Definition of equity market segmentation
A term from international finance and economics that describes how a country’s capital market can be separate from the capital markets of other countries. A related term is “barriers to capital flow”. The concept has implications for whether investors in different countries estimate a different cost of capital and, in particular, disagree about the value of a particular investment.
As a starting point, suppose that the price of stock XYZ is $50 in Boston and $45 in New York. Unless there is a legal barrier or very substantial cost to buying and selling stocks, smart traders will buy XYZ in New York and simultaneously sell it in Boston. Eventually, the pressure of buying in New York will raise the price there, the pressure of selling in Boston will lower the price there, and the value of XYZ across the two cities will converge.
Extending the example internationally, in the absence of barriers or substantial trading costs, XYZ will sell for about the same price in Boston and in Halifax. However, we can introduce some impediments to the arbitrage process that tends to force XYZ prices to be equal between the US and Canada. Perhaps there are very high brokerage costs and other fees for trading in one market or another. In that case, a gap in prices can persist. Perhaps a tax is applied when an investor buys the stock in one country and sells in another. Perhaps XYZ is a Canadian company and it cannot even be traded in Boston or New York due to national law or provisions in the company’s charter that forbid Americans or other non Canadians to own the stock.
If limitations to foreign investment apply not just to XYZ but many Canadian companies, we will observe a divergence between stock prices, returns, dividend yields, and other market conditions in Canada compared to the rest of the world. This separation is known as equity market segmentation. As a practical matter, it is more likely to be observed for a developing country where legal barriers, political and legal risks, high currency uncertainty, trading costs, and other factors are magnified, rather than for Canada or the US.
The stereotype is that a developing country lacks savings for development and segmentation of its equity market drives away inexpensive capital from overseas that might help the economy to grow. Segmentation may also deprive local citizens of the ability to diversify their wealth if laws and other facets of the capital market impede or prohibit their investing some of their savings overseas. Thus, market segmentation may be viewed as damaging the potential growth and health of an economy.
There is a counter-argument to the notion that equity market segmentation is always damaging. If foreign investors tend to rush in and out of the stock markets of small developing countries, they may increase volatility and uncertainty. Their “hot money” greatly boosts stock prices when it arrives, then causes a crash when it leaves. Thus, one can argue that keeping a country’s stock market somewhat segmented from such forces protects the country’s economy from being buffeted by short term inflows and outflows.
Because most countries are either largely or somewhat open to foreign equity market purchases and sales, it is typically hard to measure whether a country’s stock market is “completely segmented”, “partially segmented”, or “integrated”. Researchers continue to struggle with this question.