Transcription

1 bstract The aer ivestigates the imact of fiacial itegratio o asset retur, risk diversificatio ad breadth of fiacial markets. We aalyse a three-coutry macroecoomic model i which (i) the umber of fiacial assets is edogeous; (ii) assets are imerfect substitutes; (iii) crossborder asset trade etails some trasactio costs; (iv) the ivestmet techology is idivisible. I such a eviromet, lower trasactio costs betwee two fiacial markets traslate to higher demad for assets issued o those markets, higher asset rice ad greater diversificatio. For the coutry left outside the itegrated area, the welfare imact is ambiguous: it ejoys better risk diversificatio but faces a adverse movemet i its fiacial terms of trade. Whe we edogeise fiacial market locatio, we fid that fiacial itegratio beefits the largest ecoomy of the itegrated area. Oly whe trasactio costs become very small does fiacial itegratio lead to relocatio of markets i the smallest ecoomy. This aer was roduced as art of the etre s Globalisatio Programme Fiacial Itegratio ad sset Returs

2 Philie Marti ad HJlPe Rey March 2000

3 Series Editor: Graham Igham Published by etre for Ecoomic Performace Lodo School of Ecoomics ad Political Sciece Houghto Street Lodo W2 2E Philie Marti ad HJlPe Rey, submitted Setember ISN Idividual coy rice:,5

4 Fiacial Itegratio ad sset Returs Philie Marti ad HJlPe Rey. Itroductio 2. Model 3 3. Equilibrium Demad ad Suly o sset Markets 6 4. Welfare Imlicatios of Fiacial Itegratio 5. Edogeous Fiacial Market Locatio 0 6. oclusio 7 Refereces The etre for Ecoomic Performace is fiaced by the Ecoomic ad Social Research oucil

5 ckowledgemets We thak Richard aldwi, Pierre-Philie ombes, Zvi Eckstei, Olivier Jeae, Nobuhiro Kiyotaki, Peter Neary, Torste Persso, Diego Puga, Lars Svesso, Fabrizio Zilibotti as well as semiar articiats at the Istitute for Iteratioal Ecoomic Studies ad at ISOM for very helful commets. We are esecially grateful to Marco Pagao, Ke Rogoff, two referees ad a editor for may excellet commets ad suggestios. We also thak the Fodatio aque de Frace for fiacial assistace.

6 Fiacial Itegratio ad sset Returs Philie Marti ad HJlPe Rey Itroductio Trade i goods ad goods market itegratio have bee extesively studied. sset flows ad the imact of fiacial itegratio o the cost of caital ad the breadth of fiacial markets have bee comaratively far less researched. What are the imlicatios of beig art of a large ad fiacially itegrated area for risk sharig ad asset returs? I this aer, we show that whe (i) the umber of fiacial assets is edogeous, (ii) assets are imerfect substitutes, (iii) cross-border asset trade etails some trasactio costs, ad (iv) the ivestmet techology is idivisible; the size ad itegratio of fiacial markets are owerful determiats of the cost of caital. I articular, a decrease i trasactio costs betwee two fiacial markets (the way we model fiacial itegratio) icreases asset rices i the area, iduces agets to develo more risky rojects, icreases the umber of assets ad ushes owers of rojects to sell more of their roject o the stock markets so that diversificatio icreases 2. This haes because a declie i trasactio costs icreases demad for assets i the area ad so the effective size of the market is elarged 3. The resece of trasactio costs ad of imerfect substitutability traslates this size effect ito a rice effect 4. ecause the umber of assets is edogeous i our model, chages i the structure of fiacial markets also have a imact o the degree of icomleteess of fiacial markets ad o aggregate risk. What is the imact of regioal fiacial itegratio o the rest of the world? We show that whe two coutries form a fiacial bloc, the welfare imact for the rest of the world is ambiguous. O the oe had there is a ositive imact because the icrease i the total umber of assets eables agets to better diversify risk as markets become less icomlete. O the other had, the fiacial terms of trade of the coutry left outside the fiacial bloc deteriorate because the rice of assets i the itegrated area icreases. These results are corroborated by recet emirical studies o the cost of caital. Evidece surveyed i Stulz (a) shows that fiacial itegratio decreases the cost of caital. mog others, Hery (8) rovides a evet study of 2 liberalisatios ad fids stock abormal returs of 4.6% er moth o average i the 4 moths before ad the 3 moths after the liberalisatio date (with a total cumulative average retur of 36.8%). ekaert ad Harvey (8) estimate that liberalisatio decreases the divided yield by 5 to 0 basis oits. Hardouvelis et al. () fid that the average savig i the cost of caital from For a discussio o the imortace of these issues i the cotext of EMU, see Portes-Rey (8). 2 Pagao (3) also relates market size ad breadth. For models where asset rices ad liquidity (deth of a market, as oosed to breadth) are edogeised, see Pagao (88), (8). 3 These demad effects have bee documeted i the literature. Shleifer (86) ad Harris ad Gurel (86) showed that whe a stock jois the S&P500 idex, there is a immediate additioal demad which raises the rice of the stock by 3 to 4%. 4 I Marti-Rey (2000), we aalyse i detail the size effect o asset rices as well as welfare ad otimal olicy. We also itroduce a richer structure of trasactio costs.

