International Financial Integration through the Law of One Price: The Role of Liquidity and Capital Controls

Abstract

This paper takes advantage of the fact that some stocks trade both in domestic and international markets to characterize the degree of international financial integration. The paper argues that the cross-market premium (the ratio between the domestic and the international market price of cross-listed stocks) provides a valuable measure of international financial integration and the effectiveness of capital controls. Using Autoregressive (AR) models to estimate convergence speeds and non-linear Threshold Autoregressive (TAR) models to identify non-arbitrage bands, we document that price deviations across markets are rapidly arbitraged away and bands are narrow, particularly so for companies with liquid stocks. We also show that regulations on cross-border capital flows can effectively segment domestic markets: controls on outflows (inflows) induce positive (negative) premia that vary with the intensity of the controls.