1 s2.0 S105905602200051X Main

International Review of Economics and Finance 80 (2022) 526–551
Contents lists available at ScienceDirect
International Review of Economics and Finance

journal homepage: www.elsevier.com/locate/iref
Global factors and stock market integration✩

Yue Qiu a , Yu Ren b ,∗, Tian Xie c
a
Finance School, Shanghai University of International Business and Economics, Shanghai, China
b
Wenlan School of Business, Zhongnan University of Economics and Law, Wuhan, Hubei, 430073, China
c
College of Business, Shanghai University of Finance and Economics, Shanghai, China
ARTICLE INFO ABSTRACT
JEL classification: We propose a novel approach for generating global factors to measure global equity market
C12 integration using a panel data model with cross-sectional dependence (CD). Based on the
G12 previous literature, our global factors are obtained by explicitly controlling the effects of local
Keywords: factors of different regions in one asset pricing model, which further provides an integration
Global factor measure based on the adjusted-𝑅2 . We empirically investigate the dynamics of global integration
Market integration from 1990–2017 and find that (1) the integration measure based on the considered developed
Factor analysis
markets shows a slightly upward trend during our sample period, (2) the main driving force
behind volatility in global integration arose from the Asia-Pacific (excluding Japan) region, and
(3) integration between North America, Europe and Japan showed a relatively flat and moderate
trend.
1. Introduction
As stated in Bekaert, Hodrick, and Zhang (2009), financial markets are likely to become increasingly integrated at the global
level through increased capital flows and trade openness. This phenomenon poses new challenges for international investors and
researchers in the area of asset pricing in studying sources of return comovement and therefore identifying possible sources of
portfolio risk. In particular, the determinants of global stock returns have been a central focus of the literature (Hou, Karolyi, and
Kho 2011). Controversy surrounds whether the explanatory power of these firm-level characteristics arises locally or globally. Some
studies find that only local, country-specific factors built from these firm-level characteristics matter for stock returns (Griffin 2002),
while others perceive a more globally integrated market and propose models that should incorporate both local and foreign factors
(Fama and French 1998; Bekaert et al. 2009; Hou et al. 2011).
Our study contributes to this debate by proposing a new approach to obtaining global factors in a panel-based international
asset pricing model. Our framework is an application of the common correlated effect framework established by Pesaran (2006)
and Chudik and Pesaran (2015) to asset pricing problems. In our model, we use local (regional) firm-level characteristic factors to
capture regional effects on cross-sectional portfolio returns while permitting cross-sectional dependence (CD) between the residuals
of panel regressions. In this way, we are able to extract principal components from the residuals and treat them as unobserved
global factors, which affect all asset returns simultaneously. This approach is the first contribution of this paper.
✩ We wish to thank the editor and anonymous referees; and Kee-Hong Bae, Bruno Solnik, Jun Yu, Lu Zhang, seminar participants at the European Financial
Management Association (EFMA) 2017 Xiamen annual meeting, Young Econometricians around Pacific (YEAP) 2018 annual conference, Chinese Academy of
Sciences, Renmin University, and Xiamen University for helpful comments and suggestions. Qiu appreciates the support by Shanghai Philosophy and Social
Science Planning Foundation (2020BJB026). Ren acknowledges the support by the Natural Science Foundation of China (71771192). Xie’s is supported by the
Natural Science Foundation of China (72173075), the Shanghai Research Center for Data Science and Decision Technology, and the Fundamental Research Funds
for the Central Universities. The usual caveat applies.
∗ Corresponding author.
E-mail address: yren@vip.163.com (Y. Ren).
https://doi.org/10.1016/j.iref.2022.02.031
Received 18 June 2020; Received in revised form 9 November 2021; Accepted 12 February 2022
Available online 10 March 2022
1059-0560/© 2022 Elsevier Inc. All rights reserved.
Y. Qiu et al. International Review of Economics and Finance 80 (2022) 526–551
Our approach has two advantages. First, the effects of our global factors are orthogonal to those of local factors. Since
theoretically global factors can be regarded as approximating systematic risks that local factors cannot represent, the global factor
proxies are more appropriate when local effects are separated.1 Second, our method permits multiple latent global factors and their
respective effects on asset returns, which greatly enhances our model in terms of capturing the heterogeneous impacts of various
underlying systematic forces driving asset returns.
As the second contribution of this paper, we develop a quantitative measure of global integration by the partial-𝑅2 of global
factors in this panel data model framework. The partial-𝑅2 in our model denotes the additional explanatory power of global factors
for all asset returns. Our study adds additional evidence to the literature on the empirical assessment of international market
integration. Similar measurement can also be found in Diebold and Yilmaz (2009), which calculates the interdependence of asset
returns. Cross-country correlations of stock index returns have been widely documented and were first proposed as a measure of
market integration, such as in Bekaert and Harvey (1995) and Carrieri, Errunza, and Hogan (2007). However, Pukthuanthong and
Roll (2009) pointed out that these correlations present a fundamental flaw, as they can be less than one even when two countries
are perfectly integrated. Pukthuanthong and Roll (2009) proposed the use of the explanatory power of global factors in a multifactor
model to quantify global integration. The authors essentially estimate global factors by extracting principal components of global
stock index returns and then regress the index returns on these global factors to obtain the adjusted-𝑅2 for each country. The average
𝑅2 across countries is the authors’ relevant measure of integration. Berger and Pukthuanthong (2012) extended this measure to
provide an estimate of systematic risk within international equity markets. Lehkonen (2015) used this measure to study dynamics
of stock market integration during global crisis periods. Carrieri et al. (2007), Van Schotman and Zalewska (2006) and Eun, Wang,
and Xiao (2015) employed a similar 𝑅2 measure to quantify global integration.2
There are two issues that have not been properly addressed in regard to 𝑅2 -related measures. The first issue concerns how
global factors can be obtained. Pukthuanthong and Roll (2009) extracted principal components directly from stock index returns.
As is known, over the past three decades, hundreds of linear asset pricing models have been proposed. Every asset pricing model
includes several factors formed based on the information in domestic markets, such as those in Fama and French (1993, 2015).
These are defined as local factors, and they stand for domestic systematic risks only. In an attempt to obtain global factors, we
should control the effect of those local factors. Our approach appropriately fulfills this purpose.
The second issue concerns how to better utilize the explanatory power of global factors as a measure of integration. The simple
average of 𝑅2 from each country-level regression cannot be the correct answer. For example, suppose that there are two separate
country-level regressions of asset returns, one with an 𝑅2 of 0.9 and the other with an 𝑅2 of 0.1. Another pair of country-level
asset pricing regressions is almost identical in every respect, and both have 𝑅2 s of 0.5. The simple average of 𝑅2 would lead to
the conclusion that these two pairs of country-level markets have the same level of integration, although, in the latter case, the
markets are more integrated than the former. Therefore, it is preferable to measure the explanatory power of global factors within
one unified framework instead of averaging across the individual regression explanatory powers. The above issue can be resolved
with our framework.
As one illustration of our method, empirically, we revisit the Fama–French (FF) five-factor (FF5) models by analyzing returns of
their sorted portfolios for four regions (i.e., Asia-Pacific (AP), North America (NA), Europe and Japan). Initially, we follow Fama
and French (2012, 2017) to estimate the FF5 with ordinary least squares (OLS) and find evidence of a cross-sectional correlation
for the estimation residuals. Then, we show that this correlation is due to global risks, which cannot be replaced by the FF global
factors. Finally, we employ cross-sectional Fama and MacBeth (1973) tests of individual asset returns and time-series regression-
based tests of multifactor models to compare the performance of the FF5 model with and without our global factors. We find that
after incorporating our global factors, the model can deliver a much smaller number of significant estimated intercepts for every
region. In addition, when we run the cross-sectional regression (CSR) with our global factors for the portfolios in each region, the
adjusted-𝑅2 increases dramatically irrespective of the underlying number of global factors. This result suggests that our global factors
indeed capture additional risks that local factors cannot.
After estimating integration indices for various groups of regions, we find that starting in the 1990s, the global integration of
developed markets in our regions has slightly increased. Several spikes were caused by global crises, such as the Asian financial crisis,
the dot-com bubble and the recent global financial crisis. During the recent financial crisis, global markets initially became more
integrated and then soon became segmented, which corresponds with the findings of Lehkonen (2015). Our study also presents new
results demonstrating that volatility in global integration for developed markets is mainly due to the integration of the AP region
(excluding Japan) with NA and Europe. In contrast, integration between NA, Europe and Japan shows a moderate and flat pattern.
To show that our results are not sensitive to the particular portfolio set used, we also include the portfolios of emerging markets in
our analysis and find a similar pattern of global integration.
1 As shown by Hou et al. (2011) through their empirical evidence, foreign components of their characteristic-based factors appear to matter as global risk
factors when capturing global covariance risk and systematic market under- and overreactions caused by investors’ behavioral biases, which are not seized by
local firm-level characteristics.
2 There has been ample literature on measuring global market integration. Dumas, Harvey, and Ruiz (2003) and Chambet and Gibson (2008) analyzed financial
integration through economic fundamentals. Hardouvelis, Malliaropulos, and Priestley (2006) investigated the changing integration of European markets through
the relative influence of European-wide risk factors. Bekaert, Harvey, Lundblad, and Siegel (2011) measured a country’s market segmentation by calculating
industry level earnings yield differences. Eiling and Gerard (2015) defined market integration as the proportion of return variance explained by a single global
factor relative to the total variance of a country’s return. Brooks and Negro (2004) adopted a latent factor approach to decompose firms’ returns into global,
country, industry and idiosyncratic components. Kiviaho, Nikkinen, Piljak, and Rothovius (2014) examined the comovement of European frontier stock markets
with the USA and developed markets in Europe through the application of wavelet coherency.
527
There are economic and financial implications for our global integration index. The level of the integration reveals the
importance of the international systematic risks represented by the global factors, and the integration between equity markets in
different countries determine the diversification benefits of international investing. Since the gains and motivations of international
diversification rely on low correlations across international stock markets, global integration could have eroded much of the
gains from international diversification by making market to co-move more closely and enhancing spillovers. Moreover, strong
comovements in extreme market realizations may increase the risk of global financial instability, with local market disruptions
quickly spreading across countries, independently of fundamental dynamics.
To demonstrate that our findings are not specific to developed markets, we also include the portfolios of emerging markets in
our analysis. The main upward trend of the index is unaltered, with an overall lower level of market integration. Our results are also
robust for controlling the effects of volatility and employing alternatively sorted portfolios. Moreover, we analyze the macroeconomic
drivers of our market integration index. The analysis shows that for our sample of developed markets the only significant driver is
the 10-year treasury bill rate.
The rest of this paper is organized as follows. In Section 2, we discuss our model and the method used to construct the global
integration index. Section 3 describes the data. The main empirical analysis is presented in Section 4. Section 5 provides additional
analyzes. Section 6 concludes the paper.
2. Methodology
2.1. Model setup
In this section, we consider a panel-based international asset pricing model in the spirit of Pesaran (2006). For time 𝑡 and
𝑡 = 1, … , 𝑇 , we use the portfolios sorted within each region as the unit of analysis, which is indexed by group member 𝑖 for
𝑖 = 1, … , 𝑁. If there are in total 𝐺 regions for 𝑔 = 1, … , 𝐺 and each region contains 𝑃𝑔 portfolios, summing across regions leads
∑
to 𝑁 portfolios (𝑁 = 𝐺 3
𝑔=1 𝑃𝑔 ). We postulate that the average return of each portfolio 𝑦𝑖𝑡 is explained by both local and common
factors:
𝑦𝑖𝑡 = 𝜶 ⊤ ⊤
𝑖 𝒅 𝑡 + 𝜷 𝑖 𝒙𝑔𝑖 ,𝑡 + 𝑒𝑖𝑡 , (1)
where the set of local factors 𝒙𝑔𝑖 ,𝑡 (𝑘 × 1) is computed based on the portfolios belonging to specific region 𝑔 at time 𝑡 and only vary
across regions, and 𝒅 𝑡 is a 𝑛 × 1 vector of observed common effects (including deterministic such as intercepts or seasonal dummies).
If we apply 𝒅 𝑡 = 1, 𝜶 𝑖 captures all of the heterogeneous intercepts. Note that we assume that heterogeneous coefficients 𝜷 𝑖 capture
the varied marginal effects of local factors in explaining each average asset return.
Next, we specify how the unobserved common factors, also called the global factors in our empirical exercise, affect the portfolio
return. The model is assumed to contain 𝑚 unobserved common factors with 𝒇 𝑡 that can be correlated with 𝒙𝑔𝑖 ,𝑡 and/or 𝑒𝑖𝑡 . The
following multifactor error structure is imposed:
𝑒𝑖𝑡 = 𝜸 ⊤
𝑖 𝒇 𝑡 + 𝜖𝑖𝑡 , (2)
𝒙𝑔𝑖 ,𝑡 = 𝑨⊤
𝑖 𝒅𝑡 + 𝜞⊤
𝑖 𝒇𝑡 + 𝒗𝑔𝑖 ,𝑡 , (3)
where 𝒇 𝑡 is the 𝑚 × 1 vector of unobserved global effects; 𝜸 𝑖 , 𝑨𝑖 (𝑛 × 𝑘), and 𝜞 𝑖 (𝑚 × 𝑘) are factor loading matrices; 𝜖𝑖𝑡 denotes the
idiosyncratic errors assumed to be distributed independent of (𝒅 𝑡 , 𝒙𝑔𝑖 ,𝑡 ); and 𝒗𝑔𝑖 ,𝑡 denotes the specific components of 𝒙𝑔𝑖 ,𝑡 distributed
independent of the common effects and across 𝑔 but that are assumed to follow general covariance stationary processes. We also
assume that 𝑚 is fixed but unknown.
Note that if the specification of 𝒙𝑔𝑖 ,𝑡 follows the FF5 model (Fama & French, 2015), our model is clearly a generalization of this
model, which allows individual portfolio returns to be affected by both observed local factors and unobserved global factors, albeit
not necessarily with the same strength. Furthermore, Eq. (3) implies that the latent global effects, 𝒇 𝑡 , indirectly affect portfolio
returns through the local pricing factors, 𝒙𝑔𝑖 ,𝑡 .
2.2. The problem of ignoring unobserved global factors
Under the assumptions specified in (2) and (3), regressor 𝒙𝑔𝑖 ,𝑡 and error term 𝑒𝑖𝑡 share a set of latent common factors, 𝒇 𝑡 . This
may imply that if 𝜸 𝑖 and 𝜞 𝑖 were nonzero, a conventional panel estimation of (1) not accounting for 𝒇 𝑡 could yield biased and
inconsistent estimates of coefficients 𝜶 𝑖 and 𝜷 𝑖 . This issue is more clearly illustrated by a direct substitution of 𝒇 𝑡 in Eq. (1)4
⊤ ⊤
𝑦𝑖𝑡 = (𝜶 𝑖 − 𝑨𝑖 𝜞 −1 −1 ⊤ ⊤ −1
𝑖 𝜸 𝑖 ) 𝒅 𝑡 + (𝜷 𝑖 + 𝜞 𝑖 𝜸 𝑖 ) 𝒙𝑔𝑖 ,𝑡 + 𝜖𝑖𝑡 − 𝜸 𝑖 (𝜞 𝑖 ) 𝒗𝑔𝑖 ,𝑡 (4)
⏟⏞⏞⏞⏞⏞⏞⏞⏟⏞⏞⏞⏞⏞⏞⏞⏟ ⏟⏞⏞⏞⏞⏞⏟⏞⏞⏞⏞⏞⏟ ⏟⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏟⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏟
𝝍𝑖 𝜽𝑖 𝜉𝑖𝑡
= 𝝍⊤
𝑖 𝒅𝑡 + 𝜽⊤
𝑖 𝒙𝑔𝑖 ,𝑡 + 𝜉𝑖𝑡 ,
3 Taking the empirical case described in Fama and French (2012) as an example, the portfolios are allocated to 4 regions with each region containing 6 and
25 portfolios sorted by two different benchmarks. In our framework, this arrangement leads to 24 and 100 region-portfolio group members (𝑁 = 24 and 100).
4 Here, we adopt a similar demonstration as that described in Eberhardt, Helmers, and Strauss (2013).
528
where 𝜞 𝑖 is assumed to be invertible for simplicity.

