Are European Financial Markets Integrated? An Approximate Factor Model Investigation

Abstract

This paper proposes an alternative to extract European common factors and to measure the level of European equity markets integration. Following Heston, Rouwenhorst and Wessels [1995], we use an approximate factor model (Connor 1984) to perform European integration tests. The key feature of this approach is to work with T, the number of time series observations which is typically far smaller than the number of assets, N. The use of the Jones [2001] procedure allowing for heteroskedasticity in time-series residuals is fundamental because the explanatory power of integration tests strongly depends on the pervasive common factors extraction method. Our findings can be summarised as follows. First, European financial markets have been highly integrated over the last 5 years. Second, being a member of the EMU is not sufficient to be integrated to the European capital markets. Third, we demonstrate that the factor structure of European stock returns has changed in the last few years.