EMU and European Stock Market Integration

Abstract

The paper examines whether or not the convergence of European economies towards Economic and Monetary Union (EMU) and the launch of the single currency leads to an increase in stock market integration through a reduction in investment barriers. We estimate a conditional asset pricing model, which allows for a time-varying degree of integration that measures the importance of EU-wide risk relative to country-specific risk. The model accounts for intra-European currency risk, time-varying quantities and prices of risk. The results indicate that the degree of integration is closely related to forward interest differentials vis-a-vis Germany, i.e. to the probability of a country joining EMU. As the probability of the single currency materializing increases, restrictions on holding foreign assets become less binding, leading to higher market integration.