The Behavior of International Stock Market Excess Returns in an Increasingly Integrated World*

Abstract

This chapter studies the behavior of international (i.e., emerging and advanced) Center of Excellence SAFE, Goethe, University Frankfurt, Germanystock market excess returns, both at the country and sector level, in a dynamic and globally integrated context. A preliminary analysis confirms that emerging stock markets have compensated international investors with generous excess returns and tend to be highly unstable. In addition, the correlation between international stock market excess returns is increasing over time. Preliminary statistics also suggest that emerging stock market excess returns have been largely influenced by the domestic shocks of the late 1990s and early 2000s (i.e., emerging crises). In contrast to existing empirical findings, this chapter shows that financial market liberalizations do not necessarily imply economic integration. Using the ${\overline{R}}^2$ of a multi-(artificial) model as a robust measure of financial integration and the trade-to-GDP ratio as a measure of real integration, it is shown that (i) there is a delay between financial market liberalizations and de facto integration; (ii) international stock markets are increasingly integrated; and (iii) average excess returns rise as de facto integration rises. The empirical findings of this chapter might have strong implications for the estimation of the cost of capital and the implementation of international portfolio diversification strategies.