Cost of capital changes from financial market liberalization and integration

¶ … capital fall if financial markets are no longer segmented? What evidence is there of this effect?

Up until the mid-1940's markets where knows to be restrictive in cash flow movement, this in combination with tax and transactional barriers on ownership by foreign entities meant that equity markets were not developed. They were in fact marked with low liquidity, not enough regulation and inconsistent disclosures.

If capital markets are segmented, then investors can only invest domestically. This means that the market portfolio (M) in the CAPM formula would be the domestic portfolio instead of the world portfolio.

This equilibrium had banks, securities market and capital markets as the primary source of finance. The localized source of finance meant that domestic investors were they only players in the market with most shares, resulting in high cost of capital.

1970's brought on the liberalization of markets in the developed countries which resulted in the eradication of all financing barriers. Portfolio investors began take on a risk sharing role to match the returns on their investment, and the debtor's ability to pay.

All decisions to invest in an emerging market depends on future expectation of the asset pricing when the liberalized stock market opens and shares are traded. Here the expected asset price can also be interchanged with inverse cost of capital. It determines whether investments will be profitable.

Foreign portfolio Investment involvement in the capital markets around the globe meant that risk sharing was spread and cost of capital fell.

The impact on equity premium due to stock market integration is proportional to the variance of the country's aggregate cash flows. Liberalization aids the economy towards more integrated and the equity premium becomes proportional to the covariance of its aggregate cash flows with the global portfolio. Now when we observe domestic prices of risk which is the variance excels the covariance (global risk price) as result the equity premium falls.

Gordon's Dividend growth model suggests the estimated cost of capital depends on the expected dividend growth at the time of integration. In essence the growth rate at that period is crucial to the analysis.

A segmented market has returns which are high due to the high risk premium.

Measuring changes in cost of capital is no easy task as suggested by Stulz (1997), esp. In markets currently experiencing emergence. More so because liberalization is a long process and difficult to set a start or end date. Studies by Bekaert and Harvey (1998) and Henry (1998) in order to counter it, used prolonged observation periods to measure cost of capital during the liberalization.