Neal (JEH 1895) - Integration of International Capital Markets - Quantitative Evidence From the Eighteenth To Twentieth Centuries

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Integration of International Capital Markets: Quantitative Evidence from the Eighteenth toTwentieth CenturiesAuthor(s): Larry NealSource: The Journal of Economic History, Vol. 45, No. 2, The Tasks of Economic History(Jun., 1985), pp. 219-226Published by: Cambridge University Press on behalf of the Economic History Association

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Integration of International Capital

Markets:Quantitative Evidence

from the Eighteenth to TwentiethCenturies

LARRY NEAL

The integrationof capitalmarkets s usuallytested with an interestratearbitragemodel even thoughmuch different inancialassets must be compared.Thispapercomparesprices of identical assets that are tradedsimultaneouslyn two or moremarkets.The range,average level, andtime series patternof the differencescanbe used to infer threshold levels, transactioncost levels, and the efficiencyofarbitrageoperations,respectively. Examples are given for financialcrises from1745to 1907, using prices from the London, Amsterdam,Paris, and New Yorkstock exchanges. These show Europeancapitalmarkets o be well integratedbymid-eighteenth entury.

EASURINGthe degree of integrationn financialmarkets sdifficult both theoretically and empirically. The difficulties are

well illustrated n the literaturedealingwith Americancapital markets nthe late nineteenth century.' This literaturedemonstratesthe inherentweaknesses in trying to measure an economic phenomenon-integra-tion of capital marketsin this case-with a variablemeasuringrod. Themeasuringrod, the short-term nterestratesearnedby banks on a broad

class of loans, must vary as local regulationsvary, as the riskiness anddurationof the loans withinthe category vary, and as monopolyrentsvary. All these variationsmust be allowedfor if a consistent measuring

Journal of Economic History, Vol. XLV, No. 2 (June 1985). ? The Economic History

Association.All rightsreserved.ISSN 0022-0507.

The author s Professorof Economics,Universityof Illinois, Urbana,Illinois61801. He wishes

to acknowledge he inspiration f DonaldMcCloskey orthis paper, he researchassistanceof Eric

Schubert,andusefulcommentsby JeremyAtack,David Good, Peter Lindert,andmembersof the

University of Illinois Economic History Workshop.Researchwas supportedby the NationalScience Foundationand the Universityof IllinoisResearchBoard.

' Theliterature eginswithLance Davis, "The InvestmentMarket,1870-1914:The Evolutionof

a NationalMarket,"this JOURNAL, 25 (Sept. 1965), pp. 355-99 (commercialpaper market);and

continueswith RichardSylla, "FederalPolicy, BankingMarketStructure,andCapitalMobiliza-

tion in the UnitedStates, 1863-1913," his JOURNAL, 29 (Dec. 1969),pp. 657-86(nationalbanks);

L. Neal, "TrustCompaniesand FinancialInnovation,1897-1914,"Business HistoryReview,45

(Fall 1971),pp. 35-51 (trustcompanies);J. James, "The Developmentof the NationalMoney

Market, 1893-191 ," this JOURNAL, 36 (Dec. 1976), pp. 878-97 (local monopoly);R. Keehn,

"FederalBankPolicy, BankMarketStructure,and BankPerformance:Wisconsin,1863-1914,"

BusinessHistoryReview, 15 (March1980) local regulations); ndM. SushkaandW. B. Barrett,

"BankingStructureandthe NationalCapitalMarket,1869-1914," his JOURNAL, 44 (June1984),pp. 463-477 (riskpremia).

219



220 Neal

instrument s to be obtained.If they are not, then the possibilityalways

remainsthatdivergencesor convergencesof interestrates between two

capital markets may be due to factors other than integration orseparationof the two markets. These difficultiesof interpretationare

inherent in the use of the interest rate arbitragemodel to derive a

measuringstandard.In this paper,I takeavantageof a previouslyoverlookedpossibility-

the difference n the price of a shareof stock as quotedon the sameday

in both the domestic exchange for the company and on a foreign

exchange. Machiuprefers to this as the simplest test of all for market

integration,since the product is not only standardizedbut identical inthe two marketsand the cost of transportbetween the two marketsis

essentially zero.2 Morgensterngoes so far as to assert "on different

nationalstock marketsthe prices of the same sharesareas a rulenot at

variance,owing to perfect arbitrage."3This enablesus to avoid all the

problemsmentionedabove that are associatedwith usinginterestrates

on short-termor long-termsecurities as measures of financialintegra-

tion.

