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We develop a new global asset pricing model to study how illiquidity interacts with market segmentation and investability constraints in 42 markets. Noninvestable stocks that can only be held by foreign investors earn higher expected returns compared to freely investable stocks due to limited risk sharing and higher illiquidity. In addition to the world market premium, on average, developed and emerging market noninvestables earn an annual unspanned local market risk premium of $1.17\%$ and $9.04\%$, and a liquidity level premium of $1.06\%$ and $2.39\%$, respectively. These results obtained in a conditional setup are robust to the choice of liquidity measure.

We find that the degree and dynamics of sovereign bond market integration across 21 developed and 18 emerging countries is significantly heterogeneous. We show that better spanning can significantly enhance market integration through dissipating local risk premiums. Integration of the sovereign bond markets increases by about 10% on average, when a country moves from the 25th to the 75th percentile as a result of higher political stability and credit quality, lower inflation and inflation risk, and lower illiquidity. The 10% increase in integration leads to, on average, a decrease in the sovereign cost of funding of about 1% per annum. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

We develop an international asset pricing model to measure the impact of investability constraints on asset pricing. For a sample of 18 emerging markets, we use Standard & Poor’s investable weight factor (IWF) to show a 26.33% reduction in the cost of equity capital when non-investable firms become partially investable, with a further 12.51% reduction when partially investable firms become unrestricted. We demonstrate the generality and usefulness of the IWF by examining stocks with global/American depositary receipts and foreign institutional holdings as alternate investability proxies. Our results provide strong evidence of the economic benefits of market liberalization policies.

We develop an asset pricing model to analyze the joint impact of liquidity costs and market segmentation. The freely traded securities command a premium for liquidity level and global market and liquidity risk premiums whereas securities that can only be held by a subset of investors additionally command a local market and liquidity risk premiums. Based on a new methodology, we find that the liquidity level premium dominates the liquidity risk premiums for our sample of 24 emerging markets. Whereas the local liquidity risk premium is empirically small, the global market liquidity risk premium dramatically increases during crises and market corrections.

We observe significant heterogeneity across countries and maturities in the degree and dynamics of sovereign bond market integration. We analyze the role of credit quality, political and inflation risks, liquidity and investor sentiment in integrating developed and emerging bond markets and show that political risk and credit quality are the dominant factors. Bond market integration is significantly negatively related to sovereign CDS spreads. A one percent increase in integration corresponds to an average decrease in the cost of funding of about 3% of the average observed 5-year CDS spreads across all developed bond markets.

International asset pricing models suggest that barriers to portfolio flows and availability of market substitutes affect the degree and time variation of world market integration. We construct diversification portfolios for eight emerging markets over the period 1976-2000, use GARCH-M methodology to estimate the Errunza-Losq model and empirically assess the time variation in market integration. Our results suggest that although local risk is the most relevant factor in explaining time-variation of emerging market returns, global risk is also conditionally priced for some countries. Further, there are substantial cross-market differences in the degree of integration. We find evidence of a significant increase in the degree of integration during the last decade. Our results suggest the impropriety of directly using correlations of marketwide index returns as a measure of market integration. Finally, financial market development, macroeconomic development and financial liberalization policies play important roles in integrating emerging markets.

We attempt to answer the following questions: What are the revaluation effects and the impact on performance, volatility, and return correlation from stock market liberalization in emerging markets? These questions have been studied extensively at the market level but not at the firm level. Our results show significantly different impact of stock market liberalization across firms. Large firms tend to exhibit large revaluation effects, insignificant change in performance, large declines in volatility, and insignificant change in correlation from liberalization. Small firms show small revaluation effects, improved performance, smaller decline in volatility and decreases in correlation after liberalization.

