Discussion of model assumptions

K. Hargis International Review of Economics and Finance 9 2000 101–122 117

6. Discussion of model assumptions

The model makes assumptions regarding market integration and correlations that deserve further discussion. First, the domestic and foreign price for the cross-listed equity are assumed to be perfectly integrated perfect information transparency across markets, consistent with the claim of Chowdhry and Nanda 1991 that incentives exist which would lead to market integration. Under this assumption, the price of the cross-listed equity will be the same in both the domestic and the foreign market and the depth of the market will reflect the number of investors participating in either the domestic or foreign market. Models for international cross-listing usually assume either perfect integration or fragmentation, consistent with this model. I illustrate the case of moving from segmen- tation to integration to highlight the impact of this change on domestic stock prices and its influence on incentives for issuers and investors to enter the market. This mechanism is central for market development and needs to be analyzed in the context of an international asset pricing model. The international asset pricing model here builds on previous models for example, Alexander, Eun, Janakirmanan, 1986; Errunza Losq, 1995 and complements models which focus on the market microstructure of cross-listed equities such as Hargis and Ramanlal 1998 and Domowitz, Glen and Madhavan 1998. The model here differs from these models by allowing the price impact of moving from market segmen- tation to market integration to impact the decisions of domestic companies. These microstructure models focus on varying degrees of information transparency, extent of order flow migration, and foreign ownership restrictions in the domestic market prior to listing. They do not address issues such as market segmentation in an asset pricing model context, as addressed in this article. Nevertheless, the conclusions of this paper and these microstructure models are similar for the case of perfect transpar- ency in finding that cross-listing improves domestic market liquidity. The second issue is the assumptions in the case presented for the benefits of integration. For purposes of illustrating the model, correlations between domestic companies were assumed to equal one, while correlations between domestic and foreign companies were assumed to be zero. These assumptions illustrate the maximum benefits of internationalization. First, correlations between emerging equity markets and the world equity markets were quite low prior to liberalization see Bekaert Harvey, 1997; Errunza, Hogan, Hung, 1998. For the five year period ending in 1992, 13 of the 20 emerging markets followed by the International Finance Corporation IFC had a correlation coefficient of less than 0.2 with the United States. 14 Second, correlations among individual equities within each market were higher than in the developed world, averaging 70 for all Mexican stocks compared to 49 in the United States. 15 As a result, prior to liberalization, the benefits to domestic listing by companies may have been low even if all companies were expected to be in the market. In contrast, the benefits of listing domestically or internationally may be substantial after liberalization even if only a small sample of equities is listed in the international market. 118 K. Hargis International Review of Economics and Finance 9 2000 101–122

7. Empirical implications of the model