Working Paper: NBER ID: w9880
Authors: Robert P. Flood; Andrew K. Rose
Abstract: This paper develops a simple new methodology to test for asset integration and applies it within and between American stock markets. Our technique is tightly based on a general intertemporal asset-pricing model, and relies on estimating and comparing expected risk-free rates across assets. Expected risk-free rates are allowed to vary freely over time, constrained only by the fact that they are equal across (risk-adjusted) assets. Assets are allowed to have general risk characteristics, and are constrained only by a factor model of covariances over short time periods. The technique is undemanding in terms of both data and estimation. We find that expected risk-free rates vary dramatically over time, unlike short interest rates. Further, the S&P 500 market seems to be well integrated, and the NASDAQ is generally (but not always) integrated. However, the NASDAQ is poorly integrated with the S&P 500.
Keywords: financial integration; asset pricing; marginal rate of substitution
JEL Codes: G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Expected MRS should be equal across different asset markets (G19) | Asset-market integration (G19) |
| Expected risk-free rates vary significantly over time (E43) | S&P 500 market exhibits strong integration (F02) |
| Expected risk-free rates vary significantly over time (E43) | NASDAQ shows inconsistent integration with S&P 500 (C43) |
| MRS does not behave uniformly across NYSE and NASDAQ portfolios (G34) | Strong rejection of integration between NYSE and NASDAQ portfolios (G19) |