But even for the price of the same stock, differences in the twomarketsmay still arise fromdelays in informationand fromdifferences

in investor preferences in response to the information,which will be

reflected n pricedifferences.These pricedifferencesprovidea measure

of the separationor lack of integrationof the two markets.The absolute

level of these price differencesdepends only on the transactionscosts

between the two markets. (Since the largest portion of transactions

costs, however, turns out to be brokers' fees, and these are chargedas

percentagesof the sale value in each marketexamined n thispaper,it isthe percentageshareof the pricedifferencesto the averagevalue of the

sharesin the two markets hatis the best measureof transactionscosts.)

The durationof a given pricediscrepancybetweenthe two marketswill

dependon the length of time requiredfor the transmissionof informa-

tion between the two markets.Theaveragedifference n price between

the two marketswill normallydepend on differencesin quotingprices

(for example, money prices are usually lower thanterm or on account

prices)and on the differences n transactionscosts of all kinds(taxes on

transfers,brokers' fees, implicit interest rates for tradingon account

timesthe normal engthof settlement)between the two markets,andon

the typical premiumor discountrulingin the exchange rate of the two

currencies involved. If perfect arbitrageoccurs nevertheless within

these constraintsof transactionscosts, informationdelays, and price

movements in the interveningforeign exchange market, there should

2 Fritz Machiup, A History of Thought on Economic Integration (New York, 1977), p. 26.

3 Oskar Morgenstern, International Financial Transactions and Business Cycles (Princeton,

1959), p. 508.



Integrationof Capital Markets 221

exist no detectable ime seriespattern n thepricedifferences etweenthe twomarkets.That s, the randomwalkbehavior f efficientmarkets

(in theweak sense of Fama)shouldbe observednot only for thepricemovementsn eachmarket,but also in thedifferences f pricebetweenthe two markets. f something therthan a randomwalk is observed,then unexploited rbitrage pportunitiesemainbetween he two mar-kets and they cannotbe consideredullyintegrated.

Startingnthe secondquarter f the eighteenth entury,we havedataon the prices of sharesof the majorBritishoint stock companiesastradedon the Amsterdam xchange.By the end of the nineteenth

century,we havedaily data on prices of American ailroad haresastraded n eachof themajorEuropean tockexchanges.At thistimeeachmarketwasinformedwithinhoursof prices n the othermarkets y wayof multiple ubmarine ables.Moreover, orward rderswereregularlyplacedby London radersor particularecurities ndforeign xchangeinthe New Yorkmarketo takeeffectafter he Londonmarket losed.There were still no formaltaxes, regulations,or controlson capitalmovements.Further, ach countrywas formally n a fullgold standard

so therewere no uncertaintiesssociatedwithacceptabilityf a meansof paymentacrossnationalboundaries.n short,all the conditions orthe perfectarbitrage f Morgensternwere in place and working.Wehave then, in these historicalshare-pricedata across two or morenationalmarkets, hepossibility f measuringhe integrationf Europe-ancapitalmarkets gainst hestandards et just beforeWorldWar fornearly wo centuriesof experience, he very centuries hat witnessedthe buddingand full floweringof the worldcapitalisteconomy. Did

integration roceed n a steady pace,or in fits and starts?How did itrespond o politicaldivisions,wars, changes n tradepolicies,changesin monetary tandards, eriodsof inflation nddepression?Thesearesome of thequestionshatcanbe tackled nprinciple sing hesedata,butin thisexploratoryffortthey will have to be ignored.Firstmustcometheworkof developinghisalternative tandardf measurement.