As shown in (4), the OLS is biased and inconsistent, as 𝝍 𝑖 ≠ 𝜶 𝑖 and 𝜽𝑖 ≠ 𝜷 𝑖 in general.5 This bias critically depends on the factor
loading 𝜸 𝑖 of 𝒇 𝑡 for error term 𝑒𝑖𝑡 . If the unobserved 𝒇 𝑡 is merely a weak factor (with a small 𝜸 𝑖 ), then the OLS estimates of 𝜶 𝑖 and
𝜷 𝑖 coefficients may not be seriously biased. However, if we have multiple common factors with combinations of weak and strong
types, i.e., error terms 𝑒𝑖𝑡 are significantly correlated across 𝑖, the OLS estimates can be fairly misleading.
2.3. Common correlated effect estimator
As demonstrated above, a conventional OLS or GLS estimator is invalid for estimating main return Eq. (1) when explanatory
variables and error terms are correlated through some unobserved common effects. In this section, we revisit the common correlated
effects (CCE) estimators originally proposed by Pesaran (2006) and demonstrate how they develop in our framework.
For each 𝑖 and 𝑡, rewriting (1) and (2) in matrix notation, we have
𝒚 𝑖 = 𝑫𝜶 𝑖 + 𝑿 𝑖 𝜷 𝑖 + 𝑭 𝜸 𝑖 + 𝝐 𝑖 (5)
where 𝒚 𝑖 = [𝑦𝑖1 , … , 𝑦𝑖𝑇 ]⊤ , 𝑫 = [𝒅 1 , … , 𝒅 𝑇 ]⊤ , 𝑿 𝑖 = [𝒙𝑔𝑖 ,1 , … , 𝒙𝑔𝑖 ,𝑇 ]⊤ , 𝑭 = [𝒇 1 , … , 𝒇 𝑇 ]⊤ , and 𝝐 𝑖 = [𝜖𝑖1 , … , 𝜖𝑖𝑇 ]⊤ . Matrix 𝑭 consists of 𝑚
unobserved global factors for all time periods and causes an estimation problem for conventional panel estimators. The basic goal
of Pesaran (2006) is to filter individual explanatory variables with a projection matrix denoted as 𝑴 𝑤 . To eliminate the differential
effects of 𝒇 𝑡 asymptotically, matrix 𝑴 𝑤 is constructed from the information set orthogonal to the set spanned by 𝑭 .
Following the above reasoning, we apply filtering matrix 𝑴 𝑤 to both sides of (5). The individual slope coefficient, 𝜷 𝑖 , is then
given by
( )−1 ⊤
𝜷̂ 𝑖 = 𝑿 ⊤𝑖 𝑴 𝑤𝑿𝑖 𝑿𝑖 𝑴 𝑤 𝒚𝑖 . (6)
We denote this estimator as the CCE estimator, in which the differential effects of unobserved global factors 𝒇 𝑡 are purified by
filtering matrix 𝑴 𝑤 .
A potential issue is that the regressors in asset pricing models may be weakly exogenous since they may contain information on
the lagged dependent variable. The consistency of the constructed global factor crucially depends on the consistency of (6). Chudik
and Pesaran (2015) proved the consistency of (6) under heterogeneous panel data models with a lagged dependent variable and/or
weakly exogenous regressors, which validates our proposed method.
Filtering matrix 𝑴 𝑤 plays a crucial role in Eq. (6) and is constructed as a 𝑇 × 𝑇 projection matrix such that
−1
𝑴 𝑤 = 𝑰 𝑇 − 𝑷 𝑤 = 𝑰 𝑇 − 𝑯 𝑤 (𝑯 ⊤
𝑤𝑯 𝑤) 𝑯 𝑤,
where projection matrix 𝑷 𝑤 stands for the information set spanned by 𝑯 𝑤 , which contains the approximation of unobserved common
factors 𝒇 𝑡 . Following Pesaran (2006), we formally define 𝑯 𝑤 = [𝑫, 𝒁̄ 𝑤 ]. Matrix 𝒁
̄ 𝑤 = [𝒛̄ 𝑤1 , … , 𝒛̄ 𝑤𝑇 ]⊤ is the 𝑇 × (𝑘 + 1) matrix of
6
observations on the weighted cross-section averages, where
[ ]
∑𝑁
𝑦𝑖𝑡
𝒛̄ 𝑤𝑡 = 𝑤𝑖 𝒛𝑖𝑡 and 𝒛𝑖𝑡 = .
(𝑘+1)×1 𝒙𝑔𝑖 ,𝑡
𝑖=1
The main purpose of 𝒁 ̄ 𝑤 is to approximate the unobserved global factors to explicitly account for them during the estimation
process. Intuitively, unobserved global factors 𝒇 𝑡 are included in both error terms 𝑒𝑖𝑡 and observed explanatory variables 𝒙𝑔𝑖 ,𝑡 as
demonstrated in Eqs. (2) and (3).7 Therefore, (𝑘 + 1) × 1 vector 𝒛𝑖𝑡 contains the information on 𝒇 𝑡 for each region-portfolio group
member, 𝑖 = 1, … , 𝑁.
To approximate 𝒇 𝑡 , we take weighted cross-section averages of the dependent variable and the individual-specific regressors. In
general, weights {𝑤𝑖 } need to satisfy the following conditions:
∑
𝑁 ∑
𝑁
(i) 𝑤𝑖 = 𝑂(𝑁 −1 ), (ii) 𝑤𝑖 = 1, (iii) |𝑤𝑖 | < 𝐾. (7)
𝑖=1 𝑖=1
As shown in Pesaran (2006), weights 𝑤𝑖 are not unique and do not affect the asymptotic distribution of the estimators. Specifically,
when 𝑁 is reasonably large, one could use equal weights 𝑤𝑖 = 1∕𝑁 without compromising estimation consistency; however,
alternative selections of 𝑤𝑖 can significantly influence the results when 𝑁 is relatively small. See Section 2.4 for a detailed discussion.
With a properly calibrated 𝑤𝑖 , we can estimate the standard error for each 𝜷̂ 𝑖 following the asymptotic distribution derived
in Pesaran (2006):
√ 𝑑
𝑇 (𝜷̂ 𝑖 − 𝜷 𝑖 ) → N(𝟎, 𝜮 𝛽𝑖 ),
5 In fact, 𝝍 = 𝜶 and 𝜽 = 𝜷 only when 𝜸 = 𝟎, since 𝑨 and 𝜞 −1 cannot be 𝟎 in general. To assume 𝑨 = 𝟎, all asset pricing factors have to be controlled
𝑖 𝑖 𝑖 𝑖 𝑖 𝑖 𝑖 𝑖
at mean 0, which is not feasible in practice. Consider the widely used pricing factor measuring market impact (such as 𝑅𝑀𝑡 − 𝑅𝐹 𝑡 in the FF three-factor model
and the corresponding five-factor model), which is generally shown to have nonzero means.
6 The asymptotic assumption of Pesaran (2006) requires that the cross-section dimension (𝑁) goes to infinity. In our set-up, this requirement can be achieved
by including more countries/regions or portfolios.

