Reversals in Market Integration: A Funding Liquidity Explanation

Abstract

This paper provides an explanation for reversals in global equity market integration through the funding liquidity channel. I show that financial market integration decreases as funding constraints bind more strongly, consistent with limits to arbitrage and increased home bias during funding distress periods. An International Margin-CAPM, which incorporates borrowing frictions of international investors in the form of investor-specific and country-specific margin constraints, explains how reversals occur as funding liquidity becomes scarce. Empirically, the betting against beta portfolios of the model that load on funding liquidity comove less across markets during global funding distress periods. This suggests that at these times funding liquidity risk is local in nature. A funding-liquidity segmentation indicator, constructed from the betting against beta portfolios, not only fits the previously documented evidence on market segmentation, but also explains reversals in integration in the absence of foreign investment barriers.

Keywords: International Finance, Market Integration, Segmentation, Margin, CAPM, BAB portfolio, Funding Liquidity

JEL Classification: F36, G01, G12, G15