Access Costs And The Structure Of International Returns

We have suggested that the prevalence of home bias in investment portfolios may be evidence of costs to international investment and that these costs may drive a wedge between the equilibrium returns on different markets. If access costs lead to market segmentation, they could also affect the covariance structure of returns. Conversely, by examining the covariance structure we may gain some clues as to the source of the costs.  An important question here is how far the covariance structure of equity returns relates to the structure of the operating cash flows or is induced by partial segmentation in the financial markets.  Several studies have provided evidence that stocks may move more closely with their local market than one would expect simply from the nature of the assets that they hold or the business they conduct.  One extreme would be that international equities are fully integrated and behave essentially as a single market. In this case, we might expect that the component of an equity return that is caused by a shock to its expected excess returns will be independent of the market in which it is listed. However, we argued earlier that international equity markets appear to be, at least partially, segmented from each other. Such segmentation may result in expected return factors in different markets that are specific to the market and do not represent global factors. For instance, suppose that investors in one country become more risk averse (perhaps as a result of a reduction in wealth) and demand a higher premium for holding risky assets. This will result in a common decline in the price of locally traded stocks and, depending on the portfolio shifts that are forced on investors in other countries, a smaller adjustment in the prices of internationally traded stocks and of the other countries’ locally traded stocks. Thus changes in risk aversion that are country specific will induce common price adjustments in locally traded stocks that are not highly correlated with changes in expected returns on other markets.