Measuring Stock Market Integration in the Eurozone Via a Stochastic Discount Factor Approach

We test for stock market integration in the Eurozone using a novel stochastic discount factor (SDF) approach. The proposed method is adopted from Flood and Rose and rests upon estimating and comparing the expectations of pricing kernels across publicly listed stocks. While expected SDFs are allowed to vary over time, they ought, for integration to hold, to be equal across countries. We allow stocks to have standard risk characteristics. We only constrain those through (i) the CAPM, (ii) the Fama and French, and the (iii) Carhart model of covariances. Using a sample of 16 European countries and 11 pan-European industries over three different time periods between January 1990 and April 2008, we find that equity markets are as whole not integrated across Europe, the European Union, or the Eurozone. Yet, our findings suggest that the stock markets of Europe's biggest economies, namely Germany, France, and the United Kingdom, are integrated. We also document that the majority of European equity markets is integrated with Germany's stock market. There is also empirical support for an interdependence among the stock markets of the BeNeLux states