International financial integration through the law of one price : the role of liquidity and capital controls

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This paper takes advantage of the fact that some stocks trade both in domestic and international markets to characterize the degree of international financial integration. The paper argues that the cross-market premium (the ratio between the domestic and the international market price of cross-listed stocks) provides a valuable measure of international financial integration and the effectiveness of capital controls. Using Autoregressive (AR) models to estimate convergence speeds and non-linear Threshold Autoregressive (TAR) models to identify non-arbitrage bands, the paper shows that price deviations across markets are rapidly arbitraged away and bands are narrow, particularly so for liquid stocks. The paper also shows that regulations on cross-border capital flows effectively segment domestic markets. As expected, the effects of both types of capital controls are asymmetric but in the opposite direction: controls on outflows induce positive premia, while controls on inflows generate negative premia. Both vary with the intensity of capital controls.
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83329 AUTHOR ACCEPTED MANUSCRIPT FINAL PUBLICATION INFORMATION International Financial Integration through the Law of One Price : The Role of Liquidity and Capital Controls The definitive version of the text was subsequently published in Journal of Financial Intermediation, 18(3), 2009 Published by THE FINAL PUBLISHED VERSION OF THIS ARTICLE IS AVAILABLE ON THE PUBLISHER’S PLATFORM This Author Accepted Manuscript is copyrighted by the World Bank and published by . It is posted here by agreement between them. Changes resulting from the publishing process—such as editing, corrections, structural formatting, and other quality control mechanisms—may not be reflected in this version of the text. You may download, copy, and distribute this Author Accepted Manuscript for noncommercial purposes. Your license is limited by the following restrictions: (1) You may use this Author Accepted Manuscript for noncommercial purposes only under a CC BY-NC-ND 3.0 Unported license http://creativecommons.org/licenses/by-nc-nd/3.0/. (2) The integrity of the work and identification of the author, copyright owner, and publisher must be preserved in any copy. (3) You must attribute this Author Accepted Manuscript in the following format: This is an Author Accepted Manuscript of an Article by Levy Yeyati, Eduardo; Schmukler, Sergio L.; Van Horen, Neeltje International Financial Integration through the Law of One Price : The Role of Liquidity and Capital Controls © World Bank, published in the Journal of Financial Intermediation18(3) 2009 http://creativecommons.org/licenses/ by-nc-nd/3.0/ © 2013 The World Bank International Financial Integration through the Law of One Price: The Role of Liquidity and Capital Controls Eduardo Levy Yeyati Sergio L. Schmukler Neeltje Van Horen * September 2008 Abstract This paper takes advantage of the fact that some stocks trade both in domestic and international markets to characterize the degree of international financial integration. The paper argues that the cross-market premium (the ratio between the domestic and the international market price of cross-listed stocks) provides a valuable measure of international financial integration and the effectiveness of capital controls. Using Autoregressive (AR) models to estimate convergence speeds and non-linear Threshold Autoregressive (TAR) models to identify non-arbitrage bands, the paper shows that price deviations across markets are rapidly arbitraged away and bands are narrow, particularly so for liquid stocks. The paper also shows that regulations on cross-border capital flows effectively segment domestic markets. As expected, the effects of both types of capital controls are asymmetric but in the opposite direction: controls on outflows induce positive premia, while controls on inflows generate negative premia. Both vary with the intensity of capital controls. JEL Classification Codes: F30; F36; G15 Keywords: capital market integration; market segmentation; AR; TAR; law of one price * Levy Yeyati is with Barclays Capital and the Barcelona Graduate School of Economics, Schmukler is with the World Bank, and Van Horen is with the Dutch Central Bank and the University of Amsterdam. We are grateful to Ross Levine (the Editor) and two anonymous referees for excellent suggestions. We also thank Stijn Claessens, Constantino Hevia, Woochan Kim, Franc Klaassen, Luis Serven, Dick van Dijk, Naoyuki Yoshino, and participants at presentations held at the Asian Development Bank Institute (Tokyo), the European Economic Association Annual Meetings (Amsterdam), the Latin American and Caribbean Economic Association Annual Meetings (Paris), and the World Bank Macro Research BBL (Washington) for helpful comments. We thank the Asian Development Bank Institute for offering financial support for this project. Francisco Ceballos, Maria Bernarda Dall’Aglio, David Khon, Mira Olson, and Maria Mercedes Politi provided excellent research assistance. The views expressed in this paper are those of the authors and do not necessarily represent those of the institutions with which they are affiliated. E-mail addresses: [email protected], [email protected], and [email protected] 1. 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 (DRs) in international markets (henceforth, the cross-market 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 cross-market 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: liquidity and capital controls. Liquidity affects the ability to perform arbitrage. Two mechanisms stand out. First, stocks may not be traded in all markets on a daily basis (i.e., stocks might be infrequently traded). Thus, it takes longer to effectively arbitrage a price difference, since 1 See Gozzi et al. (2008a,b), Levine and Schmukler (2006 and 2007), and references therein. 