Market Segmentation, Liquidity Spillover, and Closed-End Country Fund Discounts

Abstract

In a segmented international capital market, illiquidity in the market in which the shares of a country fund are traded affects only the share price of the fund (S), while illiquidity in the market in which the underlying assets are traded affects only the fund net asset value (NAV). In an integrated market, illiquidity in one market can easily spill over to another and affect both the fund share price and its underlying asset value. It follows that the closed-end country fund premium, P=ln(S)-ln(NAV), is negatively (positively) affected by the share (asset) market illiquidity in segmented capital markets, but has only an ambiguous association with either share or asset market illiquidity in an integrated market. Empirical evidence from U.S.-traded single-country closed-end funds shows a strong negative (positive) association between the fund premium and the share (asset) market illiquidity, and the relation is much stronger for funds investing in segmented markets. The results suggest that relative market illiquidity plays a significant role in explaining the variation in closed-end country fund premia.