Working Paper: CEPR ID: DP2282
Authors: Philippe Martin; Hélène Rey
Abstract: The paper investigates the impact of financial integration on asset return, risk diversification and breadth of financial markets. We analyse a three-country macroeconomic model in which i) the number of financial assets is endogenous; ii) assets are imperfect substitutes; iii) cross-border asset trade entails some transaction costs; iv) the investment technology is indivisible. In such an environment, lower transaction costs between two financial markets translate into higher demand for assets issued on those markets, higher asset price and larger diversification. For the country left outside the integrated area, the welfare impact is ambiguous: it enjoys better risk diversification but faces an adverse movement in its financial terms of trade. When we endogenise financial market location, we find that financial integration benefits the largest economy of the integrated area. Only when transaction costs become very small does financial integration lead to relocation of markets in the smallest economy.
Keywords: financial integration; asset trade; transaction costs; cross-listing
JEL Codes: F12; F40; G10; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Decrease in transaction costs (D23) | Increase in asset prices (G19) |
| Increase in asset prices (G19) | Induce agents to develop riskier projects (D82) |
| Decrease in transaction costs (D23) | Greater diversification (G19) |
| Financial integration (F30) | Welfare implications are ambiguous (D69) |
| Financial integration (F30) | Benefits for the integrated area (F15) |
| Reduced transaction costs + Positive financial terms of trade + Increased asset variety (G19) | Enhanced market completeness and aggregate risk reduction (G19) |
| Financial integration (F30) | Deteriorating financial terms of trade for countries outside integrated area (F14) |