Pricing externalities in the world financial markets: Theory and policy implications

Abstract

In this paper, we investigate the equilibrium asset pricing mechanism in a partially segmented world capital market where some assets are internationally tradable while others are not. The major findings are: First, nontraded assets are priced according to a world systematic risk, reflecting the spill-over effect generated by the traded assets, as well as a country-specific risk. Second, our asset pricing model allows for a continuum of domestic/international mixed pricing, with the degree of international pricing determined by the ability of traded assets to replicate the country market portfolios. Third, nontraded firms of a country get a “free ride” from the traded counterparts in that the former benefits from integration without incurring the concurrent costs. Fourth, notwithstanding a relatively small number of traded securities, the world capital market can be much more integrated than it may appear, due to the asset pricing externality effect. Fifth, to maximize the indirect benefit from partial integration, dual-listed assets or country funds should be chosen so that they have the highest correlation with the domestic market portfolio. Sixth, examination of our sample Australian firms that are cross-listed on the U.S. stock exchanges indicates that these firms experienced a decline in the expected return upon U.S. listings.