7 itegratio i Euroe over the eriod 2-8 is aroud 2% 5. What haes to the geograhy ad the relative imortace of fiacial cetres whe we allow for iteratioal cross-listig of comaies? We show that a etrereeurs decisio to list o oe or several markets deeds o the relative sizes of the various ecoomies, as well as the relative magitudes of the fixed ad variable trasactio costs that he faces. Fixed costs ca be iterreted as differeces i accoutig rocedures, legislatio ad iformatio asymmetries across coutries. Variable costs ca be liked to roortioal commissios ad fees charged by various fiacial itermediaries, icludig foreig exchage trasactio costs, as well as other tyes of iformatioal asymmetries. The model delivers imlicatios for the rice of caital uder dual listig, which deeds o the relative size of ecoomies. These results are i lie with emirical evidece o cross-listig, as surveyed i, for examle, Karolyi (8). ross-listig is foud to be associated with a small but sigificat decrease i the cost of caital. Our model redicts a ositive effect o asset rice i the case of double (or trile) listig due to a demad effect. The ositive rice effect is stroger: the larger the ew fiacial area i which equities are issued; ad the higher the trasactio costs betwee the fiacial area where the stock was reviously issued ad the ew fiacial area. lexader, heol ad Jaakirama (88) study the effect of iteratioal listig o stock rices. They look at o-us firms, which get listed o the NYSE, ad fid a sigificat icrease i their rice. Whe they slit their samle ito aadia ad o-aadia firms, they fid that these effects are much weaker for the aadia firms tha for the others. This is what our model would redict if oe believes that aada s fiacial markets are relatively well-itegrated (low trasactio costs) with the US fiacial cetres comared to the other coutries. Miller () looks at Deositary Receits (DRs) 6 to estimate the imact of iteratioal cross-listig. ased o a samle of 8 firms from 35 coutries, he fids strog ositive rice effect of cross-listig. He also fids that the effect is larger i magitude whe the dual cross-listig takes lace with a large stock exchage (NYSE or NSDQ as comared to PORTL). Fially, our model redicts that the mai determiats of gross equity flows are the size of ecoomies ad the tradig ad issuig costs. This is also cosistet with the emirical evidece rovided i Portes-Rey (2000) about bilateral gross equity flows. s far as theory is cocered, the existig literature o trade uder ucertaity ioeered by Helma ad Razi (78) ad Svesso (88) has laced emhasis o comarative advatage 7. Size ad demad effects lay o role i the aalysis ad the set of assets traded is exogeously give. Gehrig (8) discusses the delocalisatio of fiacial cetres as cost of market access ad trasactio cost declie. He argues that the fragmetatio of iformatio is the key elemet layig agaist the cocetratio of fiacial activity. Therefore, small stock exchages will survive oly if they are good roviders of secialised local iformatio. Pagao (3) is the oly theoretical aer we kow of which edogeises the breadth of fiacial markets. He models very elegatly the flotatio decisios of comaies o the stock market. His aalysis, which relies o a tradig exterality, differs from ours o several dimesios: i his model, the amout of shares traded is edogeous, but ot the risky 5 From the theoretical side, Vayaos (8) studies the imact of a decrease i trasactio costs i a OLG, ifiite horizo model. He shows the existece of two off-settig effects: o the oe had, sice the reset discouted value of future trasactio costs declies, asset rice rises. O the other had, stocks are held for a shorter time, so i equilibrium the margial ivestor holds more of them ad requires a higher risk remium, i.e. a lower rice. 6 DR is a certificate issued by a deositary bak for o-us securities that are held by a custodia i the home market of the o-us. DRs trade like ay other US security. 7 Persso ad Svesso (8) ad Svesso (8) itroduce moey ad discuss the imact of moetary olicy o omial asset trade.

8 ivestmets themselves; he looks exclusively at a closed ecoomy eviromet; moreover the ay-off structure of the assets, as well as the trasactio costs structure are differet from ours 8. More closely related to our modellig aroach is the work of cemoglu ad Zilibotti (7), which builds o a market structure (edogeous umber of rrow-debreu rojects) similar to ours, excet that it is embedded i a cometitive eviromet while we have elemets of mooolistic cometitio. They focus exclusively o caital accumulatio ad growth, ad the issue of fiacial market itegratio is left aside. Ulike them, we emhasise the iteractio betwee the icomleteess of markets, the size of markets ad the rice of fiacial assets i a iteratioal eviromet. We reset the model i Sectio 2. Sectio 3 derives the equilibrium demads ad sulies o asset markets. Sectio 4 aalyses welfare imlicatios of fiacial itegratio i a three-coutry world. Edogeous locatio decisios (cross-listig) are studied i Sectio 5, as well as the imact o market caitalisatio of a decrease i trasactio costs ad of istitutioal harmoisatio withi the itegrated area. Sectio 6 cocludes. 2. Model The geeral framework is similar to Marti ad Rey (2000) where we aalyse a two-coutry versio, albeit i a more geeral set-u. Here, we exted the model to a set of three coutries,, ad, so as to study the imact of fiacial itegratio i a subset of two of these coutries. Physical eviromet ad timig outries are oulated with j, j {,, }, risk averse immobile idetical agets where the subscrit idetifies the coutry. The model has two eriods. I the first eriod all agets i the world are edowed with y uits of a freely traded good (the uméraire) which they ca choose to cosume or ivest i fixed size risky rojects. Durig the secod eriod, Nature chooses betwee N equally likely states. M differet rojects are develoed with the followig secod eriod ay-offs: d if state i roject i ays 0 otherwise N occurs Shares of these rojects are traded o the stock markets of the three coutries. This imlies that ivestig i a secific roject (either directly or through the stock market) is equivalet to buyig a rrow-debreu asset that oly ays i oe state of ature. This formalisatio is close to the oe develoed by cemoglu ad Zillibotti (7). It catures a essetial feature of the model: differet rojects ad assets are imerfectly correlated so that assets are imerfect substitutes ad variety imroves safety. The fixed size ivestmet rojects are equally costly to develo ad give the same divided d. aget h j {, j } chooses to develo z hj differet rojects. The choice of the rojects is ublic kowledge. This imlies that M, the 8 as Lombardo ad Pagao () model the imact of differeces i legal eviromets o the breadth of fiacial markets ad o asset returs. The correlatio betwee our assets is. We cojecture however that our qualitative results are valid log as there are trasactio costs ad imerfect substitutio betwee assets, i.e. their correlatios is strictly less tha.