We provide new evidence on the pricing of local risk factors in emerging stock markets. We investigate whether there is a significant local currency premium together with a domestic market risk premium in equity returns within a partial integration asset pricing model. Given previous evidence on currency risk, we conduct empirical tests in a conditional setting with time-varying prices of risk. Our main results support the hypothesis of a significant exchange risk premium related to the local currency risk. Exchange rate and domestic market risks are priced separately for our sample of seven emerging markets. The empirical evidence also suggests that although statistically significant, local currency risk is on average smaller than domestic market risk but it increases substantially during crises periods, when it can be almost as large as market risk. Disentangling these two factors is thus important in tests of international asset pricing for emerging markets.

We extend Campbell’s (1993) model to develop an intertemporal international asset pricing model (IAPM). We show that the expected international asset return is determined by a weighted average of market risk, market hedging risk, exchange rate risk and exchange rate hedging risk. These weights sum up to one. Our model explicitly separates hedging against changes in the investment opportunity set from hedging against exchange rate changes as well as exchange rate risk from intertemporal hedging risk. A test of the conditional version of our intertemporal IAPM using a multivariate GARCH process supports the asset pricing model. We find that the exchange rate risk is important for pricing international equity returns and it is much more important than intertemporal hedging risk.

This paper examines the shareholder wealth effects associated with global equity offerings made by foreign firms after their initial cross-listing in the United States. We document that the market reaction to seasoned global equity offerings is economically and statistically insignificant. However, it is 1.5% larger than the market reaction to offerings made on local exchanges only. In addition, we find that the adverse market reaction to local equity offerings is mitigated as more capital is raised globally. Our findings support the hypothesis that global capital raising is associated with significant benefits.

Reform of local capital markets and relaxation of capital controls to attract foreign portfolio investments (FPIs) has become an integral part of development strategy. The proximity of market openings and large, sudden shifts in international capital flows gave credence to the notion that the liberalization was the primary culprit in precipitating the recent Asian crisis. Hence, this paper reassesses the benefits and costs of FPIs from the perspective of the recipients. Specifically, it discusses the various FPI contributions and presents empirical evidence regarding the relationship between FPIs and market development, degree of capital market integration, cost of capital, cross-market correlation and market volatility. It is clear that the evidence on benefits of FPIs is strong, whereas the policy concerns regarding resource mobilization, market comovements, contagion, and volatility are largely unwarranted. The authors make some policy suggestions regarding preconditions for capital market openings, market regulation, and liberalization sequencing.

Recent empirical studies have documented the dramatic growth of privatizations globally and the resultant efficiency gains. We develop a theoretical model that incorporates the costs and benefits of privatization as complex options. This framework allows us to (1) highlight the impact of government's overall public sector policies on the potential benefits of privatization (2) illustrate the manner in which a government's specific policies concerning the SOE before and after privatization affects its share price at privatization and (3) examine the role of subsidies, tax shields and bankruptcy costs in determining the optimal leverage and investment choices made by the firm's management after privatization. It yields testable hypotheses and policy implications concerning the prioritization of SOE sales, public sector investment policies, tax subsidies, entry restrictions, and the state's use of monopoly power.

In recent years, we have witnessed a significant loss of national welfare from economic crises resulting from the weakness of the global financial system. After analyzing the root causes of this experience, we focus on two major fault lines that have characterized most of these occurrences: First, we review the arguments in favor of and against the open capital markets paradigm. We identify factors that must be taken into account for a successful integration of the national economies in the global capital market. Second, we discuss the lack of attention to innovations in risk management practices, which deal with the new sources of risk inherent in an increasingly integrated and complex global economy. Finally, we suggest some desirable democratic features and the importance of recognizing national architectures in the design of a new global financial architecture.