7 Section 3 of Pesaran (2006) contains the motivation for approximating the generalized unobserved common factors by weighted cross-section averages.
529
where a consistent estimator of 𝜮 𝛽𝑖 can be obtained using the Newey and West (1987) type procedure
( ⊤ )−1 ( ⊤ )−1
𝑿𝑖 𝑴 𝑤𝑿𝑖 𝑿𝑖 𝑴 𝑤𝑿𝑖
̂
𝜮 𝑇 ,𝛽𝑖 = ̂
𝑺 𝑖𝜖
𝑇 𝑇
with
( )
∑
𝑝
𝑗
𝑺̂ 𝑖𝜖 = 𝜦
̂ 𝑖0 + 1− ̂ ⊤ ),
̂ 𝑖𝑗 + 𝜦
(𝜦
𝑝+1 𝑖𝑗
𝑗=1
∑
𝑝
̂ 𝑖𝑗 = 𝑇 −1
𝜦 𝑒̂𝑖𝑡 𝑒̂𝑖,𝑡−𝑗 𝒙̂ 𝑖𝑡 𝒙̂ ⊤
𝑖,𝑡−𝑗 .
𝑡=𝑗+1
Note that 𝑝 is the window size that can be assigned either arbitrarily or following the optimal routine proposed in Newey and West
(1987), 𝑒̂𝑖𝑡 is the 𝑡th element of 𝒆̂ 𝑖 = 𝑴 𝑤 (𝒚 𝑖 − 𝑿 𝑖 𝜷̂ 𝑖 ), and 𝒙̂ ⊤ ̂
𝑖𝑡 is the 𝑡th row of 𝑿 𝑖 = 𝑴 𝑤 𝑿 𝑖 .
Once we obtain individual slope coefficients 𝜷̂ 𝑖 by (6), we can estimate the coefficients of the observed common effects, 𝜶 𝑖 ,
following the procedure described in Pesaran and Tosetti (2011)8
( )−1 ⊤ ( )
𝜶̂ 𝑖 = 𝑫 ⊤ 𝑫 𝑫 𝒚 𝑖 − 𝑿 𝑖 𝜷̂ 𝑖 . (8)
Since the above estimator only requires a simple OLS procedure, we can derive its standard error and asymptotic distribution
following the classic routine.
2.4. Selection of weights
The asymptotic results hold for all weights 𝑤𝑖 that satisfy the conditions listed in (7). However, the selection of weights matters
for a small 𝑁. Pesaran (2006) proposed a possible approach to determining weights such that the asymptotic variances of the
interesting coefficient estimators are minimized subject to the conditions listed in (7). In this section, we extend this idea to put
forward a data-driven optimization procedure for determining a 𝑤𝑖 value that minimizes estimated intercepts 𝜶̂ 𝑖 .9
We first denote the conditions listed in (7) as set 𝜴. Bounding parameter 𝐾 may be arbitrary in practice. Therefore, we propose
slightly restrictive condition set 𝜴1 in which 𝐾 = 1. To satisfy 𝜴 or 𝜴1 , empirical weights 𝑤𝑖 are likely to be negative. If we constrain
each 𝑤𝑖 to be positive, we obtain more restrictive condition set 𝜴+ . Note that 𝜴+ ⊂ 𝜴1 ⊂ 𝜴.
We denote 𝒘∗ = [𝑤∗1 , … , 𝑤∗𝑁 ], where 𝑤∗𝑖 is a specific weight assigned to unit 𝑖. For the individual slope coefficients, the CCE
estimator (6) with weights 𝒘∗ can be denoted as 𝜷̂ 𝑖 (𝒘∗ ), since 𝜷̂ 𝑖 is a (nonlinear) function of 𝒘∗ through 𝒛̄ 𝑤𝑡 . We consider a simple
case of 𝒅 𝑡 = 1, as there is only a constant term in the observed common factor. Intercept term 𝛼̂ 𝑖 is a function of 𝜷̂ 𝑖 by Eq. (8), which
implies that we can also write 𝛼̂ 𝑖 (𝒘∗ ) as a function of 𝒘∗ . The asymptotic variance of the mean group estimator of the intercepts
can be given by
1 ∑(
𝑁
)2
𝑉𝛼 (𝒘∗ ) = 𝛼̂ (𝒘∗ ) − 𝛼0 ,
𝑁 − 1 𝑖=1 𝑖
where 𝛼0 is the expected intercepts for all units 𝑖.
In practice, the true values of coefficients are unknown. However, the null hypothesis of the GRS statistic implies that if the factor
returns minimize variance for a given level of expected return, the intercept is not significantly different from zero in a regression
of an asset’s excess returns on the model’s factor returns.10 Therefore, the vector of empirical weights 𝒘∗ can be reasonably defined
as the solution to
1 ∑(
𝑁
)2
̂ ∗ = arg min 𝑉𝛼 (𝒘∗ ) = arg min
𝒘 𝛼̂ (𝒘∗ ) − 𝛼0 (9)
𝑁 − 1 𝑖=1 𝑖
subject to 𝒘∗ ∈ 𝜴 or 𝜴1 or 𝜴+ and 𝛼0 = 0. This procedure involves a convex optimization process.
2.5. Global factors and integration index
In this section, we explain how to obtain the global factors and propose our global integration index accordingly. Although global
factor 𝑭 defined in (5) is unobserved, we can obtain estimates of the true global factors using the principal component analysis
(PCA) method. For completeness, we rewrite (5) as:
𝒚 𝑖 = 𝑫𝜶 𝑖 + 𝑿 𝑖 𝜷 𝑖 + 𝑭 𝜸 𝑖 + 𝝐 𝑖 .
8 In the original paper, Pesaran (2006) did not focus his discussions on estimating 𝜶 . Pesaran and Tosetti (2011) proposed a valid procedure for estimating
𝑖
𝜶 𝑖 and investigated its asymptotic properties.
9 As stated in Gibbons, Ross, and Shanken (1989) and Fama and French (2015), if an asset pricing model can mimic expected returns well, the intercept is
indistinguishable from zero in a regression of an asset’s excess return on the model’s factor returns. If the null hypothesis of the GRS statistic is true, we have
a central 𝐹 distribution.
10 See Gibbons et al. (1989) and Fama and French (1993) for detailed explanations.
530
As explained in Section 2.3, we can consistently estimate coefficients 𝜶 𝑖 and 𝜷 𝑖 with Eqs. (6) and (8), respectively. Therefore, the
residuals are given by
𝒆̂ 𝑖 = 𝒚 𝑖 − 𝑫 𝜶̂ 𝑖 − 𝑿 𝑖 𝜷̂ 𝑖 ,
where 𝒆𝑖 are assumed to follow a multi-factor error structure defined in (2). Residuals 𝒆̂ 𝑖 share the common component 𝑭 across all
cross-section units of 𝑖, and 𝝐 𝑖 are the idiosyncratic errors. Therefore, it is natural to use the PCA to extract 𝑭̂ from the information
set spanned by 𝒆̂ 𝑖 for 𝑖 = 1, … , 𝑁. Appendix A.2 provides technical details on the PCA method under our framework. By design,
𝑭̂ contains standardized vectors with mean 0 and variance 1. In practice, the number of vectors in 𝑭̂ , equivalent to the number
of unobserved factors, m, can be selected either arbitrarily or using the selection criterion proposed in Bai and Ng (2002). An
illustration of Bai and Ng (2002) criterion is provided in Appendix A.3. Note that consistent estimation of 𝜷 𝑖 and 𝜶 𝑖 is guaranteed
under any fixed number of unobserved factors, m.
Once we obtain the estimated global factors, we can use them to quantify the global market integration level. Our intuition is
that since the global factors represent the common effects in the global markets, if the global factors can explain a fair amount of
the variation in average returns, the global market integration level must be high, and vice versa. That is, we are interested in seeing
how much additional proportion of variation in average returns can be exclusively explained by our global factors. In this paper,
we calculate the partial-𝑅2 of 𝑭̂ to measure the relative importance of our global factors and thus the global market integration
level.
The partial-𝑅2 of the panel regression (1) are defined as the proportion of variation that cannot be explained in a reduced model
without the global factors, but can be explained in a full model incorporating the global factors. Note that the reduced model should
not incorporate any global factors. Since the local factors 𝒙𝑔𝑖 ,𝑡 are also affected by the global factors 𝒇 𝑡 , as indicated in Eq. (3), we
screen the global effects out of 𝒙𝑔𝑖 ,𝑡 and obtain the purified local factors 𝒙̃ 𝑔𝑖 ,𝑡 following:
⊤
𝒙̃ 𝑔𝑖 ,𝑡 = 𝒙𝑔𝑖 ,𝑡 − 𝜞̂ 𝑖 𝒇̂ 𝑡 ,
where 𝒇̂ 𝑡 are the estimated global factors and 𝜞̂ are computed from Eq. (3). We plug in 𝒙̃ 𝑔𝑖 ,𝑡 in Model (1) and obtain the following
reduced model:
𝑦𝑖𝑡 = 𝜶 ⊤ ⊤
𝑖 𝒅𝑡 + 𝜷 𝑖 𝒙
̃ 𝑔𝑖 ,𝑡 + 𝑒̃𝑖𝑡 .
Following the definition of the coefficient of partial determination, the global integration index is given by
SSRreduced − SSRfull
Integration Index = 𝑅̃ 2partial = ∈ [0, 1),
SSRreduced
where SSRreduced and SSRfull represent the sum of squared residuals of the reduced model and full model, respectively. SSRreduced is
typically greater than SSRfull and the index falls within interval (0, 1). A high value of this index represents a strong level of global
market integration and a low value of the index indicates the opposite.
2.6. Simulation
In this section, we present simulations to show the validity of our method and compare ours to the measures described
in Pukthuanthong and Roll (2009) and Rangvid, Santa-Clara, and Schmeling (2016).
We consider the following simplified data generating process (DGP):
𝑦𝑖𝑡 = 𝛼𝑖 + 𝛽𝑖 𝑥𝑔𝑖 ,𝑡 + 𝑒𝑖𝑡 ,

𝑒𝑖𝑡 = 𝛾𝑖 𝑓𝑡 + 𝜖𝑖𝑡 ,
𝑥𝑔𝑖 ,𝑡 = 𝛼𝑖 + 𝛤𝑖 𝑓𝑡 + 𝑣𝑔𝑖 ,𝑡 ,
where we assume that there is a latent global factor and that the return in each region is affected by one local factor explicitly.
However, the local factor is driven by global factor 𝑓𝑡 . We set identical coefficients 𝛼𝑖 = 𝛽𝑖 = 𝛾𝑖 = 𝛤𝑖 = 1 and allow 𝑓𝑡 ∼ 𝑁(0, 1) and
𝑥𝑔𝑖 ,𝑡 ∼ 𝑁(0, 1) for all 𝑖. Error terms 𝜖𝑖𝑡 and 𝑣𝑔𝑖 ,𝑡 are also generated from 𝑁(0, 1). We fix 𝑇 = 100 for each region and consider various
numbers of regions 𝑁 = 2, … , 10.
For each round of estimation, we compute our integration index and that described in Pukthuanthong and Roll (2009). For both
methods, we only use the most important eigenvector as the global factor by the PCA. We compare the estimated indices to the true
explanatory power of the global factor by regressing the (infeasible) 𝑓𝑡 on 𝑦𝑖𝑡 . All indices are averaged by 𝐵 = 1000 repetitions.
We plot the results of various measures on explanatory power against different numbers of regions in Fig. 1. The dashed, dotted,
and solid lines represent results of the true measure, the averaged 𝑅2 developed by Pukthuanthong and Roll (2009), and our
integration measure, respectively.
As our simulation design is invariant to different numbers of regions, the true measure forms a straight line. Compared to the
true measure, both estimated measures overshoot and it is clear that our measure shows less significant biases under all values of
𝑁. This trend is particularly true when 𝑁 is small, in which extra noise term 𝜷 ⊤ 𝑖 𝒗𝑔𝑖 ,𝑡 has a significant impact. As 𝑁 increases, both
measures converge to the true value, although our measure still shows better performance.
We also evaluate the Var(𝑅𝑖,𝑡 )0.5 measure developed by Rangvid, Santa-Clara, and Schmeling (2016) using a similar simulation
design. Measure Var(𝑅𝑖,𝑡 )0.5 calculates the variance of asset returns across regions at time 𝑡. The measure does not rely on explanatory
531
Fig. 1. Performance of various measures under different numbers of regions.
Fig. 2. Performance of the Var(𝑅𝑖,𝑡 )0.5 measure under different number of regions.
power and it is inappropriate to compare the two types of measures quantitatively.

