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

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  • DAVID C. PARSLEY
  • CHRISTIAN SCHLAG

Abstract

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.

Suggested Citation

  • David C. Parsley & Christian Schlag, 2007. "Measuring Financial Integration via Idiosyncratic Risk: What Effects Are We Really Picking Up?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 39(5), pages 1267-1273, August.
    • Handle: RePEc:wly:jmoncb:v:39:y:2007:i:5:p:1267-1273
    DOI: 10.1111/j.1538-4616.2007.00065.x
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    1. Flood, Robert P & Rose, Andrew, 2004. "Estimating the Expected Marginal Rate of Substitution: Exploiting Idiosyncratic Risk," CEPR Discussion Papers 4684, C.E.P.R. Discussion Papers.
    2. Chen, Zhiwu & Knez, Peter J, 1995. "Measurement of Market Integration and Arbitrage," The Review of Financial Studies, Society for Financial Studies, vol. 8(2), pages 287-325.
    3. Marshall, David A., 2005. "Comment on: "Estimating the expected marginal rate of substitution"," Journal of Monetary Economics, Elsevier, vol. 52(5), pages 971-979, July.
    4. Flood, Robert P. & Rose, Andrew K., 2005. "Estimating the expected marginal rate of substitution: A systematic exploitation of idiosyncratic risk," Journal of Monetary Economics, Elsevier, vol. 52(5), pages 951-969, July.
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    Cited by:

    1. Huang, Biqing & Wald, John & Martell, Rodolfo, 2013. "Financial market liberalization and the pricing of idiosyncratic risk," Emerging Markets Review, Elsevier, vol. 17(C), pages 44-59.

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