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...

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Despite the dramatic reduction in explicit barriers to international investment activ-ity over the last 60 years, the impact of financial globalization has been surprisingly limited. I argue that country attributes are still critical to financial decision-making because of “twin agency problems ” that arise because rulers of sovereign states and corporate insiders pursue their own interests at the expense of outside investors. When these twin agency problems are significant, diffuse ownership is inefficient and cor-porate insiders must co-invest with other investors, retaining substantial equity. The resulting ownership concentration limits economic growth, financial development, and the ability of a country to take advantage of financial globalization. AT THE END OF WORLD WAR II, the financial markets of most countries were closed to cross-border trade in financial assets. Since then, many countries have sharply reduced such barriers. The liberalization of trade in financial assets is often called “financial globalization.” In neoclassical models, financial globalization generates major economic ben-

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 the international finance literature to assess the extent to which international factors affect financial asset demands and prices. International asset pricing models with mean-variance investors predict that an asset’s risk premium depends on its covariance with the world market portfolio and, possibly, with exchange rate changes. The existing empirical evidence shows that a country’s risk premium depends on its covariance with the world market portfolio and that there is some evidence that exchange rate risk affects expected returns. However, the theoretical asset pricing literature relying on mean-variance optimizing investors fails in explaining the portfolio holdings of investors, equity flows, and the time-varying properties of correlations across countries. The home bias has the effect of increasing local influences on asset prices, while equity flows and cross-country correlations increase

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