Galiya Chupabayeva

International asset pricing theory suggests that capital market liberalisation will reduce the cost of domestic equity capital through increased international diversification by domestic and international investors. For a liberalising country, this will have a positive effect on domestic investment. Existing empirical evidence provides only partial support to this prediction. Some studies register a decrease in the cost of equity, but to a lesser extent than is predicted by theory. The results are also sensitive to different specifications of liberalisation dates and assumptions about the preand post-liberalisation degree of integration. In this paper, we review and analyse existing theoretical and empirical evidence on the behaviour of asset returns in a liberalising country with special reference to the nature of integration process. We argue that stock market liberalisation is a gradual process and cannot be analysed using event study methods. Instead, the time-variation in the degree of integration should be explicitly defined when measuring the impact of liberalisations on asset returns and the cost of capital. We also discuss alternative methods for modelling the time-varying integration in asset pricing models.