9 total umber of rojects (ad assets) i the world is: h z h h z h h z h because, i equilibrium, agets will have o iterest i dulicatig a roject that has already bee develoed ad all agets of a same coutry will develo the same umber of rojects. Deote by M j the set of rojects that have bee develoed i each coutry j so that the total umber of assets i the world is M M M M. We will restrict arameters so that M < N: markets will ot be comlete. It will ot be ossible to elimiate all risk by holdig a ortfolio of all traded assets because for some states of the world, a corresodig asset will ot exist. Hece the matrix of the ay-offs will be the followig: dι ON M M, M O O M, N M N M, N M where I M is the idetity matrix of rak M ad O I,J is the ull matrix with I rows ad J colums. The cost of each ew roject is icreasig with the umber of rojects a aget is erformig because we assume that the moitorig of each roject becomes more comlex ad costly as the umbers of rojects icrease. Hece, the total cost i uits of the uméraire of the ivestmet i risky rojects of a aget h j is f(z hj ), where f' ad f >0 0. There is o restrictio to develo ew rojects ad this will determie the equilibrium umber of rojects ad therefore the equilibrium umber of assets. I additio, durig the first eriod, agets sell shares of their rojects ad buy shares of other rojects. Trasactio costs The secod essetial feature of the model is the resece of iteratioal trasactio costs o asset markets. Whe agets trade assets, they icur a trasactio cost τ, which is aid i uits of the share itself whe the share is traded. The same trasactio cost also alies to the stochastic divided ad is aid i uits of the divided. The trasactio cost is modelled as a iceberg cost: art of the share ad art of the divided melt durig the trasit. The resece of iteratioal trasactio costs o the trade i assets catures differet tyes of costs: () bakig commissios ad variable fees; (2) exchage rate trasactio costs; (3) exchage rate chages related risk that is costly to isure; (4) some iformatio costs 2. I this first sectio, where the geograhy of fiacial markets is give i order that roject develoers sell their assets o their atioal stock markets oly, we assume that agets who buy foreig assets have to bear the trasactio cost. Hece, the cost of a asset of a roject develoed i coutry j ad bought by a aget of coutry k is: j ( τ kj) where τ kj is the trasactio cost betwee markets of coutries k ad j. We call s the demad by a aget i j h 0 Theoretically f is defied o ø. However we will study the extesio of f o œ to be able to use derivatives ad simlify the exositio. We will the restrict the set of the solutios of the otimisatio roblem to belog to ø. We assume that these trasactio costs caot be evaded by goig through the goods market o which, for coveiece, we assume o trasactio costs. The trasactio cost could be elimiated either o the urchase of assets or o the divideds without chagig ay of our qualitative results. 2 Later o, we cosider also fixed costs, which could accout for differece i regulatios ad accoutig riciles as well as for other tyes of iformatio costs.

10 of a asset of coutry j. I the rest of the aer, suerscrits will idetify the seller ad subscrits the buyer. If this articular asset ays a divided d i eriod 2, the a shareholder i the foreig coutry will receive oly (-τ)d er share. udget costrait The budget costrait for a aget h i coutry is: i j j ish ( τ ) jsh ( τ ) j sh y k k c h f ( zh ) h α () h M i zh M j where c h is cosumtio of aget h i eriod. The secod term o the left-had side is the cost of ivestmet i risky rojects. The last terms o the left-had side rereset the demads for domestic ad foreig assets. There are (M - z h ) differet domestic assets that aget h demads as he will oly buy assets of rojects he has ot develoed himself. There are (M- M ) differet foreig assets o which he icurs the trasactio cost τ ad τ. O the reveue side, i additio to edowmet y, aget h sells a ortio M j α k h z h k of each roject k z h that he has develoed. The budget costrait of agets i coutries ad are symmetric. Prefereces The utility of a aget h i coutry has the followig form: U h c h / c 2h βe / (2) where β is the rate of discout of the future ad s is bigger tha oe 3. The utility of agets i coutries ad are similar. is the iverse of the degree of risk aversio. It is also the elasticity of substitutio betwee assets. The state of the world is revealed i the begiig of the secod eriod. gets maximise exected utility uder their budget costrait. get z h i coutry chooses cosumtio i eriod, c h, the umber of rojects z h he will develo, the demads for the differet assets (domestic ad foreig) ad the ortio of each of his rojects that he will k retai i the secod eriod: for each roject/asset k z h. gets are rice takers α h whe they buy shares o the stock market. Note also that agets do ot iteralise the imact they have o other agets' welfare whe they otimise. I articular, they do ot iteralise the imact that the choice of the umber of rojects er aget has o the ossibility for other agets to diversify risk 4. The fixed cost that is required to develo a ew roject also isures that o aget will ever fid otimal to relicate a already existig roject. The reaso is that if he were to do so, the suly of the corresodig asset would ecessarily icrease so that its equilibrium rice would decrease. It will therefore be more rofitable to develo a roject that has ot yet bee oeed. 3 I Marti ad Rey (2000), we discuss more geeral utility fuctios. The liearity of the utility fuctio i the first eriod suresses wealth effects while keeig the mai isights of the model. 4 This is similar to Pagao (3).