We examine whether portfolios of domestically traded securities can mimic foreign indices so that investment in assets that trade only abroad is not necessary to exhaust the gains from international diversification. We use monthly data from 1976 to 1993 for seven developed and nine emerging markets. Return correlations, mean-variance spanning, and Sharpe ratio test results provide strong evidence that gains beyond those attainable through home-made diversification have become statistically and economically insignificant. Finally, we show that the incremental gains from international diversification beyond home-made diversification portfolios have diminished over time in a way consistent with changes in investment barriers. THE BENEFITS OF INTERNATIONAL DIVERSIFICATION have been emphasized over the past 40 years by financial economists, who have shown that investing in foreign indices reduces the volatility of U.S. market portfolios, with gains attributed to low return correlations between national equity indices.1 Such investment in foreign indices requires holding securities that trade abroad, involving additional costs and potential barriers to international investment. Yet, over the past 20 years, an increasing number of country funds and depository receipts have started trading in the U.S. that, along with shares of multinational corporations, can be used to gain benefits from international diversification. In this paper, we examine whether investors can take advantage of the gains of international diversification by forming a portfolio of securities that trade in the United States, and we find that this * Errunza is from McGill University, Montreal; Hogan is from Barclays Global Investors, San Francisco; and Hung is from National Taiwan University, Taipei. Our special thanks to Ren6 Stulz (the editor) and an anonymous referee for many insightful suggestions. We also thank Warren Bailey, Geert Bekaert, Jin-Chaun Duan, Campbell Harvey, Andrew Karolyi, Ken Kroner, Usha Mittoo, and Michael Rebello, Marcia Roitberg, and Jahangir Sultan for helpful comments. Research assistance from Carlton Osakwe and Yuxing Yan is gratefully acknowledged. The authors thank the Social Sciences and Humanities Research Council of Canada and the Faculty of Management at McGill University for financial support. We are grateful to the capital markets department of the International Finance Corporation for providing the data on emerging markets.

This paper provides a theoretical and empirical analysis of country funds focusing on emerging economies whose capital markets are not readily accessible to outside investors. We study country fund pricing and the associated policy implications under alternative variations of international market structure segmentation. We show that country funds traded in the developed capital markets can be beneficial in promoting the efficiency of pricing in the emerging capital markets and in enhancing capital mobilization by local firms. These efficiency gains vary depending upon the degree to which the emerging market securities are spanned by the core or advanced market securities, and cross-border arbitrage restrictions. A country fund premium or discount arises in our framework owing to access and substitution effects characterizing the relationship between the host and emerging markets. We present some empirical evidence supporting our principal predictions. In particular, we investigate the issues of country fund pricing, relative influences of the home market, the international market, the global closed-end fund factor, and the behavior of fund premia/discounts.

We investigate the impact of currency factor on market integration. We compare integration indices estimated from international asset pricing models with and without real exchange risk. The theoretical expectation implies the integration measures should be similar when global currency premium and the sum of global and local currency premiums are small. Our empirical results support this proposition. We also examine the sensitivity of the Pukhthuatong and Roll (2009) R square to omitted currency factors. In general, currency risk does not affect the level and the dynamics of the integration measure except under crisis conditions.

We examine time varying integration of developed (DM) and emerging (EM) market government bonds. Although we find an upward trend for most countries and maturity bands, we do observe reversals and negative trends among both DMs and EMs and for some maturities during the financial crisis. We examine potential factors that could explain the integration of the long vs. the short maturity bond segments and show that enhanced institutional quality, higher credit quality and better future investment opportunities would jointly contribute to a higher integration of the long vs. the short maturity bonds by about 15%.

We employ a simple criterion, called kappa, to classify global return distributions according to their Pearson types. This classification allows us to rule out a priori several candidate distributions which have been suggested in the literature. Our results show that for some countries, the log-normal distribution can be ruled out a priori. Furthermore, we find important systematic differences between developed and emerging market returns distributions. However, we find that these differences have diminished over time.

Market liberalization may not result in full market integration if implicit barriers are important. We test this proposition for investable and non-investable segments of twenty-two emerging markets (EMs). We also measure the degree of integration for six major developed markets (DMs) as a meaningful benchmark. We find that while the DMs are close to fully integrated, both EM segments are not effectively integrated with the global economy. We quantify the importance of implicit barriers and show that better institutions, stronger corporate governance, and more transparent markets in EMs would jointly contribute to a higher degree of integration by about 20% to 30%. The Author 2013. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com., Oxford University Press.

