Stock Market Liberalization and the Cost of Capital in Emerging Markets

Abstract

I study how stock market liberalization changes an emerging market's cost of capital.

I do so in a Lucas economy with two dividend trees. One dividend tree represents the emerging market's dividends while the other tree represents the dividends paid by all other countries. I solve for equilibrium asset prices in two versions of the economy. In the first version, stock markets are partially liberalized, because the emerging market's residents cannot invest in foreign stock markets. All other agents are unconstrained. In the second version, stock markets are fully liberalized, because there are no investment constraints. I show that moving from partial to full liberalization causes an increase in the emerging market's cost of capital and risk premium, despite better international risk sharing.

Keywords: international finance, stock market integration, continuous time, general equilibrium, incomplete markets

JEL Classification: D52, F36, G11, G12, G15