Erasmus university rotterdam

Market Integration

The level of capital market integration is important to consider when investing in emerging markets. There are several determinants of market integration, for instance; capital controls, taxes and regulations, restrictions on foreign capital ownership. In some countries foreign investors may not be permitted to invest in all the listed companies, furthermore their ownership stake may also be limited (Benserud and Austgulen, 2006). According to Burner et al., the level of market integration effects the choice of which CAPM model to use in the regression (a global or local index). Mirsha and O’brien (2005) suggest that CAPM estimates can differ substantially according to whether a local or global market index is used when considering emerging markets.
The classical CAPM postulates that the risk free rate and the company’s risk premium are sufficient to derive the opportunity cost of equity capital (the expected return). This model is best fit for developed markets which are efficient and have numerous buyers and sellers of financial assets. When dealing with emerging markets, the valuation of financial assets becomes more complicated and the traditional CAPM model is not structured to deal with emerging market conditions. As mentioned before, the emerging markets are smaller, less efficient, less transparent, less liquid and measures of market integration are different. Because of these characteristics the CAPM is less easily applicable in emerging markets. In the CAPM, the covariance of a stock’s return with another asset’s return is important for the investors rather than the total variance of an asset. It is important for the risk averse investor to hold a well diversified portfolio in order to reduce the total risk of the portfolio. This is a more difficult endeavor in emerging markets where diversification is not always perfect. Hereafter the history of the CAPM and several version of the CAPM will be discussed.