Forecasting the evolution of security co-movements is critical for asset pricing and portfolio allocation. Hence, we investigate patterns and trends in correlations over time using weekly returns for developed markets (DMs) and emerging markets (EMs) over the period 1973–2012. We show that it is possible to model co-movements for many countries simultaneously using BEKK, DCC, and DECO models. Empirically, we find that correlations have trended upward significantly for both DMs and EMs. Based on a time-varying measure of diversification benefits, we find that it is not possible to circumvent the increasing correlations in a long-only portfolio by adjusting the portfolio weights over time. However, we do find some evidence that adding EMs to a DM-only portfolio increases diversification benefits.

We examine the role of emerging markets in providing currency diversification benefits. We use global sectoral portfolios for developed and emerging markets. Our empirical tests based on a conditional international asset pricing model show that on average the prices of currency risks are very close to zero but they increase significantly during crisis periods. We find that the currency exposures and risk premia are lowest for the G7 portfolios augmented with a small set of eight emerging markets over most of the time period for almost all sectors. Finally, holding a most diversified portfolio of developed and emerging markets may not provide additional benefits.

International equity markets are characterized by nonlinear dependence and asymmetries. We propose a new dynamic asymmetric copula model to capture long-run and short-run dependence, multivariate nonnormality, and asymmetries in large cross-sections. We find that correlations have increased markedly in both developed markets (DMs) and emerging markets (EMs), but they are much lower in EMs than in DMs. Tail dependence has also increased, but its level is still relatively low in EMs. We propose new measures of dynamic diversification benefits that take into account higher-order moments and nonlinear dependence. The benefits from international diversification have reduced over time, drastically so for DMs. EMs still offer significant diversification benefits, especially during large market downturns. The Author 2012. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com., Oxford University Press.

International equity markets are characterized by nonlinear dependence and asymmetries. We propose a new dynamic asymmetric copula model to capture long-run and short-run dependence, multivariate nonnormality, and asymmetries in large cross-sections. We find that copula correlations have increased markedly in both developed markets (DMs) and emerging markets (EMs), but they are much lower for EMs than for DMs. Tail dependence has also increased but its level is still relatively low for EMs. We propose new measures of dynamic diversification benefits that take into account higher order moments and nonlinear dependence. The benefits from international diversification have reduced over time, drastically so for DMs. EMs still offer significant diversification benefits, especially during large market downturns.

Recent studies show that the transfer of corporate governance structure across borders has significant valuation consequences. It is equally important to consider the valuation effect of state expropriation risk as well as its interaction with quality of corporate governance. Using a sample of cross-border acquisitions during 1989–2009, we find that targets, which operate under some degree of state expropriation risk, receive a significantly lower premium. The target shareholders are not fully rewarded for the improvement in firm governance since the benefits of improvement are mitigated under predation. Our results provide evidence for twin-agency theory of Stulz (2005) through cross-border mergers.

This paper investigates conditional return distribution characteristics for seven developed markets (DMs) and eight emerging markets (EMs). With the exception of Germany and Japan, the behavior of monthly returns of DM sample countries is similar to that of the U.S. In contrast, EM returns exhibit a substantially greater degree of serial correlation and a higher incidence of autoregressive conditional heteroskedasticity (ARCH) in monthly data. Aggregation of returns into two- and three-month holding periods decreases the significance of the ARCH effects. However, there are cross-sectional differences in the rate at which ARCH effects become insignificant. The findings of ARCH in monthly returns sample data is attributed to differences in the rate at which information arrives and is transmitted into prices in each market.

