Equity Market Liberalization, Information Asymmetry and Cost of Capital

Abstract

This paper examines the effect of expanding an economy’s investor base to include foreign investors on the pricing of information asymmetry. When equity markets are imperfectly competitive, theory predicts that information asymmetry will be priced. But whether the pricing diminishes as the investor base expands to include more investors depends on whether the investors are informed or uninformed; as such it remains an open empirical question. Given the cross-sectional and temporal variation in the level of competitiveness in emerging equity markets, markets of this nature provide an ideal setting to examine whether expanding the investor base to include foreign investors affects the price impact of information asymmetry. Employing equity market liberalization for 27 countries between 1996 and 2006 as shocks to foreign investor participation, we find that the pricing of information asymmetry declines as an economy’s foreign investor base expands.