THE GLOBALIZATION OF EQUITY MARKETS If we go back to just a couple of decades ago, many countries had equity
THE GLOBALIZATION OF EQUITY MARKETS If we go back to just a couple of decades ago, many countries had equity
(stock) markets that were segmented. A segmented market is one in which foreign investors are not allowed to buy domestic stocks and domestic investors are not allowed to buy foreign stocks. Part of the process of the globalization of world economies is the liberalization of stock market restrictions to open markets to the world. Table 10.2 provides dates of first stock market liberalizations for several countries.
What happens when a country moves from a segmented market, cut
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the chapter. Now, we can think about a risk premium that must be paid to compensate investors for taking risk. Let us denote the return on the risk-free asset (like a U.S. government security) as Rf. Then we can con- sider the risk premium on small country C’s assets as being equal to the return on C’s assets minus the risk-free rate of return, or: Risk
Premium 5 R C 2 Rf. The size of this risk premium should depend upon the variance of the return on the market portfolio and the price of risk. In a segmented market, the variance of returns is just the variance of the domestic market return, so the risk premium before globalization is:
Risk Premium in segmented market 5 Pvar ½R C ð10 :4Þ where P is the price of risk. So, the risk premium required on domestic
stocks in segmented financial market C will just depend upon the vari- ance of stock prices in country C multiplied by the price of risk P. P is determined by the degree of risk aversion of investors. If all investors are the same everywhere, then P is a constant across countries. In a world of segmented markets, a country with a variance of returns twice as high as another country would have twice the risk premium on its stocks. This risk premium is what investors require in order to willingly hold shares of the stocks.
In the globalized equity market we can think of the portfolio return volatility for the residents of small country C as the variance of a portfolio comprised of the stocks of country C and the stocks of the rest of the world. Using the formula for portfolio variance introduced earlier in the chapter, this would be:
2 var ½R 2 p 5w var ½R W 1c var ½R C 1 2wc cov½R W ;R C ð10 :5Þ where w and c are the fraction of the portfolio devoted to stocks from the
rest-of-the-world and the small country, respectively; R W and R C are the returns on the stocks of the rest-of-the-world and small country C, respec- tively. Equation (10.5) shows that the variance of the portfolio is deter- mined by the amount invested in each area, the variance of returns on the
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its financial markets to become more globalized. The risk premium on C’s stock should depend upon the contribution of C’s stock to the variance of the world portfolio, which is given by the covariance of the return on stock in country C with the returns in the rest-of-the-world, or
Risk Premium in globalized market 5 Pcov ½R W ;R C ð10 :6Þ Should we expect the risk premium on country C stock to rise or fall
with globalization? To answer that question, compare Equations (10.4) and (10.6) . For globalization to reduce the risk premium on country C,
we need var(R C ) . cov(R W ,R C ). Note that the square root of the vari- ance is known as the standard deviation (SD). So SD(R C ) is equal to the sqrt(var(R C )). The standard deviation is just another measure of how a variable deviates from its mean or average value. What is useful for our purposes is that the covariance is equal to the correlation coefficient between two variables multiplied by the product of their standard devia-
tions, or cov(R W ,R C ) 5 ρSD(R W )SD(R C ) where ρ is the correlation coefficient. The correlation coefficient is a number between 1 and 21 that indicates how these two variables change together. If ρ 5 1, then the two variables are perfectly correlated and move together about their respective means. If ρ 5 21, then the two variables are perfectly nega- tively correlated and move exactly opposite to each other, so that when one is above its mean value, the other is below its mean value. If ρ 5 0, then the two variables are independent and have no relationship.
Now we can find the conditions under which globalizing a financial market will reduce the risk premium on a country’s stock. Comparing Equations (10.4) and (10.6) again, we need var(R C ).cov(R W ,R C ), which may be written as:
varðR C Þ . ρ SDðR W ÞSDðR C Þ ð10 :7Þ If we divide both sides of this inequality by SD(R W )SD(R
C ), we have:
ð10 :8Þ So the risk premium on country C stock will fall with globalization,
SDðR C Þ =SDðR W Þ.ρ
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be true. In this case, country C stock prices would tend to rise when the rest-of-the-world stock prices tend to fall, and the risk premium on C’s stock will always fall with globalization. In general, we need a rela-
tively small ρ and a large SD(R C ) relative to SD(R W ). This is, in fact, what one usually observes in the world. Small countries with segmented stock markets typically have relatively small correlations of their stock prices with the rest-of-the-world. In addition, the volatility of their stock prices tends to be high relative to rest-of-the-world volatility. So, in general, we expect that when a government liberalizes its financial markets to become globalized, or integrated with the rest of the world, the risk premium on its stock falls.
This, then, points out a major benefit of globalized financial markets: a lower risk premium on domestic financial assets allows domestic firms to lower their cost of capital. The cost of capital is what firms have to pay investors to raise new funds. If a domestic firm sells new shares of stock, then the lower the risk premium, the smaller dividends or cash flows the firm must pay stockholders. This allows firms to raise money more cheaply and will allow greater investment spending and expansion than otherwise.