Market segmentation, liquidity spillover, and closed-end country fund discounts

Abstract

In a segmented international capital market, the illiquidity of a country fund in the market in which its shares are traded affects only the share price of the fund ( S), while the illiquidity of its underlying assets in the market in which these 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 fund (underlying asset) illiquidity in segmented capital markets, but has only an ambiguous association with either fund or underlying asset illiquidity in an integrated market. Empirical evidence for the 8/1987 to 12/2001 period from U.S.-traded single-country closed-end funds shows that the fund premium has a negative (positive) association with the fund (underlying asset) illiquidity, and the relation is much stronger for funds investing in segmented markets. The results suggest that illiquidity plays a significant role in explaining closed-end country fund premia.