SELECTING EPISODESFOR COMPARISON

The interestrate arbitragemodel, used in previousstudies, hasprovendifficult o specify correctlyin theoretical erms and moredifficult,even treacherous, o implementempirically.Morgensternfoundit to work as expected duringthe late nineteenthand earlytwentiethcenturiesonly duringperiodsof financial risis. These areperiodswhen nterestrateschanged harplyn the financialmarkethatoriginatedhecrisis, creatingarge nterest atedifferentialsnternation-

ally. OnlythencouldMorgensternind hesequenceheexpected n theinterestratearbitragemodel-gold flowingntothemarketwithhigher



222 Neal

interest rates, its exchange rate rising, and then its prices rising. By

contrast, the asset-pricingmodel described above mightbe expected to

workleast well duringsuch episodes. A liquidityscramble n one centershoulddrive down prices of all financialassets and if the crisis had not

yet appearedin the other marketwhere the security was traded, we

would expect a largerthan normalgap in the price to emergebetween

the two markets.(Thiswouldbe the corollaryof an unusualwideningof

the interestrate differential n the interestrate arbitragemodel.)

For this firsteffort, we may as well measurecapital marketintegra-

tion with the asset-pricingmodel duringsuccessive financialcrises that

were propagated romone of the financialcentersto the other,thatis, inthe "worstcase scenario." The crises were selected on groundsof both

the availabilityof data and their characteristicsas truly international

crises that affected both marketsbut with differencesin intensity and

timing.Meetingthese joint criteriawere the crises of 1745, 1763, 1772,

and 1793for the capitalmarketsof London andAmsterdam; he crises

of 1825, 1873,and 1907for the LondonandParismarkets; he crises of

1873 and 1907 for the New York and London markets in American

railroadstocks; and the crisis of 1907for the Amsterdammarketonceagain.

RESULTS

The results of measuring he price differencesfor the varioussecuri-

ties across the several marketsin these financialcrises spanningnearly

two centuries are shown in Table 1. This shows the average of the

percentageabsolute price differences, and their variances in order tocomparethe effectof transactionscosts in each marketand between the

two marketson price differences. The remainingstatistics-the stan-

dard deviation, the maximumdifferencethat was observed, the mini-

mum difference, the range of the differences, and then for good

measure,the autoregressivemovingaveragetime series modelthatbest

describesthe dynamicpatternof the differences-are calculatedfor the

percentage actual price differences. These are the precise statistical

measures that reflect the concepts of transactions costs, delays ininformation,and the degree to which arbitrage s carried out. Other

measures might be devised to reflect other aspects of integration(for

example, longest run of observations greaterthan one standarddevi-

ation from the average difference)but these seem to cover the most

obvious dimensionsof integrationacross each pairof markets.4

4 The Amsterdampriceswere adjustedbeforetaking he differencewiththe Londonprice.The

adjustment risesfromthediscoverythatAmsterdampriceswereconsistentlyhigher hanLondon

prices.Thisled to thedeterminationhatthe Amsterdampricesweretimepriceswhilethe London

priceswere spot. (L. Neal, "EfficientMarkets n the EighteenthCentury?The AmsterdamandLondon Stock Exchanges," in Jeremy Atack, ed., Proceedings of the Business History Conference



Integrationof Capital Markets 223

TABLE I

SUMMARYSTATISTICSON STOCKMARKETINTEGRATION N CRISES OF THEEIGHTEENTHAND NINETEENTHCENTURIES

Auto-Maximum Minimum regressive

Standard Difference Difference MovingName Average Variance Deviation Observed Observed Range Average

EIGHTEENTHCENTURYBankof Englandand East IndiaCompanysharesquotedon the Amsterdamand London stockexchanges averageandvarianceare forpercentageabsolutepricedifferences,remainingtatisticsarefor percentageactualdifferences).

A. TheCrisis of 1745 (biweekly,June 1744-June1747)Bank 0.999 0.518 1.190 3.783 -2.923 6.706 (3,0)East India 1.345 1.293 1.709 7.008 -4.619 11.627 (1,0)

B. TheCrisis of 1763(biweekly,June 1761-June1764)Bank 1.062 0.869 1.356 4.934 -2.293 7.227 (0,0)East India 1.448 1.366 1.824 4.991 -3.382 8.373 (1,0)

C. TheCrisisof 1772(biweekly,Jan. 1772-Jan.1775)Bank 0.714 0.266 0.798 1.569 -2.599 4.168 (1,0)East India 1.591 1.532 1.951 5.610 -4.582 10.192 (1,1)

D. TheCrisisof 1793 (biweekly,Dec. 1791-Dec. 1794)Bank 1.180 1.822 1.671 8.751 -2.685 11.436 (1,1)East India 1.342 2.706 2.078 9.156 -8.923 18.079 (1,1)

NINETEENTHCENTURY(Average and variance are for absolute percentagedifferencesof prices in the two marketscompared; emaining tatistics are for percentageactualdifferences.)