11 Market structure Note that each aget has a otetial ower of moooly o the rojects that he has develoed ad therefore o the sale of the assets that corresod to these rojects. This is a dearture from the rrow-debreu world where asset markets are assumed to be erfectly cometitive. It is easy to check that the erceived elasticity of demad for ay asset k with resect to its rice is: ( α k / k )/(α k / k ) -, k M. The ower of the asset will use this mooolistic structure ad will sell oly a ortio of his roject. This meas that i equilibrium the develoer of the roject will remai the largest shareholder of the roject. ecause all agets i a same coutry are idetical ad the rojects are symmetric, the demad for assets of a give coutry by agets of the same atioality will be symmetric. Eve though agets, i equilibrium, will ot be idetical because they will hold differet amouts of the differet assets, they will be symmetric i the sese that their diversificatio choice will be idetical. lso, the rice of all rojects/assets develoed by agets of a same coutry will be idetical for the same reaso. Hece, from ow o we will geerally omit otatios that refer to the idetity of the agets ad of the assets. s for the demad for assets, the suerscrit deotes the origi of the asset ad the subscrit deotes the atioality of the buyer. For examle, s is the demad for a asset of coutry by a aget of coutry. Usig the first order coditios for a aget i the demad for differet assets are give by: τ τ β τ τ β β α ) ( ) ( ) ( ) ( ; ) ( / / / d N s ; d N s d N s (3) The demad by agets i ad are symmetric. Note that the first equatio imlies that there is ot full diversificatio eve of the domestic ortfolio. gets kee more of their ow roject tha they buy of rojects develoed by other agets i the same coutry as: s α <. This is due to imerfect cometitio o the asset market as roject owers have a icetive to retai some ortio of it to exloit their mooolistic ower. This imlies that i equilibrium rojects have a atioality: oe aget ows more of the roject tha ay other aget i the world. The two last lies imly that the demad for assets decreases i rice ad the demad for foreig assets decreases i the trasactio cost. 3. Equilibrium Demad ad Suly o sset Markets Usig first order coditios ad the equilibrium coditio o the market for each asset, we ca derive the ortio of shares of the rojects that are sold o the differet stock markets: α α α ; (4)

12 where τ the three coutries are: ij ij, τ ij ; i, j, ad is decreasig i trasactio costs. The asset rices i β d N β d N β d N / / / / / / (5) Sice there is free etry i the market of ivestmet rojects, each aget will develo rojects u to the oit where the margial cost is equal to its rice: f '( z ) ; f' (z ) ; f' (z ) (6) ecause of the covexity of the cost fuctio, the umber of rojects develoed by a aget icreases with the rice of assets 5. Note that ulike Pagao (3), we do ot have multile equilibria. This is because the margial utility of beig isured agaist oe state of ature ad therefore the rice of a asset i our model is ideedet of the umber of existig assets. Hece agets decide whether or ot to develo a roject ideedetly of the decisios of other agets. Moreover, sice there are o issuig costs, they ca oly be better off by sellig their asset o the market. d sice urchasers of assets, ulike i Pagao s model, do ot face a fixed cost to gai access to the market, there are o strategic comlemetarities. If we iterret fiacial itegratio as a decrease i trasactio costs betwee two coutries, we ca aalyse its imact by simle comarative statics. For examle, the decrease i trasactio costs betwee markets ad have a ositive imact o rices α α ( > 0 ; > 0 ) ad fiacial diversificatio ( > 0 ; > 0 ) i those two coutries. oth rice ad fiacial diversificatio i are uaffected by fiacial itegratio betwee ad. It is also easy to check that the rice elasticity with resect to a chage i trasactio costs is higher i the small coutry tha i the large coutry. The icrease i the asset rices of the fiacially itegrated area iduces agets of the zoe to develo more risky rojects i order that the umber of assets offered will also icrease. For each roject, the ortio sold o the stock market will icrease. Hece, turover o fiacial markets i the bloc should icrease ot oly because some ew rojects will be floated but also because owers of existig rojects will choose to icrease ortfolio diversificatio ad sell more of their ow rojects. The ituitio of these results is best uderstood by aalysig the determiats of suly ad demad of assets i our framework. The choice of the ortio of each roject which is sold o the market (α) is derived from first order coditios: agets set the margial cost of doig 5 z 0 ø so the equilibrium z is defied as the biggest iteger such that f (z)#.

