Equity Integration in Japan: An Application of a New Method

This paper develops a simple new methodology to test for asset integration and applies it to the Japanese stock market. The technique is tightly based on a general intertemporal asset-pricing model, and relies on estimating and comparing expected risk-free rates across assets. Expected risk-free rates are allowed to vary freely over time, constrained only by the fact that they are equal across (risk-adjusted) assets. Assets are allowed to have general risk characteristics, and are constrained only by a factor model of covariances over short time periods. The technique is undemanding in terms of both data and estimation. I find that expected risk-free rates vary dramatically over time, unlike short interest rates. Further, the Tokyo stock market does not always seem to be well integrated in the sense that different portfolios of stocks are priced with different implicit risk-free rates. JEL Classification Numbers: G12, G15