The process towards more integrated financial markets during the last decades suggests that the investment opportunities as well as the environment for politically induced policy decisions have changed. Financial deregulation of the stock markets could itself be seen as a sequence of policy decisions aiming at removing different barriers preventing cross-border trade of financial assets. Examples of such barriers relevant for the Nordic markets are legal restrictions on ownership of foreign stocks or on foreign ownership of domestic stocks and currency controls preventing free cross-border capital flows. Not only the removal of legal barriers has created more integrated stock markets, also the rapid development and more widespread use of information technology have probably contributed significantly to the integration process. The main purpose of this paper is to document to what extent this liberalization process could be associated with changes in return behavior on the four largest Nordic stock markets, Sweden, Finland, Denmark and Norway.
The elimination of legal barriers preventing free cross-border trade of stocks in the Nordic countries has certainly been a gradual process stretching over several decades. The process accelerated in the beginning of the 1980s and at the end of 1992 almost all restrictions on both cross-border ownership and capital flows were officially removed. The barriers were most severe for Sweden and Finland; in the 1970s and earlier Swedish and Finnish investors’ were effectively prevented to diversify by portfolio investments abroad and foreign exchange controls were prohibitive. These barriers were successively removed and 1990 both restrictions on domestic investors ability to foreign financial investments and currency controls had been abandoned. The remaining restrictions on foreign owner-ship of Swedish and Finnish stocks were finally removed at the end of 1992. In contrast, accompanying the Danish EU membership, foreign investors have had access to the Danish stock market since 1973. However, it was not until 1984 restrictions for Danish investors to buy foreign stock were completely removed. In Norway, financial deregulation was implemented during the 1980s and in 1990 most remaining foreign exchange rate controls were abolished. Norway is however different from the other Nordic countries considered in the respect that there are still indirect ownership restrictions due to substantial state ownership in many industries.
The Nordic countries belong to the small open economy category, with large imports and exports in relation to gross domestic products. One interesting implication of this is that companies, and hence stock markets, are likely to be highly sensitive to international business conditions. Hence, it is possible that common stock market characteristics, at least partly, follow from similar shocks affecting segmented, rather than integrated markets. Another problem is that legal restrictions may be non-binding, i.e. they are possible to circumvent by for example large institutional investors, which also makes it difficult to use prespecified dates for integration.
For these reasons, i.e. in order to preserve generality, we specify an empirical model to endogenously date structural breaks in the return behavior and to allow for different return characteristics at different points in time. In particular, a priori expectations based on for example an asset pricing argument of common priced sources of risk, implies that stock market liberalization is associated with stronger links to international stock markets. This is because in perfectly integrated markets all assets with identical risk exposure also command identical expected returns, see Campbell and Hamao (1992) and Bekaert and Harvey (1995) for thorough discussions. We measure the changing international dependence of the Nordic stock markets by allowing for regime dependent sensitivities, i.e. different ”betas” with international stock returns at different points in time.
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Financial Liberalization and the Changing Characteristics of Nordic Stock Returns
