Capital market equilibrium has been extensively studied in the recent past, mostly in a mean-variance framework. In a perfect capital market with riskless assets and homogenous expectations among risk-averse investors, Sharpe and Lintner have shown that the efficient set of all investors could be described by only two portfolios (or mutual funds):(1) the market portfolio(2) the riskless asset.

The Markowitz-Sharpe market model has been extensively applied to the study of price behavior of American common stocks. In this paper an international market model will be used assuming that the return on any security is a linear function of the return on the world market portfolio. A justification for this approach lies in the International Asset Pricing Model (IAPM) proposed by Solnik [14] and [15]. This market model is by no means the only stochastic process of security returns consistent with the IAPM, but it is the most simple and straightforward extension of the traditional approach to domestic markets.

Revised May, 1973.

We propose a simple metric to measure two aspects of market integration, namely, economic integration (defined as a common cash-flow dynamic) and financial integration (defined as a common risk-pricing dynamic) and then examine their evolution through time while controlling for volatility. We find that developed (DEV) countries exhibit greater degrees of financial and economic integration than emerging (EMG) markets. Although the financial integration gap between these markets remains large throughout the sample period, the EMG economies are catching up with their DEV counterparts in recent years; their level of economic integration has reached that of DEV countries.