Academic journal article International Journal of Business

Stock Market Integration in the EURO Area: Segmentation or Linear Modelling Misspecification?

Academic journal article International Journal of Business

Stock Market Integration in the EURO Area: Segmentation or Linear Modelling Misspecification?

Article excerpt

I. INTRODUCTION

Determining the extent to which stock markets are integrated is an empirical question which has a decisive impact on a number of issues pertaining to financial market theory. In general, stock markets are said to be perfectly integrated if they enable investors to exchange stocks that share the same characteristics under the same conditions regardless of the investor's location and if they allow domestic and foreign firms access to similar external financing. Financial Integration (FI) has obvious economic and financial implications. It offers improved opportunities for risk reduction and diversification, leads to better allocation of capital across investment options, an increase in liquidity, and greater economic growth.

FI has recently been stepped up worldwide, especially in Europe. (1) In fact, stock markets in the Euro Area (EA) have shown evidence of significant FI over the last few decades, with considerable development, particularly after the introduction of the Euro. Several factors can account for this increase in FI in EA stock markets. Firstly, the standardization of information and the harmonization of infrastructures as well as financial instruments, legislation, regimentation, taxes, rules and regulations have led to fast convergence between the financial systems of the different member states. Secondly, the restructuring of European banking business, the liberalization process, the implementation of the Financial Service Action Plan, and rapid transmission of information via the European Central Bank (ECB) and the European System of Central Banks have helped to develop a single financial service market in the EA (e.g., Baele et al., 2004). Thirdly, the removal of restrictions and barriers on capital movements, the synchronization in business cycles, and the suppression of exchange rates, exchange-rate risk and cross-border restrictions on investor activities, may have substantially accelerated FI in the region.

As Worthington et al. (2003) noted, only a few studies in the literature have examined European capital market integration in the EU as a whole. These studies suggest greater integration between the main European stock markets in recent years, suggesting that interdependence among EA markets has increased with the stepping up of economic integration following the move to a single currency. Espitia and Santamaria (1994) identified high correlation between daily equity returns in all the markets. Chung and Lai (1999) however, pointed to significant long-term comovements in French, German and Italian stock market indices, but no evidence of cointegration with Belgium and the Netherlands. Meric and Meric (1999) show an increase in the long-term of price comovements and a decrease in international diversification benefits for the twelve largest European equity markets. Worthington et al. (2003) studied the FI hypothesis before, during and after the adoption of the Euro using various econometric tools: Granger-causality tests, generalized variance decomposition and cointegration techniques. The authors identified significant linkages between European markets. They showed that the European equity markets they studied were closely linked and integrated both before and after the transition to the Euro. Finally, Hardouvelis et al. (2006) investigated whether the convergence process of European economies toward Economic and Monetary Union has led to increased FI using an international capital asset pricing model (CAPM), which allows for a time-varying degree of integration that measures the importance of EU-wide risk relative to country-specific risk. They found significant degree of recent FI between the main European stock markets.

Overall, most of the empirical studies have suggested significant FI phenomenon between the main stock markets (Germany, France, the UK, and Switzerland) but mixed results concerning the smaller equity markets (Belgium, Ireland, Austria, Norway, and the Netherlands). …

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