13 this equal to the margial gai (the Lagragia is equal to because of liearity of utility i first eriod) so that:,, i d N i i ) ( / / α β (7) The exected margial cost of sellig oe more share of the roject develoed by the aget is the exected welfare loss due to cosumtio thus foregoe (left had side of the equatio). Note that because of the cocavity of exected utility i cosumtio ( ositive), this margial cost is aturally risig with the ortio of the roject sold. The margial gai is less tha the rice of the asset as a icrease i the suly of the asset imlies a decrease i its rice. t the otimum, the rice of a share is equal to its margial cost multilied by the mark u /(-). The aggregate demads for a tyical asset of each coutry are the followig: ) ( ) ( ) ( / / / N d N d N d β α β α β α (8) They are decreasig i rice ad also i trasactio costs. Hece, fiacial itegratio betwee markets ad (a icrease i ) iduces agets of to demad more of assets of ad vice versa. We ca aalyse the effect of fiacial itegratio o a simle grah where the suly ad demad of a tyical asset are illustrated. I this examle, we assume that the three coutries are iitially idetical i size ad degree of fiacial itegratio:

14 Grah : fiacial itegratio, asset rice ad diversificatio margial cost (M) ad rices rice M /(-) M demad for assets of ad after fiacial itegratio demad for assets of, ad before fiacial itegratio α Fiacial itegratio imlies a shift i the demad curve so that i equilibrium it leads to icreased asset rices i ad ad to icreased fiacial diversificatio (the ortio of a tyical ivestmet sold o the market) i these two coutries. The result comes from two essetial features of our model. First, the existece of trasactio costs betwee markets with a segmetatio effect that gives a role to local demad i the determiatio of asset rice. Secod, the assumtio that assets are imerfect substitutes or that agets are risk averse. I our model, this turs out to be the same because the elasticity of substitutio betwee assets is the iverse of the degree of risk aversio. Without risk aversio, there would be o ortfolio diversificatio, o demad for foreig assets ad fiacial itegratio would have o imact. 4. Welfare Imlicatios of Fiacial Itegratio We ow wat to aalyse the imact of reducig trasactio costs betwee markets ad o the welfare of coutries, ad 6. Idirect exected utility for a aget i coutry is give by: U y z / β d N / α f ( z ( ) zs zs ) ( / / ( τ z ) z ) / s / s z ( τ ( τ ( α ) / ) / ) z s ( τ ) z s () The idirect utilities of ad are symmetric. ecause the rice of assets i ad the demad for assets i are ot affected by the chage i the trasactio costs betwee ad 6 too I Marti ad Rey (2000), we aalyse the market failure that exists i this model due to imerfect cometitio o the asset market ad also due to the exterality i the choice of the umber of rojects er aget. We show that i the market equilibrium, the rice of assets is too high, the diversificatio low as well as the umber of rojects er aget.

15 , it is easy to show that the welfare i rises with a decrease i trasactio costs betwee ad if this is the case for the followig exressio: z f ( z ) ( α ) z ( ) z (0) It ca be show that this exressio is icreasig i, ad therefore welfare i icreases with fiacial itegratio. There are three tyes of gai for the agets who are art of the fiacially itegrated area. () The value of assets held by agets i rises relative to the rice of assets i ad so there is a ositive fiacial terms of trade effect for agets i. (2) ecause the rices of assets i ad rise, the total umbers of assets rise as agets i the fiacially itegrated area are iduced to ivest i more risky rojects. This reduces risk at the world level ad is beeficial for all agets. (3) Fially, there is a direct effect due to the fact that the cost of diversifyig risk ad buyig assets i has decreased. This beefit is greater whe the umber of assets offered o the stock market of is larger. It ca be show that the ositive welfare effect of the decrease i trasactio costs is larger for the smallest coutry. The imact of fiacial itegratio betwee ad o the welfare of agets i is ambiguous. I the simle case where ad are idetical, it ca be show that welfare i icreases i if the followig exressio also icreases i : z. The coditio for this to be the case is: f '( z ) ( ) z f ' '( z ) > 0 which imlies: z z > () This coditio imlies that the elasticity of the umber of rojects develoed with resect to the rice of shares must be large eough for agets i to gai from fiacial itegratio betwee ad. There are two oosite effects of fiacial itegratio that exlai this result for. O the oe had, coutry suffers from a egative fiacial terms of trade effect as agets i must ow ay a higher rice to diversify risk whe buyig assets from ad. O the other had, the icrease i asset rices i the fiacially itegrated area iduces agets of the area to develo ew risky rojects. This roduces a ositive exterality for all agets as they ca better diversify agaist risk. This ositive effect is larger whe the elasticity of z with resect to the asset rice is higher. Whe is high relative to this, the demad for assets resods a lot to chages i rice so that the loss due to the terms of trade deterioratio is imortat. It also imlies that because agets are ot very risk averse the gai due to the higher umber of assets i the world is ot very large. 5. Edogeous Fiacial Market Locatio Our model ca be used i articular to thik about the imact of fiacial itegratio o fiacial markets locatio. The followig questios have come u i Euroe o this issue: will Lodo or Frakfurt gai or lose fiacial activities because of fiacial itegratio ad the creatio of the euro 7? Will the decrease i trasactio costs imly that eriheral firms cease issuig their assets i eriheral fiacial cetres ad if so will this agglomeratio 7 We iterret the creatio of the euro as a heomeo decreasig variable costs liked to foreig exchage trasactios. The euro is also a catalyst for cocetratio ad cost cuttig i the fiacial idustry. lthough it could be argued that the birth of the euro also icreases the substitutability of