E. The Crisisof 1825(weekly,July 1824-July1826)(Frenchrentes, 5%and 3%,are compared n LondonandParis.)

5%rente 0.576 0.527 0.922 4.675 -3.505 8.180 (0,1)3%rente 0.842 0.825 1.177 3.922 -1.484 5.405 (0,1)

F. The Crisisof 1873(weekly,July 1872-July1874)(Frenchrentes,5% and3%,are compared n LondonandParis.)

5%rente 1.497 1.003 1.102 1.477 -5.191 6.668 (1,2)3%rente 1.764 1.029 1.045 0.510 -4.183 4.692 (3,0)

(Americanrailroad tocks, the Erie and the IllinoisCentral,are compared n Londonand New

York)Erie 2.099 4.845 2.846 9.678 -4.487 14.165 (3,0)Illinois Central 1.799 3.358 2.564 9.800 -7.776 17.576 (1,1)



224 Neal

TABLE 1-continuedSUMMARYSTATISTICSON STOCK MARKETINTEGRATIONN CRISESOF THE

EIGHTEENTHAND NINETEENTHCENTURIES

Auto-

Maximum Minimum regressiveStandard Difference Difference Moving

Name Average Variance Deviation Observed Observed Range Average

G. TheCrisisof 1907 (weekly,July 1906-July1908)(Stock of the Erie railroad, compared on the London, Amsterdam,and New York Stock

Exchanges)London- 3.187 4.728 2.751 11.579 -8.835 20.414 (4,1)

New YorkAmsterdam- 2.250 5.837 2.784 15.464 -3.125 18.589 (2,2)New York

London- 1.817 1.480 1.994 5.000 -5.714 10.714 (2,1)

Amsterdam

(Stock of the Southern Pacificrailroad,comparedon the London, Amsterdam,and New York

Stock Exchanges)London- 2.595 1.733 1.407 7.617 -0.926 8.543 (1,1)

New YorkAmsterdam- 1.095 0.882 1.440 4.893 -4.823 9.715 (0,0)

New YorkLondon- 2.643 1.734 1.421 9.286 -0.926 10.212 (1,1)

Amsterdam

Sources: For the eighteenthcentury: London: The Course of the Exchange (appearing emi-weekly, with daily prices). Amsterdam:Van Dillen (1931), from the AmsterdamscheCourant

(takenfortnightly).For the nineteenth entury:For 1825:London:TheTimes Thursdayssueor closest match o Paris

quote).Paris:Le MoniteurUniversel Thursday ssue or closest businessday). For 1873:London:The Times(Thursday ssue or closest match to either Parisor New Yorkquote). Paris:Le Figaro

(Thursdayssue or closest business day). New York:TheCommercialand FinancialChronicle

(monthly ummary).For 1907:London, Amsterdam, ndNew York:TheTimes Thursdayssue orclosest matchto quoteof New Yorkor Amsterdam).

Panels A-D for the eighteenthcentury (Table 1) show essentiallythe

samevalues in each crisis episode for the averages,variances,standard

deviations, ranges, and patternsof the autoregressivemoving averages(ARMA). The exceptions to this observation are that the ranges are

always greaterfor East India stock than for Bankof Englandstock, and

thatthe ranges for both are noticeably greater n the 1793crisis. This isevidence that market integration might, in fact, have been breakingdown at the end of the eighteenth century in the face of the political

(Urbana,1984).A regressionequationwas estimatedrelating he excess of the Amsterdamprice

over the Londonprice to the numberof days untilthe next paymentof dividends.This equation

was thenusedto calculateAmsterdampricesadjusted o their"'spot"equivalent.The adjustment

reduced the average difference found (Amsterdamspot prices are lower on average than

Amsterdamimepricesforbothstocks)and reduced heorderof theestimatedARMAmodels.But

the variance, standarddeviation, and range of differences were largely unaffected by thisadjustment.