Market liberalization may not result in global pricing or full market integration if implicit barriersare important. We test this proposition for 22 emerging markets using the conditional version ofErrunza and Losq (1985) model. We estimate and compare the degree of integration for stocksthat are eligible for purchase by foreigners (investible) and those that are not (non-investible).Our results show that local factors are priced for both segments and the implicit barriers aresignificantly associated with the integration measure. Specifically, better institutions, strongercorporate governance and more transparent markets would jointly contribute to a higher degree ofintegration by about 15-20 percent.

We develop a structural equilibrium model with business cycles and use it to examine the economic implications of voluntary filing for bankruptcy. We find that conflict of interests that arises from the voluntary filing option of Chapter 11 causes higher ex-ante losses in firm value in recessions than in booms. These costs amount to approximately 5% of the ex-ante value for a BAA-rated representative firm and are twice as large as those produced by a model that does not allow for business cycle fluctuations. We relate these economic costs to firm fundamentals and to long-run economic uncertainty. We also show that in addition to macroeconomic conditions and liquidation costs, countercyclical distress costs and conflict of interests between debtors and creditors help to simultaneously generate reasonable credit spreads, levered equity premium and leverage ratios. Our framework nests a number of important models in the literature and we provide closed-form solutions for the equity, debt and levered asset values.

Quantifying the evolution of security co-movements is critical for asset pricing and portfolio allocation, and so we investigate patterns and trends in correlations and tail dependence over time using weekly returns for developed markets (DMs) and emerging markets (EMs) during the period 1973-2009. We use the DECO, DCC, and BEKK correlation models, and develop a novel dynamic t-copula to allow for dynamic tail dependence. We show that it is possible to characterize co-movements for many countries simultaneously. Correlations have signi…cantly trended upward for both DMs and EMs, but correlations between EMs are lower than between DMs. Further, our evidence clearly contradicts the decoupling hypothesis. The tail dependence has also increased for both EMs and DMs, but its level is still very low for EMs as compared to DMs. Thus, while our correlation analysis suggests that the diversi…cation potential of EMs

To investigate the structure of world capital markets, this paper tests the competing hypotheses of integration, mild segmentation and segmentation for a group of emerging markets. The test is based on the theoretical model of Errunza and Losq and uses the mle procedure. The results provide strong evidence in favor of a nonpolar structure and the widely accepted notion that the world market is neither fully integrated nor completely segmented.

In countries with secure property rights, corporate transparency improves investment efficiency and increases growth by alleviating information asymmetry. However, in countries with insecure property rights, greater transparency can increase the risk of government expropriation. Therefore, some firms that would benefit most from transparency cannot take full advantage of it, as they set sub-optimal transparency levels. Using data from 59 industries in 69 countries, we find that in countries with weak property rights protection, industries that would benefit the most from transparency exhibit worse investment efficiency and grow slower compared to industries that can efficiently operate at minimal levels of transparency.

We investigate whether cross-country diversification, particularly into emerging markets, has an impact on the pricing of exchange risk for globally diversified portfolios. Our empirical tests based on a conditional IAPM show that the price of exchange risk is highly significant in global sector portfolios that include only developed countries. In contrast, when we include emerging markets with the developed market assets, the hypothesis of zero price of exchange risk cannot be rejected. Also, global sector portfolios that include EM assets show lower currency beta and lower contribution of the currency premium on average. The reduction in the contribution of the currency premium is specifically important in periods of crises.

This article investigates the pricing behavior of national index funds (NIFs). Under barriers to capital flows in an otherwise perfect capital market, the familiar result of zero premium/discount obtains. The more realistic assumption of imperfect cross-border arbitrage suggests that in a two country setting the NIFs will sell at a premium. In a multicountry framework, the investment barriers will result in NIFs generally trading at a premium, although theoretically one cannot rule out a discount from net asset value (NAV). A simple test supports the proposition that under investment barriers, NIFs should trade at a premium to NAV after controlling for the average domestic closed-end fund discount.

