Are International Financial Markets Integrated?

For many people the key dimension of international finance is obvious: international finance involves currencies and this makes it different from domestic finance.  If international capital markets are completely integrated, then international finance is just like domestic finance. The same asset pricing relationships hold and the same corporate finance decision rules are optimal. In this case, while international finance does involve currency rates, these rates are simply another set of relative prices and are, in principle, no more or less important than any other set of relative prices.  GLS assumed purchasing power parity and therefore abstracted from foreign exchange risk. Not surprisingly, therefore they arrived at a model that is effectively identical to the domestic CAPM, but with a world index instead of a domestic index. But one can still have integrated market with foreign exchange risk. They showed that there continues to be a single international CAPM that is universal for all companies irrespective of their domicile. However, it includes an equity risk premium and an inflation risk premium. The most important implication of these models is that expected returns on international assets are priced by a single international asset pricing model, so that expected returns are independent of the domicile of the company.  Many researchers have conducted tests of international financial integration using models of expected returns to test whether actual financial market returns are consistent with integration. The results are inconclusive. Some researchers find integrated international capital markets, others find evidence of segmentation.  Instead of providing a general test of the impact of international integration on asset prices, it may be productive to focus on indirect tests of integration.  Since the question of international integration is likely to be multidimensional, such tests might be expected to shed light on aspects of international finance that tests of international asset pricing may miss. An understanding of these more detailed dimensions of the international nature of the financial environment in which companies operate is important in dealing correctly with issues in corporate finance.