√ We consider the following modification of the
original simulation design. We allow 𝜖𝑖𝑡 ∼ 𝑁(0, 𝜎 2 ) and set coefficient 𝛽𝑖 = 1 − 𝜎 2 based on 𝜎 2 . All other settings are identical to
those of the original design. Under this set-up, actual noise term (𝜷 ⊤
𝑖 𝒗𝑔𝑖 ,𝑡 + 𝜖𝑖𝑡 ) has a constant variance of 2 despite which values
we assign to 𝜎. However, the explanatory power of 𝑓𝑡 is affected by the value of 𝜎 through its coefficient 𝛽𝑖 . We consider various
values of 𝜎 = 0.1, … , 0.9. We want to show that measure Var(𝑅𝑖,𝑡 )0.5 cannot capture the integration movement due to the noise term.
For simplicity, we report the average Var(𝑅𝑖,𝑡 )0.5 measure across all repetitions for all time periods. The results are presented in
Fig. 2.
√
We note that measure Var(𝑅𝑖,𝑡 )0.5 remains constant through all values of 𝜎 as expected and is quite close to 2. On the other
hand, both the averaged 𝑅2 presented by Pukthuanthong and Roll (2009) and our integration measure decrease with the value of
𝜎 since the explanatory power of 𝑓𝑡 decreases as 𝜎 increases. As usual, our measure tends to be smaller than the averaged 𝑅2 .
532
Table 1
Summary statistics for the 25 Size-B/M excess returns.
B/M → Low 2 3 4 High Low 2 3 4 High
Size ↓
Asia-Pacific Europe
Small 0.472 0.381 0.737 1.062 1.441 −0.082 0.372 0.453 0.593 0.754
(8.132) (7.491) (7.127) (6.895) (7.050) (5.492) (5.269) (4.955) (4.843) (4.826)
2 −0.083 0.208 0.371 0.577 0.930 0.288 0.486 0.549 0.707 0.761
(6.884) (7.187) (6.500) (6.710) (7.374) (5.628) (5.248) (5.019) (5.061) (5.301)
3 0.136 0.296 0.766 0.686 0.772 0.337 0.562 0.540 0.545 0.740
(7.012) (6.652) (6.634) (6.643) (7.302) (5.712) (5.230) (5.138) (5.178) (5.592)
4 0.617 0.773 0.566 0.896 1.038 0.489 0.526 0.591 0.553 0.645
(6.323) (6.217) (6.140) (6.426) (7.664) (5.389) (4.987) (5.012) (5.347) (5.805)
Big 0.570 0.769 0.793 0.791 0.985 0.345 0.527 0.571 0.644 0.536
(6.237) (5.970) (6.178) (6.235) (7.828) (4.840) (4.766) (5.212) (5.418) (6.339)
Japan North America
Small 0.357 0.336 0.352 0.392 0.532 0.434 0.603 0.906 0.881 1.163
(8.911) (7.436) (7.194) (6.769) (6.919) (7.957) (6.816) (6.126) (5.388) (5.275)
2 0.254 −0.032 0.120 0.275 0.272 0.402 0.622 0.793 0.801 0.857
(8.310) (7.321) (6.803) (6.682) (6.844) (7.314) (6.487) (5.471) (4.917) (5.155)
3 −0.178 0.019 0.093 0.113 0.333 0.786 0.684 0.779 0.778 0.893
(7.721) (6.677) (6.303) (6.177) (6.626) (6.883) (5.703) (5.018) (4.721) (4.879)
4 −0.167 0.093 0.090 0.242 0.272 0.821 0.701 0.809 0.767 0.856
(7.117) (6.251) (5.877) (5.923) (6.652) (6.439) (5.061) (4.566) (4.578) (4.757)
Big −0.066 0.075 0.107 0.234 0.444 0.640 0.657 0.633 0.648 0.572
(6.552) (5.790) (5.887) (5.844) (6.989) (4.533) (4.098) (4.209) (4.124) (5.232)
The sample period of the 25 size-B/M portfolios runs from July 1990 to November 2017. The data cover 23 developed markets
that are combined into four regions: (i) AP, (ii) Europe, (iii) Japan, and (iv) NA, which are, respectively, reported in each of
the four panels. The table summarizes the average monthly percent excess returns and standard deviation (in parentheses) for
each portfolio in each region.
3. Portfolios and pricing factors
For data accessibility and convenience of model comparison, we directly download monthly average returns and five FF factors
from their online data library. The sample period runs from July 1990 to November 2017. We examine the portfolios of the following
four regions combined from 23 developed markets, similar to those used in Fama and French (2012)11 :
(i) AP, including Australia, New Zealand, Hong Kong, and Singapore;
(ii) Europe, including Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, the Netherlands, Norway,
Portugal, Spain, Sweden, Switzerland, and the United Kingdom;
(iii) Japan; and
(iv) NA, including the United States and Canada.
Note that all returns are in U.S. dollars and monthly excess returns are returns in excess of the one-month U.S. Treasury bill rate.
The construction procedure for the left-hand-side (LHS) portfolio returns and right-hand-side (RHS) factor-mimicking portfolios is
comprehensively described in Fama and French (2015, 2017).
In the main analysis, the LHS portfolio returns for each region in regression (1) are constructed on the basis of local stocks and
are built from 5 × 5 sorts on size and the ratio of book equity to market equity (B/M).12 Table 1 describes matrices of average
excess returns and their standard deviations for the 25 size-B/M portfolios of four regions. The table demonstrates that for the
sample period of 1990–2017, lower average returns for small growth stocks occur for all regions except for Japan. Japan aside, the
reverse size effect is more pronounced for extreme growth stocks (the leftmost column of the 5 × 5 size-B/M matrices).
For extreme value portfolios, we find a standard size effect in the right column of Table 1: the small high B/M portfolios have
higher average returns than the large high B/M portfolios. The value premium applies to every region: the average returns increase
from left to right in every row of all of the size-B/M matrices. Except for Japan, the value premium is larger for small stocks,
especially microcaps, which is the combined effect of lower average returns for small stocks and a typical size effect shown in the
right column. Thus, an initial examination confirms the same findings as those shown in earlier papers (Fama and French, 2012; Fama
and French, 2017), even with 6 years of new data.
For the RHS variables, we consider three types of factors in our analysis. The first pricing factors are the five FF local factors,
which are estimated based on returns of regional stocks. Note that we consider the five FF factors as in Fama and French (2015,
11 As argued in Fama and French (2012), the grouping of country-level markets has to be parsimonious so that the power of the asset pricing test (i.e., GRS
statistic) is basically unaffected, while the selection of regions must also be fine enough to sustain the assumption of market integration.
12 For a robustness check, we also consider the implications of alternative sorting schemes such as size and profitability or size and investment in Section 5,
which yields the same findings as those derived from the main exercise.
533
Table 2
Summary statistics for factor returns.
Mkt SMB HML RMW CMA Mkt SMB HML RMW CMA
Asia-Pacific Europe
Mean 0.719 −0.101 0.645 0.198 0.376 0.511 0.071 0.338 0.397 0.211
S.D. 5.879 2.935 2.979 2.683 2.472 4.905 2.172 2.382 1.506 1.819
Minimum −26.000 −11.280 −8.490 −12.850 −7.640 −22.020 −7.340 −9.120 −4.510 −7.180
Maximum 20.520 13.280 23.660 10.460 8.610 13.670 8.770 11.330 5.690 8.710
Skewness −0.371 0.405 1.470 −0.332 0.017 −0.611 −0.064 0.366 −0.223 0.399
Kurtosis 5.406 5.479 13.831 6.043 4.658 4.627 3.894 5.948 3.427 6.457
Japan North America
Mean 0.094 0.138 0.341 0.117 0.086 0.671 0.167 0.198 0.336 0.263
S.D. 5.790 3.272 2.888 2.134 2.397 4.200 2.763 3.228 2.414 2.653
Minimum −17.380 −11.560 −13.700 −7.830 −12.980 −18.430 −13.540 −13.370 −15.300 −10.020
Maximum 24.900 13.100 10.910 9.090 7.640 11.560 16.470 16.750 13.180 14.220
Skewness 0.322 0.092 −0.140 0.021 −0.727 −0.739 0.336 0.579 0.138 0.946
Kurtosis 4.235 4.685 5.179 5.007 7.301 4.673 7.630 7.672 12.219 7.660
Global
Mean 0.482 0.110 0.325 0.350 0.237
S.D. 4.271 1.968 2.329 1.487 1.882
Minimum −19.520 −8.610 −10.130 −5.830 −6.560
Maximum 11.420 8.300 12.220 6.410 9.800
Skewness −0.738 −0.332 0.549 −0.021 0.723
Kurtosis 1.792 2.498 5.673 2.214 4.262
The sample period runs from July 1990 to November 2017. The data cover 23 developed markets that are combined into four
regions: (i) AP, (ii) Europe, (iii) Japan, and (iv) NA, which are, respectively, reported in each of the upper four panels. The five
FF factors included are the same as those used in Fama and French (2015) and Fama and French (2017): 𝑀𝑘𝑡, 𝑆𝑀𝐵, 𝐻𝑀𝐿,
𝑅𝑀𝑊 and 𝐶𝑀𝐴. The last panel is for the global portfolios from the FF online database. The table shows mean, standard
deviation, minimum, maximum, skewness and kurtosis values for factor mimicking portfolio returns.
2017): the market factor (𝑀𝑘𝑡), size factor (𝑆𝑀𝐵), value factor (𝐻𝑀𝐿), profitability factor (𝑅𝑀𝑊 ) and investment factor (𝐶𝑀𝐴).
We choose to use regional factors rather than country-level factors as our local factors because Bekaert, Harvey, and Ng (2005)
demonstrates that within-region country factors can be mostly explained by regional factors. The second type of factors are FF
global factors, which are based on their global portfolios from the data of the four studied regions. The last type of variables are
our global factors, the extraction method of which are fully described in Section 2.5.
Table 2 presents summary statistics for the five explanatory returns for each region and for the FF global portfolios. In line
with Fama and French (2017), the equity premium (the average return of (𝑀𝑘𝑡) for Japan for 1990–2017 is near zero (0.094% per
month). Equity premiums for the other regions are much larger (0.671% for NA; 0.511% for Europe; and 0.719% for AP). Compared
to other factor returns, the size premium (the average SMB return) is small in all regions. The largest premium is 0.167% for NA.
Large value premiums continue to dominate for 1990–2017. Among them, NA has the lowest value premium of 0.198%.
Profitability premiums (average RMW returns) still matter more for NA and Europe than for AP and Japan (0.397% for Europe;
0.336% for NA). The investment premium (average CMA returns) is significant for AP for 1990–2017 (0.376% for AP), whereas its
effect is close to zero for Japan for the same period (0.086% for Japan). From the factor returns for the global portfolios, 𝑀𝑘𝑡, the
value and profitability premiums are relatively weighty (0.482% for 𝑀𝑘𝑡; 0.325% for 𝐻𝑀𝐿; 0.35% for 𝑅𝑀𝑊 ).
4. Empirical analysis
With the following empirical exercises, we illustrate an application of our panel-based asset pricing model to the regional
portfolios from 5 × 5 sorts of Fama and French (2015). We first demonstrate the existence of CD and evaluate the importance
of our global factors for asset returns via intercept tests used in Merton (1973) and the CSR method presented in Fama and MacBeth
(1973), respectively.13 Finally, we produce a series of integration indices based on varying combinations of the four studied regions.
4.1. Global factors
4.1.1. Cross-sectional dependence

Since the LHS portfolio returns are constructed following the FF method, it is sensible for us to fit their five-factor model as the
reference model, which is expressed as
𝑅𝑖𝑡 − 𝑅𝐹 𝑡 = 𝛼𝑖 + 𝛽𝑖1 (𝑅𝑀𝑡 − 𝑅𝐹 𝑡 ) + 𝛽𝑖2 SMB𝑡 + 𝛽𝑖3 HML𝑡 + 𝛽𝑖4 RMW𝑡 + 𝛽𝑖5 CMA𝑡 + 𝑒𝑖𝑡 , (10)
13 Merton (1973) proposed that a well-specified asset-pricing model yields intercepts that are indistinguishable from zero in time-series regressions with excess
returns as dependent variables and excess returns on zero investment portfolios as explanatory variables. In contrast, the Fama–MacBeth regressions generate
average slopes for determining which explanatory variables on average have non-zero expected risk premiums.
534
Table 3
Results of the CD test for average returns of regional portfolios.
Region Local Local and FF5 global Local and our global
CD-stat 𝑝-value CD-stat 𝑝-value CD-stat 𝑝-value
Overall 3.293 0.001 2.576 0.010 −1.276 0.210
This table reports the CD test statistics and the corresponding 𝑝-values for the residuals of the
100 regional portfolio regressions. The residuals are obtained by running the OLS of the below
three model specifications. ‘Local’ denotes that the regression contains only the five FF local
factors from 2 × 3 sorts. ‘Local and FF5 Global’ denotes that there are five FF local factors and
five FF global factors in the model. ‘Local and Our Global’ denotes that five FF local factors and
five global factors are obtained through our CCE approach.
which adds profitability (RMW𝑡 ) and investment (CMA𝑡 ) factors to the market, size, and value/growth factors of the three-factor
model of Fama and French (1993). The above five factors can be computed either on return differences of regions-specific portfolios
or on global portfolios pooling all of the stocks. Fama and French (2012, 2017) studied international asset returns with both local
and global factors in their models. Hence, we adopt their five-factor model with local factors only and one with both local and
global factors as our reference models in the sequel. However, it should be noted that neither of the above two papers explicitly
controls for any cross-regional correlations of returns.
Our framework also aims to capture the global effects on average returns from a different perspective. Our basic model
specification still conforms to the local version of the FF5 model, which implies that 𝒙𝑔𝑖 ,𝑡 contains exclusively the above five factors
for specific region 𝑔. However, instead of relying on the pooled data to build global factors, we decompose the residuals of return
regressions on local factors by extracting the common components of the PCA as our global factors. In this way, our framework can
be regarded as an extension of the previous models with accounts for error cross-regional dependence. Note that we fix the number
of unobserved factors (𝑚) at five to be comparable with the FF5 model.
To implement the CCE estimator, it is essential to first verify the existence of potential error CD. If the CD test fails to reject the
null that the error terms are cross-sectionally independent, a conventional estimator such as the OLS or GLS is reasonable; otherwise,
such an estimator can lead to inconsistent and misleading results. This is particularly true if the explanatory variables and error
terms are assumed to follow the framework described in Eq. (2) and Eq. (3).14
In Table 3, we report the CD test developed by Pesaran (2004) and the corresponding p-values, which are based on the average
of pairwise correlations of the residuals from regressions of average returns of the regional portfolios. The regressions are run by
OLS on the three model specifications discussed above: the FF5 model with local factors only (Local), the FF5 model with both local
and FF global factors (Local and FF Global) and the FF5 model with local and our global factors (Local and Our Global). For the
models with local factors only, these error terms show a considerable degree of CD.15 The 𝑝-value of the test statistics is close to
zero. The same result is found for the residuals of models with local and FF global factors with a slightly improved 𝑝-value (0.01
for Local and FF Global).
Finally, we replace the FF five global factors with our global factors in the model. The model contains five local factors and five
of our global factors. In this case, the CD test generates a statistic of −1.276 with a 𝑝-value of 0.21, which suggests that we cannot
reject the null hypothesis. This result implies that the CD of average portfolio returns does exist, which supports the utilization of
this information to improve explaining average stock returns.
4.1.2. Estimated intercepts