Integration of Capital Markets 225

disturbances hat disrupted rade andcommunicationsbetween the twomarkets. Otherwise, little change occurred in the degree of integrationof these two markets. Only one case of an ARMAprocess of (0, 0) orderoccurs, East India Company stock in the 1763crisis.

This evidence for well-integrated markets by the mid-eighteenthcentury is more convincing, the more impressiveone findsthe degree ofintegration n this period. Turningto the results of Panels E-G for thenineteenth century crises, we find that the mid-eighteenth-centuryresults, indeed, look quite respectable. The average differences n pricelevels between the various markets of the nineteenth century are much

the same right through to 1907. In fact, the largest difference foundoccurred in 1907 (for Erie stock compared on the London and NewYork exchanges). The variances are also similar, except those forAmerican railroad stocks in the nineteenth century are substantiallyhigher. The standard deviations (recall these are for the absolutepercentage differences) are also quite uniform by security and timeperiod,save for the Americanrailroad tocks. Theirstandarddeviationsaredoublethe levels for French rentes in the 1873crisis and remainhigh

for Erie stock in the 1907 panic. The range of differences for thenineteenth-centurysecurities are also much the same as in the eigh-teenthcentury with the exception of those for Americanrailroadstocksin the 1873 crisis and Erie stock in 1907. The range of differencespossible should decrease as the speed of communication of pricesbetween two markets increases, so our quantitativeevidence indicatesthat only the speeding up of communications over the nearly twocenturies under consideration had any effect in improvingthe integra-

tionof Europeancapital markets. And this improvementcouldbe easilyoffset in the case of volatile stocks (Erie in 1907)and uncertaintiesofexchange rates when governmentalpolicies changed (Americansecuri-ties in 1873).

But the improvementof communicationsdid not improve integrationto the extent that all possible opportunitiesfor profit from arbitragewere eliminated. In the ARMA models calculatedfor the nineteenthcentury, we findno randomwalk until we get to the 1907panic. Even

there the randomwalk appears in only one of the six possible cases(threemarketsandtwo stocks arecompared).Even worse is the findingthat in the 1873crisis the estimated coefficientsfor the autoregressivemoving average models (not shown in the tables) for each security-French 3 percentand 5 percentrenters,Erie and IllinoisCentralstock-indicate that the ARMA process was explosive, ratherthandampened!This is conceivable if a rationalbubbleis in progressin one marketandnot in the other, but that situationhardlyseems likelyfor the securitiesand marketsin question.

In sum, the evidence is that the Amsterdamand London capitalmarketsof the eighteenth centurywere closely integratedeven by early



226 Neal

twentieth-century tandards,andintegratedeven during inancialcrises

that affected one market more severely than the other, according to

contemporaryaccounts. This is true, of course, only for the securitieswhich were listed in both markets.For other securitiesthatwere listed

and actively traded in one market but not in the other, however,

integration ould obviously have takenplace through rading irstin one

of the commonly listed securities and then in any of the locally traded

securities.The ease of integrationwould then be improvedby increas-

ing the numberof commonlylisted securities.These do beginto growin

the nineteenthcentury and especially after the middleof the century,

with first London and then Parisjoining Amsterdamas marketswhereforeign securitiescould be locally traded.5But the degreeof integration

does not seem to have made much progressin terms of decreasingthe

average differencein prices and in eliminatingsystematic patternsof

price differences.

5 In 1855 he AmsterdamBeurs listed officially87securities,only 14 of which weredomesticand

2 colonial.Three-fourths f these, however,weregovernmentbonds.By January1914, henumber

had grownprodigiouslyo 1,796of which691 were domestic,840 foreign,and265 colonial.Of the

foreign securities, 194 were issued by North American railroads. (L. Brenninkmeyer,DieAmsterdamerEffektenboerse Berlin,1920],pp. 178-83.) By contrast,we may note that in 1983

only294foreignstockswerelistedin the United States,up sharply rom99 in 1979 BusinessWeek

[July23, 1984],p. 101).

Documents

Neal (JEH 1895) - Integration of International Capital Markets - Quantitative Evidence From the Eighteenth To Twentieth Centuries