Structural Breaks in the Mexicos Integration into the World Stock Market

Studying the integration of a domestic market into the world market is an empirical question that has decisive impact on a number of issues addressed by finance literature. If capital markets are integrated, investors face common and country-specific risks, but price only common risk because country-specific risk is diversified internationally. In this case, the same asset pricing relationships apply in all countries. In contrast, when markets are segmented the asset pricing relationship varies across countries and returns would be determined by domestic factors. When markets are partially segmented, investors face both common and country-specific risks and price them both. In this case, returns should be determined by a combination of local and global factors.

Empirical papers investigating stock market integration have been mainly limited to developed markets [De Santis andGerard (1997), De Santis et al. (2003), and Hardouvelis et al. (2006)]. These studies support the integration hypothesis of developed markets. Recently, some papers have tented to focus on emerging markets, in particular Asian and Latin American markets [Gérard et al. (2003), Bekaert et al. (2005), and Carrieri et al. (2007)]. The results of these studies are heterogeneous, but conclude that emerging markets are partially segmented and their degrees of integration are time-varying.

In this article, we develop and test an international conditional capital asset pricing model (CAPM) with segmentation effects in order to infer a time-varying measure of market integration. Unlike most previous works which study market integration in cross sections of countries, we follow Adler and Qi (2003) and investigate the issue thought a longitudinal study of a single market, Mexico, over the last twenty years. Mexico is the biggest Latin American market almost fully accessible to foreign investors. In fact, in the last two decades foreign investment barriers were reduced, country funds were introduced and depository receipts (DR) were listed in order to improve the integration of Mexico into the world market.

Integration should drive to a lower cost of capital, bigger investment opportunities and higher economic growth [Bekaert and Harvey (2003)]. Studying the Mexican stock market leads to a better view of the integration process. Furthermore, we test for structural breaks in the obtained degree of integration and try to explain changes by important facts and economic events.

Section 2 presents the methodology. Section 3 describes the data and reports the main empirical results. Concluding remarks are in section 4.

The CAPM predicts that the expected excess return on an asset is proportional to its systematic risk. Under integration, an international conditional version of the CAPM can be written as:

where

where it R is the excess return on market portfolio of country i and

At the national level, (2) becomes:

(3)

However, recent studies suggest that returns should be influenced by both global and local factors [Bekaert andHarvey (1995), andCarrieri et al. (2007)]. In this partially segmented framework, the returns are given by:

, only the world risk is priced and the market i is integrated. Finally, if

the market i is partially segmented.

Next, consider the econometric methodology. Equation (4) has to hold for both Mexican and world markets. Under rational expectations, we can write:

,

where

is the conditional covariance between Mexican and world markets,  is given by:

where C is a   Finally, we follow previous works to specify the evolution of prices of risk. These prices are modelled as a positive function of information variables:

, where Z and i Z are respectively a set of global and local variables included in 1   t . As in Hardouvelis et al. (2006), the time-varying function

is a set of variables expected to be correlated with market integration. By

. We take into account these features in the construction of variables. Precisely, we will assume that deviations of variables from zero, independent of their sign, reduce the degree of integration. The quasi-maximum likelihood (QML) method is used to estimate the model.

Once the time-varying degree of market integration becomes available, we test for structural breaks. Let t y be the degree of integration. We consider the following mean-shift model with . 4 We then choose m break dates such that the test

is not significant for any m l  .5

We use monthly stock returns for Mexico and world markets over the period January 1988-February 2008. Returns include dividend yields and are computed in excess of the 30-day Eurodollar deposit rate. In order to preserve comparability with previous studies, the choice of global, local and integration information variables is mainly drawn from previous works. The set of global information includes a constant, the MSCI world dividend price ratio in excess of the 30-day Eurodollar deposit rate (WDY), the change in the US term premium spre

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