Financial markets are said to be integrated if assets of similar maturity give the same the risk- adjusted returns in various segments of the markets. Financial markets all over the world have witnessed growing integration, within as well as across boundaries.
Financial market integration can take place horizontally and / or vertically. In the horizontal integration, inter-linkages occur among domestic financial market segments, while vertical integration occurs between domestic markets and international / regional financial markets.
The fundamental principle underlying financial market integration is law of one price (LOOP). According to LOOP, in the absence of administrative and informational barriers, risk-adjusted returns on identical assets should be comparable across markets. Integrated markets:
React faster to monetary policy changes
- Are more competitive and thus price assets more efficiently
- Are more cost effective than segmented markets
- Are more efficient than segmented markets
A major risk of market integration is that of contagion. Contagion refers to spreading out of an undesirable feature from one segment (market) to another. Increased integration accentuates the risk of contagion as problems in one market are likely to be transmitted to other markets.
Are Indian stock markets national or international in character? Due to predominant presence of FIIs the stock markets are more fully integrated with foreign markets than before. Indian papers are traded abroad in the form of GDR / ADR. Differences in prices of DRs and underlying will give arbitrage opportunities to FIIs and this makes the stock markets still more vertically integrated