Measuring Financial Integration via Idiosyncratic Risk: What Effects Are We Really Picking Up?

• Published in: Journal of money, credit and banking Vol. 39; no. 5; pp. 1267 - 1273
• Main Authors: PARSLEY, DAVID C., SCHLAG, CHRISTIAN
• Format: Journal Article
• Language: English
• Published: Malden, USA Blackwell Publishing Inc 01-08-2007; Blackwell Publishing; John Wiley & Sons, Inc; Ohio State University Press
• Subjects: Arbitrage; asset; Bank credit; Bond markets; Credit; discount; Econometrics; Estimation; Estimation methods; Evaluation; Financial economics; Financial integration; Financial management; Financial research; Financial risks; G14; Idiosyncratic risk; Impact analysis; Integration; Linear regression; market; Measurement techniques; Parsley; Rates of return; Risk; Securities trading; Shorter Papers, Discussions, and Letters; stock; Stock exchanges; Studies; United States
• ISSN: 0022-2879; 1538-4616
• DOI: 10.1111/j.1538-4616.2007.00065.x

We study the method proposed by Flood and Rose (FR, 2004, 2005) for checking for financial integration by estimating the risk-free rate using the idiosyncratic component of individual stock returns. Performing simulations with data with a known return generation process, we find that the FR methodology produces poor estimates of the risk-free rate, and hence the FR method fails to accept integration when true. We then show analytically that the FR method actually provides an estimate of the market return, and conclude the FR methodology would also falsely accept integration as long as the market returns in the two markets do not differ widely.