In asset pricing models, the intercepts are interpreted as pricing errors. If the models are able to capture the pattern of average
asset returns, the intercepts should be insignificantly different from zero. We still depend on the above three types of model
specifications and report their intercept estimates and relevant significance in Table 4. The intercepts significantly different from
zero at the level of 10% are bolded in blue.
As is shown, for the first FF5 local models for regional Size-B/M portfolios, 17 of 100 portfolios have significant intercepts.
Consistent with Fama and French (2017), the local models show problems in describing average returns on microcap and high B/M
portfolios for all regions except for Europe. After the FF global factors are added to the model, the number of significant intercepts
reduces to 16. Though the results are improved, the second set of models still fares poorly in tests on microcap and value portfolios
for AP, Japan and NA. In contrast, when the third model with error CD is analyzed, the total number of significant intercepts reduces
to 5 for all regions. The issue of value and microcap portfolios remains for NA but to a much milder degree.
4.1.3. Fama–MacBeth regression

As a complement, we also consider the CSR method proposed by Fama and MacBeth (1973) for determining the fraction of the
cross-sectional variation of average returns that can be explained by the model for the sample period. The Fama–MacBeth method
14 Appendix A.1 provides a detailed discussion of the CD test provided by Pesaran (2004).
15 Under the null of weak error CD, the CD statistics are asymptotically distributed as 𝑁 (0, 1).
535
Table 4
Results of intercept estimates for regional portfolios from 5 × 5 Size-B/M sorts.
B/M → Local Local and FF5 global Local and our global
Size ↓
Low 2 3 4 High Low 2 3 4 High Low 2 3 4 High
Panel A: Asia-Pacific
Small 0.211 −0.007 0.189 0.463 0.707 0.214 −0.016 0.189 0.446 0.686 −0.101 −0.027 −0.001 0.090 0.180
(0.238) (0.150) (0.134) (0.116) (0.125) (0.249) (0.165) (0.139) (0.115) (0.127) (0.207) (0.143) (0.125) (0.125) (0.139)
2 −0.315 −0.204 −0.138 −0.188 −0.006 −0.279 −0.151 −0.066 −0.167 −0.041 −0.085 −0.085 0.002 −0.055 −0.054
(0.163) (0.124) (0.133) (0.117) (0.118) (0.164) (0.124) (0.129) (0.128) (0.116) (0.143) (0.122) (0.115) (0.110) (0.108)
3 0.031 −0.295 −0.008 −0.125 −0.208 −0.002 −0.310 0.054 0.005 −0.219 −0.064 −0.299 0.036 0.008 −0.119
(0.163) (0.150) (0.143) (0.150) (0.161) (0.172) (0.153) (0.146) (0.147) (0.173) (0.150) (0.140) (0.125) (0.141) (0.143)
4 0.117 0.061 −0.221 −0.052 −0.061 0.172 0.190 −0.103 0.066 −0.059 0.049 0.084 0.027 0.078 0.117
(0.157) (0.170) (0.135) (0.136) (0.133) (0.155) (0.169) (0.130) (0.137) (0.137) (0.144) (0.151) (0.140) (0.124) (0.144)
Big 0.183 0.070 −0.052 −0.157 −0.094 0.118 0.103 −0.124 −0.140 −0.016 −0.077 0.047 −0.112 −0.002 0.011
(0.112) (0.087) (0.125) (0.104) (0.153) (0.104) (0.085) (0.118) (0.102) (0.138) (0.116) (0.092) (0.116) (0.110) (0.163)
Panel B: Europe
Small −0.217 0.064 0.078 0.008 0.079 −0.430 −0.116 −0.015 −0.005 0.038 −0.226 −0.025 −0.006 −0.024 0.046
(0.107) (0.085) (0.068) (0.059) (0.054) (0.116) (0.087) (0.078) (0.066) (0.062) (0.099) (0.077) (0.065) (0.056) (0.058)
2 0.042 0.042 −0.049 −0.017 −0.016 −0.010 0.076 −0.082 0.103 0.016 0.019 0.042 −0.075 0.015 −0.037
(0.075) (0.071) (0.057) (0.065) (0.061) (0.082) (0.098) (0.067) (0.077) (0.066) (0.074) (0.062) (0.055) (0.056) (0.054)
3 0.156 0.022 −0.181 −0.209 −0.069 0.031 0.086 −0.007 0.041 −0.005 −0.017 0.025 −0.093 −0.068 −0.022
(0.085) (0.077) (0.079) (0.076) (0.081) (0.102) (0.086) (0.094) (0.080) (0.089) (0.082) (0.070) (0.073) (0.070) (0.071)
4 0.255 −0.023 −0.088 −0.184 −0.160 0.212 0.097 0.074 −0.052 −0.093 0.071 −0.065 0.000 −0.162 −0.042
(0.093) (0.083) (0.072) (0.091) (0.083) (0.101) (0.087) (0.078) (0.106) (0.094) (0.085) (0.075) (0.070) (0.077) (0.077)
Big 0.089 −0.087 0.040 0.068 0.042 0.031 0.025 0.096 0.095 −0.181 −0.010 0.051 0.019 0.032 −0.079
(0.068) (0.066) (0.066) (0.079) (0.084) (0.084) (0.073) (0.073) (0.084) (0.088) (0.076) (0.064) (0.058) (0.082) (0.078)
Panel C: Japan
Small 0.184 0.132 0.124 0.165 0.180 0.223 0.163 0.127 0.167 0.176 0.080 0.036 −0.008 0.049 0.046
(0.170) (0.116) (0.120) (0.078) (0.075) (0.167) (0.113) (0.112) (0.077) (0.075) (0.180) (0.130) (0.131) (0.096) (0.094)
2 0.126 −0.176 −0.125 0.035 −0.081 0.165 −0.163 −0.104 0.043 −0.097 0.048 −0.048 0.011 0.119 0.029
(0.152) (0.098) (0.091) (0.070) (0.051) (0.150) (0.097) (0.087) (0.070) (0.050) (0.154) (0.107) (0.101) (0.076) (0.072)
3 −0.246 −0.073 −0.127 −0.158 −0.012 −0.263 −0.087 −0.117 −0.159 −0.026 −0.057 0.019 −0.036 −0.053 0.049
(0.137) (0.099) (0.086) (0.072) (0.066) (0.134) (0.098) (0.086) (0.070) (0.063) (0.172) (0.109) (0.094) (0.086) (0.077)
4 −0.171 0.008 −0.074 −0.020 −0.099 −0.186 −0.002 −0.056 −0.010 −0.111 −0.028 0.116 0.061 0.075 −0.037
(0.121) (0.097) (0.095) (0.089) (0.085) (0.119) (0.096) (0.094) (0.086) (0.081) (0.139) (0.107) (0.107) (0.095) (0.093)
Big 0.078 0.031 −0.044 0.008 0.105 0.044 0.066 −0.008 0.009 0.164 0.076 0.113 0.018 0.015 0.121
(0.088) (0.091) (0.090) (0.096) (0.150) (0.088) (0.087) (0.087) (0.095) (0.142) (0.084) (0.093) (0.095) (0.098) (0.151)
Panel D: North America

Small −0.145 −0.065 0.193 0.178 0.353 −0.144 −0.125 0.251 0.248 0.481 −0.118 −0.080 0.137 0.143 0.307
(0.132) (0.104) (0.089) (0.073) (0.074) (0.160) (0.115) (0.107) (0.090) (0.082) (0.131) (0.114) (0.089) (0.070) (0.075)
2 −0.184 −0.055 −0.050 −0.058 −0.131 −0.268 −0.023 −0.059 −0.106 −0.113 −0.024 −0.047 −0.010 −0.017 −0.009
(0.112) (0.082) (0.077) (0.061) (0.052) (0.137) (0.098) (0.094) (0.067) (0.058) (0.112) (0.081) (0.069) (0.063) (0.066)
3 0.133 −0.076 −0.086 −0.150 −0.035 0.188 −0.100 −0.107 −0.198 −0.117 0.099 −0.057 0.026 −0.050 0.007
(0.104) (0.089) (0.078) (0.076) (0.071) (0.126) (0.104) (0.091) (0.088) (0.091) (0.095) (0.088) (0.082) (0.085) (0.075)
4 0.275 −0.001 −0.022 −0.150 −0.058 0.213 0.012 −0.003 −0.176 −0.088 0.129 0.082 0.081 −0.007 0.030
(0.107) (0.084) (0.084) (0.092) (0.076) (0.158) (0.098) (0.096) (0.107) (0.089) (0.106) (0.087) (0.090) (0.096) (0.078)
Big 0.047 −0.003 −0.048 −0.006 −0.169 0.010 −0.013 0.013 0.045 −0.277 0.025 −0.013 0.054 0.012 −0.033
(0.057) (0.064) (0.070) (0.077) (0.091) (0.064) (0.074) (0.079) (0.099) (0.097) (0.058) (0.064) (0.072) (0.070) (0.113)
We report the intercepts with the corresponding standard errors in parentheses for a set of regressions: ‘Local’ denotes that the regression contains only the five FF local factors. ‘Local
and FF5 Global’ denotes that there are five FF local factors and five FF global factors in the model. ‘Local and Our Global’ denotes that five FF local factors and five global factors
are obtained by the CCE approach. The significant intercepts are bolded in blue. Each panel refers to a specific region.
involves a two-step process, where we first estimate the factor loadings of the FF five factors for each region with one of the three
considered specifications. We then consider the following CSR for each region
𝐸(𝑅𝑖𝑡 − 𝑅𝐹 𝑡 ) = 𝛿0 + 𝛿1 𝛽̂𝑖1 + ⋯ + 𝛿5 𝛽̂𝑖5 + 𝑢𝑖 for 𝑖 = 1, … , 25 portfolios, (11)
where 𝐸(𝑅𝑖𝑡 − 𝑅𝐹 𝑡 ) is the mean risk premium for each regional portfolio represented by its sample analog, 𝛿0 is an intercept,
𝛽̂𝑖1 , … , 𝛽̂𝑖𝑝 are the estimated factor loadings for the FF factors, and 𝑢𝑖 is an error term. We use the adjusted-𝑅2 in the CSR as an
intuitive measure.
Table 5 summarizes the adjusted-𝑅2 s for the four regions. The first column reports the values obtained when only local factors
are included in the model. The second column reports the results for the models containing five local factors and five global FF
factors. The remaining columns report the results for our panel-based model with both local factors and unobserved global factors.
In addition, we run the CSRs for different numbers of our global factors to examine how the adjusted-𝑅2 is sensitive to this number.
It is interesting that adding the FF global factors only helps for the cross-sectional performance of AP and Japan. This result
coincides with the finding presented in Fama and French (2012) showing that global models fare poorly when used to explain the
536
Table 5
Adjusted 𝑅2 s for cross-sectional regressions.
Model Local Local and FF5 global Local and our global
𝑚=1 𝑚=2 𝑚=3 𝑚=4 𝑚=5 𝑚=6 𝑚=7 𝑚=8 𝑚=9 𝑚 = 10
Panel A: Asia-Pacific
0.597 0.653 0.921 0.927 0.924 0.929 0.926 0.924 0.920 0.922 0.915 0.912
Panel B: Europe
0.622 0.544 0.853 0.844 0.841 0.847 0.836 0.831 0.817 0.831 0.826 0.808
Panel C: Japan
0.502 0.592 0.922 0.917 0.914 0.911 0.908 0.901 0.905 0.897 0.893 0.887
Panel D: North America
0.360 0.351 0.736 0.721 0.741 0.725 0.707 0.861 0.888 0.882 0.879 0.873
We run the CSR for each region based on three different models. ‘Local’ denotes that the regression contains only the five FF local factors.
‘Local and FF5 Global’ denotes that there are five FF local factors and five FF global factors in the model. ‘Local and Our Global’ denotes
that five FF local factors and five global factors are obtained from the CCE approach. ‘m’ denotes the fixed number of unobserved global
factors set for the PCA using the CCE approach. The adjusted-𝑅2 each every region is reported in each of the above four panels.
returns on regional size-B/M portfolios. When the FF5 model is augmented with unobserved global factors, the adjusted-𝑅2 is always
higher relative to the first two models regardless of the number of unobserved global factors.16
4.2. Integration index
In this section, we present the results for our index that measures market integration across regions. Since our integration index
results from the partial-𝑅2 of panel regressions, we can change the underlying panel data by varying groups of regions, which further
provides the leave-one-out integration indices and pairwise integration indices, serving as additional examinations to understand
global market integration.
4.2.1. Global integration