We analyze the impact of both purchasing power parity (PPP) deviations and market segmentation on asset pricing and investor's portfolio holdings. The freely traded securities command a world market risk premium and an inflation risk premium. The securities that can be held by only a subset of investors command two additional premiums: a conditional market risk premium and a segflation risk premium. Our model is empirically supported with important implications for tests of international asset pricing.

We develop a three-moment international asset-pricing model (TM-IAPM) that prices coskewness and embeds the standard IAPMs as special cases. We use the model to investigate the time-series behavior of market, size, value, and momentum premiums in the United States, Japan, and the United Kingdom equity markets. We find that the model explains most of the variation of these premiums during the 1980s and 1990s and that the coskewness risk is more important than covariance risk.

We study the dynamics of gains from sectoral versus geographic diversification and relate economic sources to changes in those gains. We estimate conditional correlations between returns on the U.S. equity market and 16 equity markets and 10 local industries from other OECD countries and find that the average correlation across countries has increased in relation to that across industries. We also show that this process is accompanied by increased alignment in the industrial structures across countries and an increase in the average conditional correlation of aggregate production growth across countries relative to that of disaggregated production growth, especially among developed economies. Thus, the increased benefits of industry-level investing across developed markets are reflected in the real side of the global economy. However, country-level investing should remain the predominant asset allocation approach in emerging markets.

We provide new evidence on the pricing of exchange risk in the global stock markets. We conduct empirical tests in a conditional setting for ten developed markets and twelve emerging markets to determine whether emerging market currency risk affects emerging market equities and if it spills over into developed markets. In addition to using real exchange rates for the risk related to PPP deviations, our empirical model allows currency risk to compete with broader economic and political risks. Our main results support the hypothesis of significant exchange risk premia for both developed and emerging market assets. There is also evidence that emerging market currency risk is priced separately from other emerging market specific risks. Finally, we find that the spillover impact is heightened during crisis episodes and such information in particular affects world and major currency risks.

We attempt to answer the following questions: What are the revaluation effects and the impact on performance, volatility, and return correlation from stock market liberalization in emerging markets? These questions have been studied extensively at the market-level but not at the firm level. Our results show significantly different impact of stock market liberalization across firms. Large firms tend to exhibit large revaluation effects, insignificant change in performance, large declines in volatility, and insignificant change in correlation from liberalization. Small firms show small revaluation effects, improved performance, smaller decline in volatility and decreases in correlation after liberalization. These results hold after controlling for movements in world stock returns, concurrent economic reforms and macroeconomic fundamentals. They are also robust to the length of the liberalization window. Our results have important implications for international investors seeking to manage their global exposure as well as for policy makers considering capital market liberalization.

This paper provides new evidence on the pricing of exchange risk in global stock markets. We conduct empirical tests in a conditional setting with a multivariate GARCH-in-Mean specification and time-varying prices of risk for the US and nine emerging markets to determine whether exchange risk is priced under alternative model specifications and exchange rate measures. Since inflation rates in emerging markets are high and volatile, we argue that the use of real exchange rates offer a better proxy for risk stemming from purchasing power parity deviations. In addition to using real exchange rates, the empirical model allows for partial integration by including a time-varying price of local risk. Our main results support the hypothesis of significant exchange risk premia related to both emerging and developed markets. The price of exchange risk is also significantly time-varying consistent with previous evidence for major developed markets. The empirical evidence also suggests that there is variation across countries and over time in the relative importance of exchange risk premia. However, currency risk remains an important global risk factor even after accounting for local risk.

This paper studies privatization under moral hazard and adverse selection. We show that under the presence of moral hazard, the optimal financial package of privatization consists of selling 100 per cent equity together with a subsidy on the observed cash flow. Price of the equity reflects the costs of the subsidy. However, in the presence of both moral hazard and adverse selection, the optimal policy consists of a dual method of privatization in which the government offers simultaneously a sale of 100 per cent equity with a subsidy and a higher price with another option where the investor pays a smaller price and buys less than 100 per cent equity without subsidy. The more efficient investors opt for the first method while the less efficient investors prefer the second. The dual privatization method screens investors and provides them with maximum incentives to invest while minimizing the risk of bankruptcy in the post-privatization era. Hence, this paper suggests that while concentrated ownership is optimal for an efficient firm, the less efficient firm should be entitled to less than 100 per cent ownership in the presence of asymmetric information.

