Financial integration, financial turmoil and risk premia in emerging markets

The aim of this article is to study the dynamics of financial integration and of the risk premia in emerging markets. Accordingly, we estimate a variant of the International Asset Pricing Model (IAPM) developed by Errunza and Losq (1985) and Carrieri et al. (2007), allowing for time-varying stock market integration, in which we include the foreign currency risk. Our sample consists of monthly data for 12 emerging stock markets over the period 1988−2012. We find that the evolution of financial integration is broadly consistent with the de jure measure of capital openness, but much less sticky. Moreover, while the financial integration of emerging stock markets displays an upward trend, it has also registered short-term reversals episodes during crises. The upward trend in financial integration does not reduce the local market risk premium component as much as could be expected, as regional crises strengthen the idiosyncratic character of the risk premium. Finally, the recent global crisis has induced a reassessment of the world market risk premium for all emerging countries, highlighting the global nature of the crisis.