2 In the absence of legal or technological barriers to cross-country capital flows, effective integration (price convergence) would still be affected by the intensity of transaction costs. 1 the arbitrageur has to wait for trades to happen in both markets. Second, 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. In other words, there might be a liquidity premium that drives transaction costs upwards and reduces the scope for arbitrage. Government controls on cross-country capital movement are also expected to affect the cross-market premium. The effects will vary by type of control and will be asymmetric. To the extent that these controls are effective in limiting the ability to transfer funds across borders, the cross-market premium would reflect the desire of investors to purchase the securities inside or outside the country. 3 Controls on capital outflows would exert upward pressure on the price of the underlying stock relative to the depositary receipt, since investors can purchase the security domestically and sell it in the international market, without paying the tax to move funds outside the country. That is, though controls on outflows restrict the transfer of funds abroad, stocks can still be moved from the domestic market to the international one, effectively allowing investors to obtain cash outside the country through the sale of those securities. A higher price of the underlying stock would not be arbitraged away because it would involve the purchase of the DR abroad and the sale of the underlying stock in the domestic market. As controls on capital outflows restrict transferring the proceeds from that sale abroad, the price difference would persists. The asymmetry arises because arbitrage can take place when the DR is more expensive than the underlying stock, since there are no restrictions to enter funds into the country. Namely, the premium is expected to fluctuate above zero; negative premia will be arbitraged away. Under controls on capital inflows, the opposite effects occur. These controls would push up the relative price of the DRs, as investors buy them abroad and sell them domestically, avoiding the tax to enter funds into the country. In this case, a lower price of the underlying stock in the domestic market would not be arbitraged away because controls on inflows hamper the ability to transfer funds into the country to purchase these 3 Errunza and Losq (1989) describe some other channels through which capital controls may affect asset prices. They argue that, from a global diversification perspective, capital controls impede investors to hold directly country-specific risk. This would affect the price of securities after controls are dismantled, due to the probable rebalancing of investors’ portfolios towards more efficient ones. 2 cheaper securities. The asymmetry here arises because a higher price of the underlying stock will be arbitraged away, as investors can purchase the DR and sell it domestically. 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, Korea (South), 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 cross- market 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. 4 Depositary receipts have been used recently to assess the impact of capital controls. Rabinovitch et al. (2003) attribute the persistence of return differentials between ADRs and stocks in Chile to the presence of controls. Melvin (2003) and Auguste et al. (2006) examine the large ADR discounts that built in the midst of the Argentine crisis in early 2002, which Levy Yeyati et al. (2004) interpret as a reflection of the strict controls on capital outflows and foreign exchange transactions imposed at the time. We explore this hypothesis in more depth here. 3 The view that a minimum return differential is required to induce arbitrage (hence, the non-linearities 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 employ 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. 7 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. 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 5 The importance of non-linearities in the behavior of asset prices has received ample attention in the literature. For example, Froot and Obstfeld (1991) construct a model in which government intervention leads to non-linearities in the pricing of the foreign exchange rate. Sercu et al. (1995) build a model with a no-arbitrage band for the nominal exchange rate around its purchasing power parity value. 6 Although TAR models have mostly been used in the PPP literature, more recently the model has also been applied to financial data. Rabinovitch et al. (2003), for example, use a TAR model as an approximation for the arbitrage adjustment mechanism between the local and ADR markets for Argentine and Chilean stocks. Canjels et al. (2004) use a TAR model to study the efficiency of the dollar-sterling gold standard and provide insights into the evolution of market integration in the classical gold standard. In addition, several studies have applied TAR models to study the behavior of interest rates (Balke and Wohar, 1998, Mancuso et al., 2003, and Juhl et al., 2006, among others). 7 Narrow refers to levels comparable with standard transaction fees, which are typically small. By rapid, we mean less than one day. During tranquil periods and in the absence of controls, rapid convergence means that deviations from the law of one price that may appear at close-of-business prices are traded away during the following day’s intraday trading. 4 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. As expected, both controls on capital inflows and outflows have asymmetric but opposite effects on the cross-market premium. Controls on outflows induce positive premia, while controls on inflows generate negative premia. The effects vary with the intensity of the controls. 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 5 no-arbitrage bands). 8 Finally, the use of individual identical assets avoids any potential aggregation bias that working with indexes might induce. 9 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. 10 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 sim
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