16 heomeo beefit a large outside market such as Lodo or a isider such as Frakfurt? If we thik of coutry as the UK, coutry as Germay ad coutry as all other coutries i the euro zoe, we ca use our model to aalyse these questios. Most of the results of this sectio will deed o the relative magitudes of the fixed ad variable costs that agets icur i the various coutries to get listed o stock exchages or to egage i equity trade. We will show i articular that if fiacial itegratio imlies a decrease i variable trasactio costs, the it should icrease the icetive to issue shares o the largest market of the itegrated area: Frakfurt would gai market share at the exese of other markets outside the euro zoe ad also at the exese of other markets i the euro zoe. ut if fiacial itegratio iduces istitutioal harmoisatio (a decrease i the fixed cost of issuig abroad withi the itegrated area), the the icetive to issue shares o both markets of the itegrated area, icludig the smallest oe, icreases. I the extreme case where the fixed cost of issuig i a foreig market disaears etirely iside the itegrated zoe as well as trasactio costs iside the zoe, the locatio of the fiacial market iside the zoe is idetermiate. Fixed costs, variable costs ad edogeous listig decisios U to ow, we have assumed that agets issue assets i their ow coutry oly. system where they ca issue assets i the other coutry ad ay the trasactio costs themselves would be idetical as the trasactio cost would be fully assed to asset buyers. Hece, to make the questio of edogeous market locatio iterestig i this model we eed to itroduce some ew elemets. First, we assume that there exists a fixed cost of issuig a asset o a market, which is equal to F o all three markets. It does ot deed o the amout of shares sold, just o the umber of assets issued. Secod, there is a extra fixed cost c, that the issuer must ay if he issues the asset o a foreig market 8 Therefore, the fixed cost if he issues oly o his ow market is F er asset issued. The cost is Fc er asset if he issues oly i a foreig market, 2Fc er asset if he issues o the domestic ad oe foreig market ad 3F2c if he issues o all three markets. I this latter case, buyers ay o iteratioal trasactio cost. The fixed costs are aid i uits of y. I this sectio, we assume that coutry is a large coutry, coutry a medium sized coutry ad coutry a small coutry ( > > c ). We look at the imact of decreasig trasactio costs betwee ad o the locatio(s) roject owers choose to issue their assets. The decisio o which market to issue assets will be based o the comariso of rofits a roject ower gets (the comariso i terms of idirect utility is idetical). Project ower of coutry We first look at the choice of a roject ower i coutry. It is easy to show that such a aget will ever choose to issue his assets oly i market or i markets ad. I this cotext, a small coutry ca ever become a fiacial cetre. The reaso is that i additio to the extra cost of issuig i a foreig coutry, the small domestic demad i is a disadvatage due to the resece of iteratioal trasactio costs. For the small market to become a fiacial cetre, such as a off-shore fiacial cetre, it would eed to attract issuers by offerig a smaller fixed cost F tha the large markets. I this case, the lower the iteratioal trasactio costs the 8 to assets, this is ot the lie we take here. This cost reflects i articular the chages i accoutig stadards ad rocedures, which are required list o other stock exchages. The comliace to the GP for istace is a major fixed cost for o US comaies wishig to be listed o the NYSE.

17 greater the ossibility that small coutries with low fixed costs of issuig assets will become fiacial cetres. Hece, the relevat alteratives for are to issue i all three markets (, ad ), to issue i both ad ad to issue i oly. The rofit of issuig i market is: z f ( z ) F z z f '( z ) f ( z ) ; f '( z ) F (2) where is give i equatio (5). ecause of the fixed cost, z here is smaller tha i the revious sectio. Note that the rofit of issuig i oly does ot deed o trasactio costs betwee markets ad. If this aget was to issue o markets ad, the rofit would be: z f ( z ) 2Fz c f '( z ) z f ( z ) ; f '( z ) 2F c (3) where is the rice of a asset issued o markets ad ad is give by: β d N / / (4) This is because demad for the asset will be higher, as agets i will ot ay trasactio costs o the asset which is issued locally. lso, if trasactio costs betwee ad are lower tha betwee ad (which resumably will be the case with fiacial itegratio betwee ad ), the demad for the asset from agets i will also be higher. Hece, z i equatio (2) is differet from z i equatio (3). Fially, i the case where a aget i issues assets o all three markets, the rofit is: z f ( z ) 3Fz 2c f '( z ) z f ( z ) ; f '( z ) 3F 2c (5) He would the sell his asset at the highest rice ossible as demad for the asset i this case is at its maximum give the absece of trasactio costs: β d N / / (6) Proositio : s trasactio costs betwee ad decrease, firms i coutry will have a icreasig icetive to issue assets i, the largest market of the zoe. This will be at the exese of either or. Proof: It is immediate to see that the rofit Π(z)f (z)z-f(z) of a aget is icreasig i z. The umber of rojects z is itself a icreasig fuctio of the rice of the assets. Therefore, sice decreasig the trasactio costs betwee ad leaves ad costat but icreases, the icetive to issue o market icreases, as fiacial itegratio betwee ad roceeds. omarig rofits obtaied i (2), (3) ad (5), a aget located i will choose to issue his assets o all three fiacial markets if trasactio costs betwee the three markets are high relative to the fixed costs F ad c. I this case, because of market segmetatio, the rice differece will be high ad therefore the icetive to issue o differet markets will be strog. Of course, this icetive will also be stroger, whe the foreig market is larger ad whe there is greater foreig demad for the assets ivolved (the higher ad ). Whe trasactio costs betwee markets ad ad ad are relatively low, the assets of will oly be issued i. However, as trasactio costs betwee ad decrease with fiacial itegratio, the

