Financial integration and asset returns

The paper investigates the impact of financial integration on asset return, risk diversification and breadth of financial markets. We analyse a three- country macroeconomic model in which: (i) the number of financial assets is endogenous; (ii) assets are imperfect substitutes; (iii) cross-border asse t trade entails some transaction costs; (iv) the investment technology is i ndivisible. In such an environment, lower transaction costs between two fin ancial markets translate into higher demand for assets issued on those mark ets, higher asset price and greater diversification. For the country left o utside the integrated area, the welfare impact is ambiguous: it enjoys bett er risk diversification but faces an adverse movement in its financial term s of trade. When we endogenise financial market location, we find that fina ncial integration benefits the largest economy of the integrated area. Only when transaction costs become very small does financial integration lead t o relocation of markets to the smallest economy. (C) 2000 Elsevier Science B.V. All rights reserved. JEL classification: F4; F12; G1; G12.