segmentation.
CAPM has been the main model to evaluate financial assets since the 1960s (see for example, Brunner et al., 1998; and Graham and Harvey, 2001), although with different approaches. Despite its use in calculating the cost of equity in a segmented market context, at the end of the 1980s, portfolio managers not only looked to the US capital market, but also to other capital markets. During a short period, especifically at the end of the 1980s, the market capitalization of the Tokyo Stock Exchange overtook that of the NYSE. Henceforth, excess stock return could be explained not only by the covariance of its return with the local market return, but also by the covariance of its return with the return of world market portfolio. In the last three decades, asset pricing took into consideration those changes. Thus, emerged the debate between segmented, partially segmented, and integrated markets and the econometric developments, arising from the discussion between the CAPM based on conditional or unconditional information. |