18 icetive to issue i ad icreases because issuig i eables the roject ower of to sell with low trasactio costs to agets i. Hece, fiacial itegratio favours the fiacial markets of the largest coutry i the itegratig area. The geograhical cocetratio of fiacial activities as trasactio costs decrease ca be illustrated by a umerical examle i the Grah 2 below. I this examle, because fixed costs are relatively high, there is ever a icetive to issue o all three markets. If the fixed costs were lower, the as trasactio costs betwee ad decrease, issuers of would at some oit sto issuig o all three markets ad issue oly i ad. Grah 2: rofits of a aget i ad fiacial geograhy 0,234 rofit 0,232 issues i ad issues i 0,23 0, ,005 0,0 0,05 0,02 0,025 0,03 trasactio costs betwee ad Project ower of coutry I the case of a roject ower i, we ca readily exclude the choice of issuig oly i (domiated by issuig i oly) or issuig i ad (domiated by issuig i ad ). This leaves five alteratives - issuig i all three markets, i ad, i ad, i oly ad i oly. Proositio 2: Lower trasactio costs betwee ad icrease the icetive for firms i to issue shares o their ow fiacial markets or i market for some iitial coditios. This is doe at the exese of market ad, for some iitial coditios, of market. Proof: The rofit fuctio is icreasig i z ad z is icreasig i the rice of assets (see roositio ). P,, are ideedet of the trasactio cost betwee ad, whereas ad are icreasig whe this trasactio cost is reduced. Grah 3 below shows a examle 20 of how the rofits of a roject ower i chage with trasactio costs betwee ad. o 20 Grah 3: rofits of a aget i ad fiacial 0,235 geograhy The umerical simulatio is such that: y 0, 00, 500, 300, τ τ 0., 3, β 0., d 000, N 50000, f 0.5 m z 2 issues i, m 0.00; ad F 0.000, c We have checked that i equilibrium, markets are icomlete i all cases. For more clarity, oly the relevat cases are draw rofit 0,23 the grahs. issues i issues i The same arameters are used as i Grah 2. Note that the scale is differet from Grah 2. 0,225 0,22

19 I this secific examle, roject owers i issue i whe trasactio costs betwee ad are high. This is because that i this case the segmeted fiacial markets are too small (ad therefore the rice of assets is low), ad it is referable to issue oly o the largest market. Whe trasactio costs betwee ad are sufficietly small, followig fiacial itegratio betwee these two markets, the it becomes rofitable to issue i ad. ecause issuig i ow imlies reachig asset buyers i at low trasactio costs, the demad is large eough i the itegrated area to sustai the fixed costs of issuig i both ad. We could also move from a situatio where agets from coutry issue oly i market (because trasactio costs betwee ad ad ad are relatively low, comared to trasactio costs betwee ad ; ad the fixed cost of issuig abroad is ot too high), to a situatio where they issue i (because of a sizeable decrease i trasactio costs betwee ad ). I that case the caitalisatio of market would decrease. lteratively, if agets i were issuig i ad ad ot i (because of high trasactio costs betwee ad ad betwee ad for examle), the icreased itegratio betwee ad ca lead them to issue i ad ad sto issuig i. Other cofiguratios are ossible where for examle fiacial itegratio betwee ad lead roject owers of to switch issuig from to, from, ad to or from ad to. Project ower of coutry The choice of where to issue assets for a roject ower i (the small coutries of the euro zoe i the Euroea case) is greater ad therefore more comlex. I all cases, fiacial markets i gai at the exese of markets either i, i or i both ad. Proositio 3: There are seve ossibilities for agets of coutry to issue their assets. Whe fiacial itegratio betwee ad roceeds, the icetives to issue i oly, i oly, i ad ad i ad icrease relative to issuig i, ad, i ad ad i oly. Proof: Whe the trasactio costs betwee ad decrease,,,, icrease whereas,, ad are costat. The ituitio of the results is relatively straightforward: () whe trasactio costs are high relative to fixed costs ad the demad i coutry is ot too small, the agets from coutry refer to issue shares o all markets or at least o market ad i oe other market. This is because fiacial geograhy miimises the trasactio costs; (2) whe trasactio costs betwee ad are i a medium rage relative to fixed costs, the agets from coutry will refer ot to issue ay more i market. I this case, trasactio costs still matter so that it is referable to issue i the largest market(s) but the fixed cost becomes relatively imortat so

