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Measuring Financial Integration via Idiosyncratic Risk: What Effects Are We Really Picking Up?
Author(s) -
PARSLEY DAVID C.,
SCHLAG CHRISTIAN
Publication year - 2007
Publication title -
journal of money, credit and banking
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.763
H-Index - 108
eISSN - 1538-4616
pISSN - 0022-2879
DOI - 10.1111/j.1538-4616.2007.00065.x
Subject(s) - systematic risk , econometrics , economics , rate of return , financial integration , financial market , stock (firearms) , financial economics , finance , engineering , mechanical engineering
We study the method proposed by Flood and Rose (FR, 2004, 2005) for checking for financial integration by estimating the risk‐free rate using the idiosyncratic component of individual stock returns. Performing simulations with data with a known return generation process, we find that the FR methodology produces poor estimates of the risk‐free rate, and hence the FR method fails to accept integration when true. We then show analytically that the FR method actually provides an estimate of the market return, and conclude the FR methodology would also falsely accept integration as long as the market returns in the two markets do not differ widely.