and Jason Zweig for useful conversations and to Lipper Analytical Services for data on Texas municipal bond funds. Familiarity Breeds Investment by

We explore a new panel data set on bilateral gross cross-border equity flows between 14 countries, 1989-96. We show that a “gravity ” model explains international transactions in financial assets at least as well as goods trade transactions. Gross transaction flows depend on market size in both source and destination country as well as trading costs, in which both information and the transaction technology play a role. Distance proxies some information costs, and other variables explicitly represent information transmission, an information asymmetry between domestic and foreign investors, and the efficiency of transactions. The remarkably good results have strong implications for theories of asset trade. We find that the geography of information is the main determinant of the pattern of international transactions, while there is weak support in our data for the diversification motive, once we control for the informational friction. We strengthen our conclusions by investigating- in another data set- the ability of our information variables to explain transactions in classes of assets with different informational content (corporate bonds, equities and government bonds). Finally, we broaden the scope of our results by presenting some evidence linking the results on equity transactions to equity holdings.

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: We aim to provide insight into the observed equity home bias phenomenon by analyzing the determinants of U.S. holdings of equities across a wide range of countries. In particular, we explore the role of information costs in determining the country distribution of U.S. investors' equity holdings using a comprehensive new data set on U.S. ownership of foreign stocks. We find that U.S. holdings of a country's equities are positively related to the share of that country's stock market that is listed on U.S. exchanges, even after controlling for capital controls, trade links, transaction costs, and historical risk-adjusted returns. We attribute this finding to the fact that foreign firms that list on U.S. exchanges are obliged to provide standardized, credible financial information, thereby reducing information costs incurred by U.S. investors. This obligation stems from U.S. investor protection regulations, which include stringent disclosure requirements, reconciliation of financial stat...

Abstract: We introduce a new theoretical framework to analyze financial markets and trade in assets in an international context. We present a two-country macroeconomic model in which agents are risk averse, assets are imperfect substitutes, the number of financial assets is endogenous, and cross-border asset trade entails transaction costs. We show that demand effects have important implications for the link between market size, asset prices and financial market development. These effects are consistent with existing empirical evidence. Due to co-ordination failures, the extent of financial market incompleteness is inefficiently high. We also analyze the impact of domestic transaction costs and issuing costs on financial markets and returns.

This paper investigates to what extent globalization and regional integration lead to increasing equity market interdependence. I focus on the case of Western Europe, as this region has gone through a unique period of economic, financial, and monetary integration. More specifically, I quantify the magnitude and time-varying nature of volatility spillovers from the aggregate European (EU) and US market to 13 local European equity markets. To account for time-varying integration, I allow the shock sensitivities to change through time by means of a regime-switching model. I find that these regime switches are both statistically and economically important. While both the EU and US shock spillover intensity has increased over the 1980s and 1990s, the rise is more pronounced for EU spillovers. In most countries, shock spillover intensities increased most strongly in the second half of 1980s and the first half of the 1990s. Increased trade integration, equity market development, and low inflation are shown to have contributed to the increase in EU shock spillover intensity. Finally, I find some evidence for contagion from the US market to a number of local European equity markets during periods of high world market volatility.

We review extensive evidence about how psychological biases affect investor behavior and prices. Systematic mispricing probably causes substantial resource misallocation. We argue that limited attention and overconfidence cause investor credulity about the strategic incentives of informed market participants. However, individuals as political participants remain subject to the biases and self-interest they exhibit in private settings. Indeed, correcting contemporaneous market pricing errors is probably not government’s relative advantage. Government and private planners should establish rules ex ante to improve choices and efficiency, including disclosure, reporting, advertising, and default-option-setting regulations. Especially

In this paper we develop a model of intertemporal portfolio choice where an investor accounts explicitly for the possibility of model misspecification. This work is motivated by the difficulty in estimating precisely the probability law for asset returns. Our contribution is to develop a framework that allows for ambiguity about the joint distribution of returns for all stocks being considered for the portfolio, and also for different levels of ambiguity for the marginal distribution of returns for any subset of these stocks. We then use this framework to derive in closed-form the optimal portfolio weights of an investor who accounts for model misspecification. We illustrate the model by calibrating it to data on international equity returns. The calibration shows that when the overall ambiguity about the joint distribution of returns is high, then small differences in ambiguity for the marginal return distribution will result in a portfolio that is significantly under-diversified relative to the standard mean-variance portfolio.

This report reviews, analyses and applies alternative indicators and monitoring methodologies to measure the evolution of capital market integration in the European Union. More specifically, the report pursues the following three objectives: Firstly, it provides a comprehensive review of the methodologies and indicators proposed in the literature on capital market integration. Secondly, it discusses and analyses the various methodologies underlying the construction of such indicators and then applies the most suitable indicators to recent data to obtain measures of the actual degree of capital market integration. Thirdly, the report makes explicit proposals as to which of the indicators to follow and suggests methodological improvements to existing indicators. Based on an extensive review of the literature on financial integration, the reports classifies existing indicators of financial integration into four broad categories: A) indicators of credit and bond market integration; B) indicators of stock market integration; C) indicators of integration based on economic decisions of households and firms, and D) indicators of institutional differences that may induce financial market segmentation.

This paper analyzes the integration process of European equity markets since the 1980s. Its central focus is on the role that EMU, and specifically, changes in exchange rate volatility, has played in this process of financial integration. Building on an uncovered interest rate parity condition to measure financial integration, a trivariate GARCH model with time-varying coefficients yields three key results: first, European equity markets have become highly integrated only since 1996. Second, the Euro area market has gained considerably in importance in world financial markets and has taken over from the US as the dominant market in Europe.And third, the integration of European equity markets is in large part explained by the drive towards EMU, and in particular the elimination of exchange rate volatility and uncertainty in the process of monetary unification. JEL classification: C32, F3, G15 Keywords: financial integration, stock markets, EMU, exchange rate volatility, GARCH model, timevariation. 5 ECB Working Paper No 48 March 2001 6 ECB Working Paper No 48 March 2001 1