Introduction

Perfectly integrated capital markets may be described as markets in which financial assets, with identical risk characteristics but traded in different national capital markets, have identical expected returns: domestic financial markets will be linked such that expected returns on similar assets will not move independently. While the degree of capital market integration (and the efficiency of financial markets) has implications for the pricing of financial assets, and ultimately the allocation of resources, it is particularly important when viewed from a European perspective. By late 1992 barriers to the free movement of goods and services within the European Community (EC) should have been abolished and this should be reflected in increasing integration of EC members' goods markets. However, for goods market integration to develop smoothly there should exist a European-wide pool of capital to finance European-wide investment projects. In fact the existence of the European Monetary System (EMS) since 1979 and the gradual relaxation of capital controls which this has entailed should indeed have resulted in greater European capital-market integration.

In this chapter we consider the extent of capital-market integration for certain key European countries during the recent period of floating exchange rates. This is achieved by, first, examining the extent to which excess stock returns are predictable for a number of key European countries (France, Germany, Italy, and the UK) and the US and, secondly, examining the extent to which any such predictability is explicable in terms of international factors.