International Market Integration: A Survey

• DOI: http://doi.org/10.1111/ajfs.12297
• Published date: 01 April 2020
• Author: Lilian Ng,Amir Akbari
• Date: 01 April 2020

International Market Integration: A Survey

Amir Akbari*

Faculty of Business and IT, Ontario Tech. University, Canada

Lilian Ng

Schulich School of Business, York University, Canada

Received 19 February 2020; Accepted 4 March 2020

Abstract

Market integration is a canonical topic in international finance. The question of whether and

to what extent markets are integrated with the global economy has motivated one of the lar-

gest literatures in this field. Given this vast body of research, this survey shall only focus on

the theoretical and empirical studies on one aspect of market integration –equity market

integration. It reviews the evolution of various approaches employed in studying market inte-

gration. This survey discusses the recent empirical findings on cross-sectional and time-series

dynamics of integration across developed and emerging markets. It also describes the empiri-

cal estimation of three current measures of market integration and discusses their usefulness

as well as limitations. Finally, the survey provides a few future directions for this line of

research.

Keywords Financial market integration; Segmentation; Economic integration

JEL Classification: E44, F15, F30, G15

1. Introduction

Financial deregulation and liberalization in developed (DEV) countries gained

momentum with the abolition of capital controls in the early 1980s. However, this

process only occurred in emerging (EMG) economies in the late 1980s and the

1990s. A voluminous literature has since accumulated on the financial and eco-

nomic ramifications of financial deregulation and globalization. With this vast liter-

ature, it is almost impossible for one to conduct a comprehensive survey. Thus, in

this review, we focus on the theoretical and empirical research on one aspect of

market integration –equity market integration. We review the various approaches

employed in studying market integration and discuss the recent empirical findings

on cross-sectional and time-series dynamics of integration across DEV and EMG

markets. Our review also describes the empirical estimation of three current

*Corresponding author: Faculty of Business and IT, Ontario Tech. University, Oshawa, ON,

Canada. Tel: +1-905-721-8668, email: amir.akbari@ontariotechu.ca.

Asia-Pacific Journal of Financial Studies (2020) 49, 161–195 doi:10.1111/ajfs.12297

©2020 Korean Securities Association 161

measures of market integration and discusses their usefulness as well as their limita-

tions.

This survey starts by providing the theoretical framework in which market inte-

gration is defined and tested. Theoretically, markets are perfectly integrated if finan-

cial assets with the same risk profile have identical expected returns irrespective of

the market they are traded in. In other words, the premise of financial market inte-

gration is the law of one price (Chen and Knez, 1995). Conversely, in the presence

of foreign investment barriers, international risk sharing is inefficient and, therefore,

markets become segmented. These barriers, either explicit, such as capital controls

and taxes on repatriation, or implicit, such as investment environment and quality

of financial institutions, impede cross-border investment and risk sharing. As a

result, in the past four decades DEV and EMG markets actively have taken mea-

sures to lift these barriers and open their markets. Consistent with these steps, we

observe that the world market has become economically and financially more inte-

grated.

Despite the pervasive evidence that markets are becoming more integrated, ther e

is no uniformly accepted measure of integration. Measuring integration is a formid-

able task. Early studies have identified market integration as the convergence of

asset prices and strong co-movement of returns across countries. However, the

interpretation of this simplistic measure is fraught with a fundamental flaw. As

(Pukthuanthong and Roll 2009) argue, countries can be perfectly integrated even

when their market portfolio return correlations are low. When there are multiple

global sources of return variations, assets of countries do not necessarily have simi-

lar exposures to all of them. That is, the returns of countries’ market portfolios,

while only weakly correlated, can be fully explained by these global factors and

hence, countries can be perfectly integrated. Subsequent studies attempt to measure

market integration in the context of an asset pricing model, but such an approach

involves a joint test of multiple hypotheses, thereby making it difficult to draw any

definite inferences.

To overcome this challenge, recent empirical studies have focused mainly on

either ad hoc arbitrage pricing theory (APT) models or non-direct asset pricing

models. Following the first approach, Pukthuanthong and Roll (2009) propose a

simple and intuitive measure of integration based on the R-square of a multi-factor

regression model, where the factors are estimated using a principal component anal-

ysis. They argue that markets could be globally integrated as long as their assets are

similarly exposed to the same global shocks. Bekaert et al. (2011), on the other

hand, take a different approach to measuring market integration. They focus on an

approximation of Gordon’s growth model and develop a segmentation measure, the

SEG Index, based on industry-valuation differentials. If countries are completely

integrated, growth opportunities and discount rates of similar assets (e.g., indus -

tries) are equalized across different markets. Therefore, the current earnings to stock

price ratio should be identical within each industry across countries, therefore, SEG

should be zero for fully integrated markets.

A. Akbari and L. Ng

162 ©2020 Korean Securities Association

Both Pukhuanthong and Roll’s (2009) R-square and Bekaert et al.’s (2011)

SEG are developed on the premise that the marked increase in market integration

is due to the rise in risk sharing among financial markets, and they ignore the

existence of real economic activity. To address this issue, Akbari et al. (2019) pro-

pose the economic and financial integration metrics that are derived using a

return decomposition approach: economic integration is measured by a common

cash-flow dynamic and financial integration is a common risk-pricing dynamic.

To facilitate comparison, we provide a detailed description of how the three dif-

ferent integration measures are constructed and estimated. We then replicate each

measure using the same sample of 41 DEV and EMG markets over the same per-

iod between 1989 and 2015. Such an analysis will offer readers significant insights

on each approach, as well as their usefulness and limitations in characterizing

market integration.

We next review both the cross-sectional and time-series empirical evidence on

equity market integration, focusing mainly on the recent literature. We also survey

the numerous studies that attempt to examine the drivers of equity market integra-

tion. Our review not only summarizes prior empirical research that investigates the

dynamics of integration through time but also during the global financial crisis.

The paper is organized as follows. Section 2 surveys the theoretical literature

on international integration. It primarily discusses the framework that various

researchers employ to define market integration. Section 3 describes the construc-

tion and estimation of two widely referenced integration measures in the literature

and the recently developed metrics for assessing economic and financial integra-

tions. In this section, we also provide a comparison of these three measures across

time and across DEV and EMG markets. Section 4 surveys the cross-country evi-

dence on market integration and its determinants. Section 5 investigates the

dynamics of integration through time, and Section 6 offers some avenues for

future research.

2. Theoretical Framework and Definition

Market integration is characterized by the existence of a unique global pricing ker-

nel (or stochastic discount factor, SDF) that governs asset prices across the world

(see, e.g., Adler and Dumas, 1983; Solnik, 1974; Stulz, 1981a). If markets are fully

integrated, then assets with the same risk must have identical expected returns, irre-

spective of the market, where risk refers to exposure to common world factors.

Thus, in a globally integrated market, the price of asset jis derived based on its

expected cash flows and their covariance with SDF, as follows:

1

1

For simplicity, we adopt the notation of Cochrane (2005) when reviewing various interna-

tional asset pricing models.

International Market Integration: A Survey

©2020 Korean Securities Association 163