Traditionally, integration has been studied at the country level. With increasing economic integration, industrial reorganization, and blurring of national boundaries (e.g., EU), it is important to investigate global integration at the industry level. We argue that country-level integration (segmentation) does not preclude industry-level segmentation (integration). Indeed, our results suggest that a country is integrated with (segmented from) the world capital markets only if most of her industries are integrated (segmented). We also show that although global industry risk is small, it can be priced for certain industries. Industries that are priced differently from either the world or domestic markets represent incremental opportunities for international diversification.

A simple asset pricing model is developed to take into account two important characteristics in global investments: market segmentation and noise trader risk. Our results show the removal of international investment barriers and cross-border listings have not led to a fully integrated international capital market. We also show that different degree of investor rationality across borders induces an additional component of risk premium which is related to the "noise spill-over effect".

Recent empirical studies have documented the dramatic growth of privatizations globally and the resultant efficiency gains. We develop a theoretical model that incorporates the costs and benefits of privatization as complex options. This framework allows us to highlight the impact of government's overall public sector policies on the potential benefits of privatization, illustrate the manner in which a government's specific policies concerning the SOE before and after privatization affects its share price at privatization and examine the role of subsidies, tax shields and bankruptcy costs in determining the optimal leverage and investment choices made by the firm's management after privatization. It yields testable hypotheses and policy implications concerning the prioritization of SOE sales, public sector investment policies, tax subsidies, entry restrictions, and the state's use of monopoly power.

Hence, in this paper, we reassess the benefits and costs of FPIs from the perspective of the recipients byintegrating the theoretical literature with available empirical evidence, by providing new evidence, and byputting forward new concepts. After a brief discussion of the role of capital markets in economic development,we present evidence on contribution of emerging markets towards resource allocation and mobilization and therelationship between market development and growth. Next, we provide an in-depth analysis of thedevelopmental role ofFPIs. Specifically, we discuss the various FPI contributions and present empirical evidence regarding the relationship betweenFPIs and market development, degree of capital market integration, cost of capital, cross-market correlation and market volatility. It is clear that the evidence onbenefits of FPIs is strong, whereas the policy concerns regarding resource mobilization, market co-movements,contagion and volatility expressed by policy makers and some academics are largely unwarranted. Finally, wemake some policy suggestions regarding preconditions for capital market openings, market regulation, andliberalization sequencing in the hope that they would help towards preventing future crisis.*Bank of Montreal Chair in Finance and Banking, McGill University, Faculty of Management,1001 Sherbrooke Street West, Montreal, Canada H3A 1G5. I am grateful to John Boyd, Peter Christoffersen,Darius Miller, Michel Robe and participants at the Columbia University conferenceon ,"Is Globalization of Capital Markets a Boost or Hindrance to Development?," for insightful comments. I thank Hyunchul Chung forresearch assistance, SSHRC for financial support and International Finance Corporation for providing data onemerging markets.Correspondence: errunza@management.mcgill.ca

In recent years, we have witnessed a significant loss of national welfare from economic crises resulting from weakness of the global financial system. After analyzing the root causes of this experience, we focus on two major fault lines that have characterized most of these occurrences: First, we review the arguments in favor of and against the open capital markets paradigm. We identify factors that must be taken into account for a successful integration of the national economies in the global capital market. Second, we discuss the lack of attention to innovations in risk management practices, which deal with the new sources of risk inherent in an increasingly integrated and complex global economy. Finally, we suggest some desirable democratic features and the importance of recognizing national architectures in the design of a new global financial architecture.