20 that it is referable to issue o fewer markets ad abado the smallest (); (3) whe trasactio costs are i the low rage ad the fixed cost of issuig o a foreig market is large eough (as well as the domestic demad for these assets i coutry ), the agets i coutry will refer to issue oly i coutry or i ad. The reaso is that ow, the fixed costs are relatively the highest oes. If issuig i still has a advatage for roject owers of, because of the absece of the foreig fixed cost, the very low trasactio costs make this advatage the key determiat of locatio choice. This equilibrium may ot exist eve with very low trasactio costs if the extra fixed cost to issue o the foreig market is small. Hece, i the case of the smallest coutry, fiacial itegratio has ambiguous effects o the issuig choice. Lower trasactio costs first ush towards a cocetratio of issuig o the largest market of the itegrated area but the may give a advatage to the small market ad the largest market eve if outside the itegrated area. Note that this atter is similar to the oe suggested by the "ew ecoomic geograhy" i Krugma () i the cotext of the itegratio of goods markets. Grah 4: rofits of a aget i ad fiacial geograhy 0,227 issues i rofit 0,225 issues i ad issues i 0,223 0,22 0 0,005 0,0 0,05 0,02 0,025 0,03 trasactio costs betwee ad Grah 4, usig the same arameters as the revious grahs, illustrates oe examle of how trasactio costs betwee ad affect the choice of locatio i issuig for agets i. I this examle, whe trasactio costs betwee ad are relatively high, shares are oly issued i. The as trasactio costs betwee ad decrease, shares will be issued i both ad markets. This is because ad are ow effectively a large market. s trasactio costs go dow further, the markets of ad are basically the same market so that the size advatage of does ot matter ay more. I this case, issuig i becomes referable to issuig i ad because it elimiates the cost of issuig shares i foreig markets. Market caitalisatio Fially, we ca describe i this secific examle how market caitalisatios evolve with fiacial itegratio betwee ad. We defie market caitalisatio i this model as the value of sales of shares o the market. The aalysis of market caitalisatio follows directly from the issuig decisios studies above. For examle, we see i Grah 5 that as trasactio costs betwee ad decrease, market caitalisatio i decreases first whe (at τ 0.08) shares are issued i both

21 ad markets. Market caitalisatio i the icreases a little. t τ 0.075, shares are sold o market ad market (where agets from buy them) ad shares are sold both o markets ad. This imlies that market caitalisatio icreases i ad decreases i. t τ 0.007, shares are o loger issued o markets ad but are issued o. t that oit market caitalisatio icreases i ad decreases i ad. Grah 5: market caitalizatios ad trasactio costs market caitalizatios market caitalizatio of market caitalizatio of market caitalizatio of 0 0,02 0,04 0,06 0,08 0, trasactio costs betwee ad I this examle, fiacial itegratio will beefit the largest market of the itegratig zoe at the exese of the coutry left out of the rocess. I other examles, this beefit could be at the exese of the smallest market of the itegratig zoe. I all cases, small markets may beefit from fiacial itegratio but oly at very low levels of trasactio costs.

22 Fiacial itegratio as a decrease i c withi the itegrated area Fiacial itegratio could also be iterreted as a decrease i the fixed cost of issuig o the other market. This could be due to harmoisatio of istitutioal structures. For examle, itegratio may lead to harmoisatio of accoutig stadards i coutries ad. With this iterretatio i mid, we assume that if agets from coutry (resectively ) issue shares i coutry (resectively ), the fixed cost c of issuig o the other market decreases. Similarly if agets of coutry issue i, they ay a lower cost c if they issue also i. Proositio 4: Whe fiacial itegratio betwee coutries ad lowers the fixed cost of issuig o the other market, agets of coutry (resectively ) have a higher icetive to issue shares i (resectively ); ad agets of coutry have higher icetives to issue both i ad i. Proof: Profit is a icreasig fuctio of z, the umber of assets. d z is a icreasig fuctio of the rice of assets mius the fixed costs of issuig (Fc if oe issues i a foreig market). Therefore whe c decreases (which haes if issues i, i, or issues i ad ), the issuig i the itegrated coutries becomes more rofitable. Hece with this alterative iterretatio of fiacial itegratio as istitutioal harmoisatio, both coutries of the itegrated area may beefit, icludig the smallest market. oclusio We have costructed a very stylised model of trade i risky assets. We have studied the imact of fiacial market itegratio o the breadth of fiacial market ad asset returs i a threecoutry world. I articular, a decrease i trasactio costs betwee two fiacial markets - the way we model fiacial itegratio - icreases asset rices i the area, iduces agets to develo more risky rojects ad icreases the umber of assets. It also ushes owers of rojects to sell more of their roject o the stock markets so that diversificatio icreases. The welfare imact for the rest of the world is ambiguous: agets ca diversify risk better as markets become less icomlete but their fiacial terms deteriorate because the rice of assets i the itegrated area icreases. We have also looked at the imact of iteratioal cross-listigs o the rice of caital ad at the evolutio of the geograhy of fiacial cetres as trasactio costs declie. The relative magitudes of the fixed ad variable costs that agets icur to get listed o stock exchages or to egage i equity trade are the key determiats. Fiacial itegratio icreases the icetive to issue shares o the largest market of the itegrated area. Deedig o the iitial coditios, the outside market, if large eough, may also attract ew issuigs of firms of the itegrated area. Existig emirical evidece, as discussed i the itroductio, is cosistet with our fidigs. Fiacial itegratio decreases sigificatly the cost of caital, ad demad effects o the rice of assets have bee documeted. The volumious literature o iteratioal crosslistigs is also cosistet with the redictios of our model. Moreover, as far as we kow, our model is the oly oe able to exlai reasoably well the atter of gross equity flows. We are ot claimig, however, that our class of models is the oly oe cosistet with those emirical facts. It would be very iterestig to go o comarig the erformace of our modellig aroach to the erformace of more traditioal models: the most likely cadidate would robably be some extesios of the iteratioal PM with iformatio asymmetries followig Merto 87 or rea ad ao 7, for examle. The questios we address i this aer have however bee greatly overlooked by traditioal fiace literature which has almost exclusively focused o rices ad stocks, rather tha flows. Market icomleteess ad trasactio costs, o-reresetative agets ad aggregate risk, which emerge very aturally i

23 our framework are also o-orthodox igrediets of classic fiace ad macroecoomic models.

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