We first consider the global integration index based on the panel data of all four regions. To capture the time variation in global
stock market integration, we consider a rolling window exercise for July, 1990 to November, 2017. We set window length 𝐿 at four
years, that is, 48 monthly observations.17 The LHS and RHS portfolios are constructed using the 𝐿 observations for each region. At
each roll, we iteratively compute the partial 𝑅2 of unobserved global factors as the estimated global market integration index. The
results are plotted in Fig. 3, where the horizontal axis represents time and the vertical axis denotes the estimated global integration
index. The solid dots show the global index over time, the dashed line shows the estimated linear trend, and the solid black line
represents the smoothed curve obtained when using kernel method.
As we can observe, there are three periods of global integration since 1995. During the first period, of 1995 to 2008, the global
integration index fluctuated at around 0.4. The second period revolves around the financial crisis (2008–2014), during which the
global market suddenly became more integrated. The integration index rose sharply to the peak of 0.8 and later decreased from
this point. In the last period, from 2014 to 2017, the global integration index gradually dropped back to the pre-crisis level. The
upward trend of the index is largely due to its high levels during the recent financial crisis.
Our results conform to findings on developed markets revealed by Lehkonen (2015). The liquidity crisis of August 2007 caused
a shock that increased integration, and the collapse of Lehman Brothers in September 2008 produced segmentation in the markets,
which is fully reflected by the reverse U shape of our index for the second period. Moreover, the authors found that for other global
crises such as the Asian financial crisis, long-term capital management (LTCM) crisis and dot-com bubble crisis, global integration
slightly increased for developed markets, which also corresponds to the upward trend of our index for the first period.
Furthermore, we present the integration index for each region in Fig. 4. The four regions show quite different patterns of
integration. Since 1997, NA maintains very high levels of integration of approximately 0.6 in contrast to Japan, which shows lower
levels of integration than the others. AP is more integrated with the others during the two financial crises, and Europe displays a
gradual upward trend in integration.
4.2.2. Leave-one-out integration

Next we examine the effects of leaving one region out each time to better understand each region’s marginal contribution to
global integration. The graphs excluding AP, Europe, Japan, and NA are respectively depicted in the four panels of Fig. 5. An
intriguing result appears in Panel (a) of Fig. 5, which describes the integration index without the AP region. The exclusion of this
region produces dynamics of stock market integration between Europe, Japan and NA, showing a must flatter trend than the pattern
shown in Fig. 3. In the first and third periods with no financial crises, the average integration index fluctuated around 0.6, which is
16 The best performer for each region does switch the corresponding selection of 𝑚, where 𝑚 = 4 for AP, 𝑚 = 1 for Europe and Japan, and 𝑚 = 7 for NA.
17 We also examine other values of 𝐿 and find that the results are insensitive to the selection of 𝐿.
537
Fig. 3. The overall global market integration index.
Fig. 4. The integration for each region.
538
Fig. 5. The leave-one-out global market integration index.
a higher level relative to that shown in Fig. 3. However, in the second period, the time of the global financial crisis, the integration
of these three regions increases slightly, reaching roughly 0.8.
The remaining three plots, which report the integration indexes involving the AP region, are shaped very similar to those shown
in Fig. 3. The index level of the second period is much higher than those of the first and the third periods. Based on the above
findings, we can infer that the AP region is the main contributor to troughs and peaks of the global integration index. Moreover,
the AP markets have a closer relationship to the European and NA markets.
4.2.3. Pairwise integration

We also estimate the pairwise integration index between each pair of regions to study integration on a more granular level. The
results are presented in the six plots of Fig. 6. Several findings emerge from the analysis.
First, we find that the pairwise integration index is, on average, higher than the corresponding index in Fig. 3 or Fig. 5. This
result is understandable since the ‘global’ factors18 have more explanatory power for the portfolios formed by a smaller number of
regions.
Second, integration between AP and Europe or NA covers a wider range (relative to its integration with Japan) and fluctuates
extensively during the recent financial crisis. In contrast, integration between AP and Japan seems to be more affected by the Asian
financial crisis than by the global financial crisis.
The last trend that draws our attention is integration between Europe and NA. Although conventional wisdom is that these two
regions are closely connected culturally and economically, we find that the pairwise integration of these two regions is of roughly
18 Since we use only two regions in our approach in this analysis, the integration factors are actually based on two regions. We still use ‘global’ here to be
consistent with the previous terminology.
539
Fig. 6. The pairwise market integration level.
the same level as their relationship to Japan. On the whole, we conclude that pairwise integration fell during the global financial
crisis in all four regions in our case. Across the whole sample period, pairwise integration did not change or slightly increased.
4.3. Other existing measures
In this section, we compare our measure to the averaged adjusted-𝑅2 measure of Pukthuanthong and Roll (2009) and the
Var(𝑅𝑖,𝑡 )0.5 measure of Rangvid et al. (2016). We repeat the main exercise presented in Section 4.2.1 and estimate all three measures.
The results are presented in Fig. 7. Subplots (a) to (c) correspond to our measure, the averaged adjusted-𝑅2 measure, and the
Var(𝑅𝑖,𝑡 )0.5 measure, respectively.
We first note that both Fig. 7(a) and Fig. 7(b) show a similar pattern, which is quite different from that shown in Fig. 7(c). Both
our measure and the averaged adjusted-𝑅2 measure rely on explanatory power to construct the integration measure, and hence
they (mostly) range between 0 and 1. The Var(𝑅𝑖,𝑡 )0.5 measure on the other hand depends on the variance of returns from different
countries or regions, which is unbounded from 0 to infinity.
540
Fig. 7. Comparing various global integration measures.
Table 6
Summary statistics for the 6 size-B/M excess returns.
B/M → Low Median High Low Median High
Size ↓
Asia-Pacific Europe
Small 0.088 0.545 0.978 0.287 0.539 0.759
(6.779) (6.456) (6.814) (5.361) (4.934) (5.080)
Big 0.620 0.718 1.004 0.389 0.596 0.590
(5.909) (5.821) (7.064) (4.681) (5.006) (5.794)
Japan North America
Small 0.036 0.186 0.369 0.479 0.758 0.943
(7.694) (6.718) (6.682) (6.938) (5.365) (5.006)
Big −0.045 0.135 0.321 0.671 0.676 0.660
(6.196) (5.646) (6.155) (4.478) (4.021) (4.599)
Emerging
Small 0.229 0.706 1.203
(6.361) (6.214) (6.298)
Big 0.506 0.763 0.803
(6.073) (6.519) (6.743)
The sample period of the 6 size-B/M portfolios is from July 1990 to November
2017. The data cover 23 developed markets that are combined into four regions:
(i) AP, (ii) Europe, (iii) Japan, and (iv) NA, and 27 emerging markets that
are combined into one group: (v) Emerging. The table summarizes the average
monthly percent excess returns and its standard deviation (in parentheses) for
each portfolio in each region reported in each panel, respectively.
We also note that the averaged adjusted-𝑅2 measure yields more global integration than our measure, which is not a surprise
since we demonstrate that the averaged adjusted-𝑅2 can severely overestimate true explanatory power in a simulation (Section 2.6).
Moreover, the averaged adjusted-𝑅2 measure generates a quite smooth curve for the period of the Asian financial crisis, which
contradicts our common understanding that global integration should be intense during such a crisis.
5. Further analysis
5.1. Incorporate emerging markets
In this section, we incorporate the data of the emerging markets, obtained from the Kenneth French’s data library, in order to
explore how the emerging markets affect the global market integration. Unlike the constructed portfolios for the developed markets,
the emerging market data are sorted on size and B/M to yield only 6 portfolios (2 × 3), instead of 25 portfolios. In order to have
a fair comparison and maintain a balanced panel, we also collect the equivalent 6 portfolios for the developed markets. Summary
statistics on the constructed portfolio’s returns are reported in Tables 6 and 7, respectively.
We repeat our main analysis to estimate the overall global market integration index with emerging markets. The related index
is depicted in Fig. 8(a). For easy comparison, the global integration index without emerging markets is reproduced in Fig. 8(b). In
general, the global integration index excluding the emerging market impact seems to be at a higher level than the one including the
541
Table 7
Summary statistics for explanatory returns of emerging markets.
Mkt SMB HML RMW CMA
Mean 0.659 0.130 0.635 0.158 0.271
S.D. 6.198 2.359 2.401 1.739 1.833
Minimum −27.290 −7.920 −12.130 −10.140 −8.640
Maximum 18.400 7.820 6.350 7.940 6.430
Skewness −0.614 −0.046 −0.477 −0.606 −0.282
Kurtosis 4.919 4.052 5.883 7.877 6.598
This table summarizes the main statistics for emerging market pricing factors.
The sample period runs from July 1990 to November 2017.
Fig. 8. The global market integration index with and without emerging markets.
Note: The above results are based on the 6 portfolios’ average returns for developed markets (categorized into AP, EU, JP, and NA regions) and for the emerging
markets. The portfolios are formed from 2 × 3 sorts on size and B/M.
emerging market returns. The above finding supports the existing literature that many emerging economies still remain far behind
in terms of financial market integration (Chambet and Gibson, 2008; Bekaert et al., 2011; Lehkonen, 2015). The above results also
agree with the findings in Lehkonen (2015) that the integration index excluding emerging markets declines more steeply and appears
to be more sensitive to the 2008 crisis.
5.2. Control for excess volatility
As pointed out by the literature (see, e.g., Bekaert et al., 2005; Carrieri et al., 2007; Akbari, Ng, and Solnik, 2020), the abnormal
volatility of returns may cause an upward bias in the integration measure. Here we use the VIX to control for the effects of excess
volatility (Lehkonen, 2015). We add the VIX index as an additional regressor to the pricing model and repeat our main exercise.19
The global integration measure controlling excess volatility is presented in Fig. 9. Accounting for the effect of volatility, the new
integration index becomes much smoother. Its level is generally lower than the one in Fig. 3, especially during the crisis periods.
Nevertheless, our main arguments and findings are still qualitatively unaltered.
5.3. Alternatively sorted LHS portfolios
To check robustness of our results, we also use the average returns of portfolios from 5 × 5 sorts on size and profitability (OP)
or size and investment (INV) as alternative dependent variables. Using our model, we obtain the global integration indices, which
are plotted in Figs. 10 and 11. Comparing these two figures with Fig. 3, we find that they have similar shapes with lower values
for the first and third periods and higher values for the second period. In addition, the levels of integration in the three figures are
very close at the same point of time.
19 Note that we also compute the 𝑀-sample monthly realized volatility (RV) for individual portfolio’s returns as another proxy for volatility. The associated
results can be found in Appendix A.4.
542
Fig. 9. The global market integration index controlling excess volatility.
Table 8
Summary statistics of five macroeconomic variables.
Statistics OIL GOLD COM TB USD
Mean 0.0041 0.0043 0.0018 4.1717 0.0000
Median 0.0145 0.0007 0.0032 4.1858 0.0008
Maximum 0.2137 0.1639 0.0645 7.9550 0.0601
Minimum −0.3319 −0.1239 −0.1552 1.5040 −0.0513
Std. Dev. 0.0841 0.0366 0.0255 1.6259 0.0190
Skewness −0.6929 0.3423 −1.4134 0.1767 −0.0912
Kurtosis 4.4220 4.6079 10.9690 2.0600 3.0714
JB Test* 0.0010 0.0010 0.0010 0.0091 0.5000
ADF Test* 0.0010 0.0010 0.0010 0.0476 0.0010
*Note that the lowest 𝑝-value of the JB test and ADF test is 0.001 in the statistical
packages.
We also generate the leave-one-out integration index and the pairwise integration index for the two sets of LHS portfolios, which
are plotted in Figs. 12 and 13, respectively. These indices display similarities to the corresponding ones in the previous sections.
The above results suggest that our approach is robust to the sorting mechanism of portfolios, which reiterates the point that the
global factors generated by our approach indeed capture the risks that local factors cannot.
5.4. Potential drivers of global integration
In this section, we investigate potential drivers of global integration index by regressing our integration measure on some
macroeconomic variables. We consider oil price returns (OIL), gold price returns (GOLD), commodity index returns (COM), 10-year
treasury bill rates (TB), and the U.S. dollar index (USD). Summary statistics for the five variables are reported in Table 8, where we
report the mean, median, maximum, minimum, standard deviation, skewness, and kurtosis values. We also conduct the Jarque–Bera
(JB) test and the augmented Dickey–Fuller (ADF) test to examine normality and stationarity of the variables. We find that the null
hypothesis of unit-root can be rejected at a level of 5%.
We then regress our integration measures on these macroeconomic variables. The integration indices are computed based on
LHS portfolios sorted in three ways: size and B/M, size and INV and size and OP. The OLS regression outcomes are contained in
Table 9, where the estimated coefficients and the associated standard errors in parentheses are recorded. We also report the 𝑅2 in
the last row of Table 9. Our results reveal that the only significant driver of our global integration index is the 10-year treasury bill
rate. All other variables are not significant at the 5% level, which holds true for all three integration measures. This further implies
that when the TB rate falls, the global integration level increases, which is consistent with stories behind the most recent financial
crisis. After the 2008 crisis, the 10-year TB rate continued falling and was once close to zero, leading to a large amount of capital
outflow from the U.S. market. This outflow of capital spread globally and strengthened the global integration.
543
Fig. 10. Overall global integration index based on alternatively sorted LHS portfolios.
6. Conclusions
In this paper, we propose a unified framework for international asset returns based on a panel data model with error CD as
inspired by Pesaran (2006). Our model has the benefits of obtaining orthogonalized global factors with an explicit control of regional
factors based on firm-level characteristics. We employ cross-sectional Fama and MacBeth (1973) tests of individual asset returns and
time-series regression-based tests of multifactor models to compare the performance of the FF5 model with and without our global
factors.
We find that after incorporating our global factors, the FF5 model can deliver a much smaller number of significant estimated
intercepts for every region. In addition, when we run the CSR with our global factors for the portfolios in each region, the adjusted-𝑅2
increases dramatically despite the underlying number of global factors. This evidence suggests that our global factors indeed capture
additional risks that local factors cannot and therefore supports the international model of asset pricing. Following Hou et al. (2011),
our global factors may be interpreted as anomalies arising from systematic market under- and overreactions caused by investors’
behavioral biases or global covariance risk factors, which are not captured by the conventional FF factor-mimicking portfolios. It
544
Fig. 11. The leave-one-out global integration index based on alternatively sorted portfolios.
545
Fig. 12. The pairwise global integration index for 5 × 5 sorts on size-INV.
should be noted that the application of our methodology is not limited to the FF style of models and can be fit to a wide variety
of multifactor asset pricing models such as the momentum and cash flow-to-price model used in Hou et al. (2011) and the 𝑞-factor
model used in Hou, Xue, and Zhang (2015). An investigation of the relative performance of these models under our framework will
be an interesting extension of our paper.
We also build a global integration measure based on the partial-𝑅2 of global factors in multifactor models. We empirically
examine global integration since 1990 for four developed regions (AP, Europe, NA and Japan). We find that from 1990–2017, there
was little change in the global integration of developed markets in our sample. Several spikes of integration were caused by global
crises such as the recent global financial crisis. During the recent financial crisis, global markets initially became more integrated and
then soon became segmented, corroborating the findings of Lehkonen (2015). Our study also presents some new results. Volatility
in global integration comes mainly from the integration of the AP region (excluding Japan) with NA and Europe. However, the
integration of NA, Europe and Japan shows a much less volatile pattern. The previous literature has witnessed several applications
with country-level data (see, Pukthuanthong and Roll, 2009; Akbari et al., 2020, for instance). Admittedly, our analysis can be
extended and possibly delivers more interesting results with country-level data. We will leave this to the future research.
Our results on global integration show an upward trend in global integration. During financial crises, global integration is intense.
From the perspective of asset pricing theory, our results suggest that when global factors play a more important role in asset pricing,
the increasing explanatory ability of the global factors challenges the validity of asset pricing models, which only consider regional
546
Fig. 13. The pairwise global integration index for 5 × 5 sorts on size-OP.
factors. In the literature on asset pricing, many factors are represented by portfolios traded in regional markets and cannot reveal
the systematic risks implied by global factors. When systematic risks from global markets dominate local systematic risks, as we
show in our empirical results, the risk premia should be explained mainly by global factors. Therefore, when evaluating asset pricing
models consisting of local factors, we must control global risks to draw fair comparisons.
CRediT authorship contribution statement
Yue Qiu: Data curation, Software, Investigation. Yu Ren: Conceptualization, Methodology, Validation, Formal analysis, Writing –
original draft, Writing – review & editing. Tian Xie: Conceptualization, Methodology, Validation, Formal analysis, Writing – original
draft, Writing – review & editing.
547
Table 9
OLS regressions of global integration indices on macroeconomic variables.
Measure on size-B/M Measure on size-INV Measure on size-OP
OIL 0.0052 0.0749 −0.0032
(0.1123) (0.1133) (0.1243)
GOLD 0.2008 0.1327 0.1869
(0.2601) (0.2624) (0.2879)
COM −0.0977 −0.1340 0.1129
(0.3927) (0.3962) (0.4347)
TB −0.0792*** −0.0875*** −0.0727***
(0.0053) (0.0053) (0.0058)
USD 0.2754 0.2265 0.2468
(0.5342) (0.5390) (0.5913)
𝑅2 0.4545 0.4972 0.3630
Numbers shown in parentheses are the associated standard errors.

***Indicates that the associated variable is significant at the 1% level.
Appendix. Econometric techniques and additional results
A.1. The cross-section dependence test
As demonstrated in Section 2, the main reason for the inconsistency of OLS in the CCE type of models is the cross-section
dependence among the error terms. In this section, we describe the testing procedure of error cross-section dependence proposed
by Pesaran (2004). We denote a general term 𝑢̂ 𝑖𝑡 to be the estimated residuals for section 𝑖 at time 𝑡. Let 𝜌̂𝑖𝑗 be the sample estimate
of the pairwise correlation of the residuals. Specifically,
∑𝑇
𝑡=1 𝑢̂ 𝑖𝑡 𝑢̂ 𝑗𝑡
𝜌̂𝑖𝑗 = 𝜌̂𝑗𝑖 = ( .
∑𝑇 2 )1∕2 (∑𝑇 2 )1∕2
𝑡=1 𝑢̂ 𝑖𝑡 𝑡=1 𝑢̂ 𝑗𝑡
The CD test statistics in Pesaran (2004) is given by

√ (𝑁−1 𝑁 )
2𝑇 ∑ ∑ 𝑑
CDstat = 𝜌̂𝑖𝑗 → N(0, 1), (A.1)
𝑁(𝑁 − 1) 𝑖=1 𝑗=𝑖+1
which is asymptotically distributed as N(0, 1).
A.2. Extraction of unobserved global factors with the PCA
The estimation of global factors 𝑭 and their factor loading matrix is a two-step procedure. In the first step, we estimate the
parameters 𝜷 𝑖 and then estimate unobserved common factors 𝑭 , utilizing the CCE estimator and the principal component analysis.
The factor estimates from this procedure are expected to be consistent (Pesaran, 2006). In the second step, the factor estimates can
be plugged back directly to estimate the parameters 𝜶 𝑖 , 𝜷 𝑖 and 𝜸 𝒊 by the OLS.
Given the consistent estimates of 𝜷 𝒊 , we can approximate 𝑔𝑖𝑡 by
𝑔𝑖𝑡 = 𝜶 ⊤
𝑖 𝒅 𝑡 + 𝑢𝑖𝑡 , (A.2)
as
⊤
𝑔̂𝑖𝑡 = 𝑦𝑖𝑡 − 𝜷̂ 𝑖 𝒙𝑔𝑖 ,𝑡 (A.3)
.
After acquiring the residuals, 𝑔̂𝑖𝑡 , an estimate of 𝑒̂𝑖𝑡 is produced by integrating out the common observed factors, 𝒅 𝑡
𝒆̂𝑖 = 𝑴 𝐷 𝒈̂𝑖 , (A.4)

( ) ( ′ )−1 ′ ( ′ ′ ′
)
where 𝒆̂𝑖 = 𝑒̂𝑖,1 , 𝑒̂𝑖,2 , … , 𝑒̂𝑖,𝑇 , 𝑴 𝐷 = 𝑰 − 𝑫 𝑫 𝑫 𝑫 and 𝑫 = 𝒅 𝟏 , 𝒅 𝟐 , … , 𝒅 𝑻 . Bernoth and Pick (2011) pointed out that the
orthogonality assumption of 𝒅 𝑡 to 𝒇 𝑡 is necessary to guarantee unbiasedness of the parameter estimates of the common factors, 𝜶̂ 𝑖 .
⊤
Residual terms 𝑒̂𝑖𝑡 can also be rewritten as 𝑒̂𝑖𝑡 = 𝑦𝑖𝑡 − 𝜷̂ 𝑖 𝒙𝑔𝑖 ,𝑡 − 𝜶̂ ⊤
𝑖 𝒅 𝑡 . We consider the following model
𝑬̂ = 𝑭̂ ⋅ 𝜣 + 𝝃 , (A.5)
𝑇 ×𝑁 𝑇 ×𝑚 𝑚×𝑁 𝑇 ×𝑁
548
where 𝑬̂ = [𝒆̂1 , … , 𝒆̂𝑁 ] contains 𝑒̂𝑖𝑡 for all 𝑖 and 𝑡, 𝜣 = [𝜸 1 , … , 𝜸 𝑁 ] is the factor loading matrix, and 𝝃 = [𝝐 1 , … , 𝝐 𝑁 ] represent the
⊤
error terms. The factor matrix 𝑭̂ consists of the eigenvectors corresponding to the 𝑚 largest eigenvalues of 𝑇 × 𝑇 matrix 𝑬̂ 𝑬̂ .20 In
practice, the number of approximated unobserved common factors, 𝑚, is usually not given, although 𝑚 is bounded between [1, 𝑁].
We can choose the optimal 𝑚∗ using conventional selection criteria. See Bai and Ng (2002) and Bai (2009) for details. Once 𝑭̂ is
constructed, the factor loading matrix 𝜣 can be estimated using the simple OLS such that 𝜣 ̂ = (𝑭̂ ⊤ 𝑭̂ )−1 𝑭̂ ⊤ 𝑬.
̂ Finally, we obtain the
̂ ̂ ̂ ̂
residual matrix 𝝃 = 𝑬 − 𝑭 𝜣 that contains all 𝜖̂𝑖𝑡 for each 𝑖 and 𝑡.
A.3. Determining the number of factors
Eq. (A.5) can be rewritten as:
𝑒𝑖𝑡 = 𝜸 ⊤
𝑖 𝒇 𝑡 + 𝜖𝑖𝑡 ,
where 𝑒𝑖𝑡 is the observed data for the 𝑖th cross-section unit at time 𝑡, for 𝑖 = 1, … , 𝑁, and 𝑡 = 1, … , 𝑇 , 𝒇 𝑡 is a vector of common
factors, 𝜸 𝑖 is a vector of factor loadings associated with 𝒇 𝑡 , and 𝜖𝑖𝑡 is the idiosyncratic component of 𝑒𝑖𝑡 with mean 0 and variance
𝜎2.
Let 𝑭 𝑚 be the matrix of 𝑚 factors, and
1 ∑∑(
𝑁 𝑇
)2
𝑉 (𝑚, 𝑭 𝑚 ) = min 𝑒 − 𝛾̂𝑖⊤ 𝒇 𝑚
𝛬 𝑁𝑇 𝑖=1 𝑡=1 𝑖𝑡 𝑡
be the sum of squared residuals divided by 𝑁𝑇 on the 𝑚 factors for all 𝑖.

Following Bai and Ng (2002), the model section criteria for Mallows’ 𝐶𝑝 can be expressed as:
( ) ( )
𝑚 𝑁 +𝑇 𝑁𝑇
𝐶1 (𝑚) = 𝑉 (𝑚, 𝑭̂ ) + 𝑚𝜎 2 log
𝑁𝑇 𝑁 +𝑇
( )
𝑚 𝑁 +𝑇
𝐶2 (𝑚) = 𝑉 (𝑚, 𝑭̂ ) + 𝑚𝜎 2 2
log 𝐶𝑁𝑇
( 𝑁𝑇 2 )
𝑚 log 𝐶𝑁𝑇
𝐶3 (𝑚) = 𝑉 (𝑚, 𝑭̂ ) + 𝑚𝜎 2
2
𝐶𝑁𝑇
where 𝐶𝑁𝑇 2 = min(𝑁, 𝑇 ). The value 𝑚∗ s that yield the lowest value of the above criteria are the selected optimal number of
factors. All three criteria presented above are asymptotically equivalent; therefore, they shall yield an identical optimal number 𝑚∗
asymptotically. In practice, however, the optimal number of factors selected by the above three criteria can be dissimilar, especially
when the sample size is small.
Another issue with the above criteria is that, they include an infeasible 𝜎 2 that must be replaced by a consistent estimate, which
can be arbitrary. Bai and Ng (2002) recommended using the largest 𝑚, denoted as 𝑚max , to provide such an estimate. To avoid this
issue, Bai and Ng (2002) also proposed the following criteria:
( ) ( ) ( )
𝑚 𝑁 +𝑇 𝑁𝑇
𝐶4 (𝑚) = ln 𝑉 (𝑚, 𝑭̂ ) + 𝑚 log
𝑁𝑇 𝑁 +𝑇
( ) ( )
𝑚 𝑁 +𝑇 2
𝐶5 (𝑚) = ln 𝑉 (𝑚, 𝑭̂ ) + 𝑚 log 𝐶𝑁𝑇
( 𝑁𝑇 2 )
( 𝑚
) log 𝐶𝑁𝑇
𝐶6 (𝑚) = ln 𝑉 (𝑚, 𝑭̂ ) + 𝑚 ,
2
𝐶𝑁𝑇
where ln(⋅) stands for a logarithmic transformation. The main advantage of the above criteria is that they do not depend on the
choice of 𝑚max and its associated 𝜎̂ 2 .
A.4. Results controlling volatility with RV
As another proxy for excess volatility, we estimate the 𝑀-sample monthly RV with the data on portfolio’s returns
∑
𝑀
RV𝑖𝑡 ≡ 𝑟2𝑖𝑡,𝑗 ,
𝑗=1
where 𝑟𝑖𝑡,𝑗 for 𝑗 = 1, … , 𝑀 stands for the daily return on portfolio 𝑖 at month 𝑡. We include RV𝑖𝑡 as an additional control variable
in the pricing model and replicate our main exercise. It can be seen that Fig. A.1 resembles Fig. 9 closely with respect to the shape
and the levels. Hence our findings in Section 5.2 remain intact.
20 In the principal components analysis literature, it is customary to normalize the constructed factors 𝑭 ̂ following the condition 𝑭̂ ⊤ 𝑭̂ ∕𝑇 = 𝑰 𝑚 . Such
normalization appears to be unnecessary in our set-up, since we are interested in the identification of 𝑭̂ 𝜣
̂ and it is only affected by the number of 𝑚 (in
a small finite sample) we choose.
549
Fig. A.1. The global market integration index controlling RV.
References
Akbari, A., Ng, L., & Solnik, B. (2020). Emerging markets are catching up: Economic or financial integration? Journal of Financial and Quantitative Analysis, 55(7),
2270–2303.
Bai, J. (2009). Panel data models with interactive fixed effects. Econometrica, 77(4), 1229–1279.
Bai, J., & Ng, S. (2002). Determining the number of factors in approximate factor models. Econometrica, 70(1), 191–221.
Bekaert, G., & Harvey, C. R. (1995). Time-varying world market integration. The Journal of Finance, 50(2), 403–444.
Bekaert, G., Harvey, C. R., Lundblad, C. T., & Siegel, S. (2011). What segments equity markets. Review of Financial Studies, 24(12), 3841–3890.
Bekaert, G., Harvey, C. R., & Ng, A. (2005). Market integration and contagion. Journal of Business, 78(1), 39–70.
Bekaert, G., Hodrick, R. J., & Zhang, X. (2009). International stock return comovements. The Journal of Finance, 64(6), 2591–2626.
Berger, D., & Pukthuanthong, K. (2012). Market fragility and international market crashes. Journal of Financial Economics, 105(3), 565–580.
Bernoth, K., & Pick, A. (2011). Forecasting the fragility of the banking and insurance sectors. Journal of Banking & Finance, 35(4), 807–818.
Brooks, R., & Negro, M. D. (2004). The rise in comovement across national stock markets: Market integration or it bubble? Journal of Empirical Finance, 11(5),
659–680.
Carrieri, F., Errunza, V. R., & Hogan, K. (2007). Characterizing world market integration through time. Journal of Financial and Quantitative Analysis, 42(04),
915–940.
Chambet, A., & Gibson, R. (2008). Financial integration, economic instability and trade structure in emerging markets. Journal of International Money and Finance,
27(4), 654–675.
Chudik, A., & Pesaran, M. H. (2015). Common correlated effects estimation of heterogeneous dynamic panel data models with weakly exogenous regressors.
Journal of Econometrics, 188(2), 393–420.
Diebold, F. X., & Yilmaz, K. (2009). Measuring financial asset return and volatility spillovers, with application to global equity markets. The Economic Journal,
119(534), 158–171.
Dumas, B., Harvey, C. R., & Ruiz, P. (2003). Are correlations of stock returns justified by subsequent changes in national outputs. Journal of International Money
and Finance, 22(6), 777–811.
Eberhardt, M., Helmers, C., & Strauss, H. (2013). Do spillovers matter when estimating private returns to R&D? The Review of Economics and Statistics, 95(2),
436–448.
Eiling, E., & Gerard, B. (2015). Emerging equity market comovements: Trends and macroeconomic fundamentals. Review of Finance, 19(4), 1543–1585.
Eun, C. S., Wang, L., & Xiao, S. C. (2015). Culture and R2. Journal of Financial Economics, 115(2), 283–303.
Fama, E. F., & French, K. R. (1993). Common risk factors in the returns on stocks and bonds. Journal of Financial Economics, 33(1), 3–56.
Fama, E. F., & French, K. R. (1998). Value versus growth: The international evidence. The Journal of Finance, 53.
Fama, E. F., & French, K. R. (2012). Size, value, and momentum in international stock returns. Journal of Financial Economics, 105, 457–472.
Fama, E. F., & French, K. R. (2015). A five-factor asset pricing model. Journal of Financial Economics, 116(1), 1–22.
Fama, E. F., & French, K. R. (2017). International tests of a five-factor asset pricing model. Journal of Financial Economics, 123(3), 441–463.
Fama, E. F., & MacBeth, J. D. (1973). Risk, return, and equilibrium: Empirical tests. Journal of Political Economy, 81(3), 607–636.
Gibbons, M. R., Ross, S. A., & Shanken, J. (1989). A test of the efficiency of a given portfolio. Econometrica, 57(5), 1121–1152.
Griffin, J. M. (2002). Are the fama and french factors global or country specific? Review of Financial Studies.
Hardouvelis, G. A., Malliaropulos, D., & Priestley, R. (2006). EMU and European stock market integration. Journal of Business, 79(1), 365–392.
Hou, K., Karolyi, G. A., & Kho, B.-C. (2011). What factors drive global stock returns? Review of Financial Studies, 24(8), 2527–2574.
Hou, K., Xue, C., & Zhang, L. (2015). Digesting anomalies: An investment approach. Review of Financial Studies, 28.
Kiviaho, J., Nikkinen, J., Piljak, V., & Rothovius, T. (2014). The co-movement dynamics of European frontier stock markets. European Financial Management,
20(3), 574–595.
Lehkonen, H. (2015). Stock market integration and the global financial crisis. Review of Finance, 19(5), 2039–2094.
Merton, R. C. (1973). An intertemporal capital asset pricing model. Econometrica, 41.
Newey, W. K., & West, K. D. (1987). A simple, positive semi-definite, heteroskedasticity and autocorrelation consistent covariance matrix. Econometrica, 55(3),
703–708.
Pesaran, M. H. (2004). General diagnostic tests for cross section dependence in panels.
Pesaran, M. H. (2006). Estimation and inference in large heterogeneous panels with a multifactor error structure. Econometrica, 74(4), 967–1012.
550
Pesaran, M. H., & Tosetti, E. (2011). Large panels with common factors and spatial correlation. Journal of Econometrics, 161(2), 182–202.
Pukthuanthong, K., & Roll, R. (2009). Global market integration: An alternative measure and its application. Journal of Financial Economics, 94(2), 214–232.
Rangvid, J., Santa-Clara, P., & Schmeling, M. (2016). Capital market integration and consumption risk sharing over the long run. Journal of International Economics,
103, 27–43.
Van Schotman, P., & Zalewska, A. (2006). Non-synchronous trading and testing for market integration in central European emerging markets. Journal of Empirical
Finance, 13, 462–494.
551

1 s2.0 S105905602200051X Main

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

1 s2.0 S105905602200051X Main

Uploaded by

Copyright:

Available Formats

International Review of Economics and Finance 80 (2022) 526–551

Contents lists available at ScienceDirect

International Review of Economics and Finance

Global factors and stock market integration✩

ARTICLE INFO ABSTRACT

2.1. Model setup

2.2. The problem of ignoring unobserved global factors

where 𝜞 𝑖 is assumed to be invertible for simplicity.

2.3. Common correlated effect estimator

by including more countries/regions or portfolios.

2.4. Selection of weights

2.5. Global factors and integration index

𝑦𝑖𝑡 = 𝛼𝑖 + 𝛽𝑖 𝑥𝑔𝑖 ,𝑡 + 𝑒𝑖𝑡 ,

Fig. 1. Performance of various measures under different numbers of regions.

power and it is inappropriate to compare the two types of measures quantitatively.

3. Portfolios and pricing factors

4.1. Global factors

4.1.1. Cross-sectional dependence

4.1.2. Estimated intercepts

4.1.3. Fama–MacBeth regression

Low 2 3 4 High Low 2 3 4 High Low 2 3 4 High

Panel D: North America

𝐸(𝑅𝑖𝑡 − 𝑅𝐹 𝑡 ) = 𝛿0 + 𝛿1 𝛽̂𝑖1 + ⋯ + 𝛿5 𝛽̂𝑖5 + 𝑢𝑖 for 𝑖 = 1, … , 25 portfolios, (11)

4.2. Integration index

4.2.1. Global integration

4.2.2. Leave-one-out integration

Fig. 3. The overall global market integration index.

Fig. 4. The integration for each region.

Fig. 5. The leave-one-out global market integration index.

4.2.3. Pairwise integration

consistent with the previous terminology.

Fig. 6. The pairwise market integration level.

4.3. Other existing measures

Fig. 7. Comparing various global integration measures.

5.1. Incorporate emerging markets

5.2. Control for excess volatility

5.3. Alternatively sorted LHS portfolios

results can be found in Appendix A.4.

Fig. 9. The global market integration index controlling excess volatility.

5.4. Potential drivers of global integration

CRediT authorship contribution statement

Numbers shown in parentheses are the associated standard errors.

Appendix. Econometric techniques and additional results

A.1. The cross-section dependence test

The CD test statistics in Pesaran (2004) is given by

which is asymptotically distributed as N(0, 1).

A.2. Extraction of unobserved global factors with the PCA

𝒆̂𝑖 = 𝑴 𝐷 𝒈̂𝑖 , (A.4)

A.3. Determining the number of factors

Eq. (A.5) can be rewritten as:

be the sum of squared residuals divided by 𝑁𝑇 on the 𝑚 factors for all 𝑖.

A.4. Results controlling volatility with RV

Fig. A.1. The global market integration index controlling RV.

You might also like