International Journal of Managerial Finance

A cross-section analysis of financial market integration in North America using a four

factor model
Marie‐Claude Beaulieu, Marie‐Hélène Gagnon, Lynda Khalaf,
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Marie‐Claude Beaulieu, Marie‐Hélène Gagnon, Lynda Khalaf, (2009) "A cross‐section analysis of financial
market integration in North America using a four factor model", International Journal of Managerial Finance,
Vol. 5 Issue: 3, pp.248-267, https://doi.org/10.1108/17439130910969710
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IJMF
5,3 A cross-section analysis
of financial market integration
in North America using
248
a four factor model
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Marie-Claude Beaulieu, Marie-Hélène Gagnon and Lynda Khalaf

(Information about the authors can be found at the end of the paper.)

Abstract
Purpose – The purpose of this paper is to examine financial integration across North American stock
markets from January 1984 to December 2003.
Design/methodology/approach – The paper uses an arbitrage pricing theory framework. The risk
factors considered are the three Fama and French factors augmented with momentum for both
countries as well as their international counterparts. Both the domestic and international four factor
models in cross section and test for partial, mild, and strong financial integration are estimated.
The domestic and international model are estimated on domestic portfolios and on a subset of
Canadian cross listings matched with American stocks.
Findings – Results can be summarized as follows: first, results show stronger evidence of mild rather
than partial or strong integration in both domestic portfolios and interlisted stocks. Second, interlisted
stocks appear at first glance to be more integrated than the domestic portfolios, but this result can be
attributed to the poor explanatory power of the models applied to interlisted stocks. Once the authors
rule out the case where the model does not generate statistically important risk premiums for both
countries, the evidence of integration is similar in both domestic and interlisted stocks. Third, the
domestic and international models have similar explanatory power, although the domestic model
performs better with the Canadian interlisted stocks are found.
Originality/value – The results suggest that, in an international context, a portfolio manager is
better off using the four factor model as a benchmark in cross sections rather than the single market.
Furthermore, if the agency problem described in Karolyi is ignored, Canadian interlisted stocks and
Canadian domestic portfolios have the same diversification potential.
Keywords Integration, North America, Stock markets, Arbitrage, Pricing, Financial markets
Paper type Research paper

1. Introduction
The paper examines financial market integration between Canadian and US stock
markets in the 1984-2003 period. The impact of financial integration is important to assess
This paper was awarded the International Journal of Managerial Finance Best Paper Award at
the 2008 Northern Finance Association Conference.
The authors thank Lucie Samson, Stéphane Chrétien, Usha Mittoo, and Michael King for
several useful comments. This work was supported by the Canada Research Chair Program
(Chair in Environmental and Financial Econometric Analysis, Université Laval), the RBC Chair
International Journal of Managerial in Financial Innovations, the Institut de Finance Mathématique de Montréal (IFM2), the
Finance
Vol. 5 No. 3, 2009 Canadian Network of Centres of Excellence (program on Mathematics of Information
pp. 248-267 Technology and Complex System (MITACS)), the Social Sciences and Humanities Research
q Emerald Group Publishing Limited
1743-9132
Council of Canada, the Fonds de recherche sur la société et la culture (Québec, FQRSC), and the
DOI 10.1108/17439130910969710 Centre interuniversitaire sur le risque, les politiques économiques et l’emploi (CIRPÉE).
 for portfolio managers, given that a portfolio’s exposure to systematic risk can be reduced Analysis of
through international diversification. Indeed, the potential for international diversification financial market
is, in theory, diminished by a high degree of financial market integration since in that
context, the sources of systematic risk become global and more difficult to diversify. integration
Market integration tests appear in the literature in the late 1970s, following regulatory
changes on international capital flows resulting in increased capital mobility. Stehle (1977)
presents one of the first studies on the integration of the American market vis-à-vis the 249
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international market. For the Canadian case, Jorion and Schwartz (1986) provide one of the
first formal studies; their work has led to several published articles (surveyed in Mittoo,
1992) along the same line of work. They test integration and/or segmentation of the
Canadian financial market vis-à-vis the American one. The idea behind their approach is
the following: if markets are segmented, the only risk factor that should be rewarded is the
one representing the Canadian market index. Inversely, if markets are integrated, the
global market index is the only factor that should be significant. Results strongly reject
integration for the whole period for all portfolios formed. Three subsequent influential
studies are noteworthy for the Canadian case: Errunza et al. (1992), Mittoo (1992), and
Koutoulas and Kryzanowski (1994). Errunza et al. (1992) formulate and test three
hypotheses: integration, mild segmentation, and segmentation. Tests are conducted over a
group of eight developing countries and on Canada vis-à-vis the American market. Their
results for both developing countries and Canada suggest a non-polar market structure,
which means that markets are not fully integrated nor fully segmented. However, results
on integration with American markets show that Canada is more integrated than
segmented with the USA and that the developing countries are more segmented than
integrated. Mittoo (1992) formulates and tests integration in the context of two asset
pricing frameworks (the CAPM and arbitrage pricing theory (APT; with macro economic
factors) across various sub-periods). Her results show that North American markets tend,
over time, to become more integrated. Koutoulas and Kryzanowski (1994) study the
Canadian financial integration vis-à-vis the American market using an APT framework
(based on macro-economic factors) during the 1969-1988 period. In order to specify
relevant risk factors, they refer to the exchange rate literature. Their results show that:
.
the Canadian market is partially integrated with the American market; and
.
Canadian stock returns are influenced by a few domestic factors (such as term
structure and the lagged industrial production level) and by some international
factors (such as the Eurodollar rate).

Cross listings are often studied jointly with financial market integration. Indeed, Jorion
and Schwartz (1986) and Mittoo (1992) found that interlisted stocks are more integrated
than domestic stocks and that the systematic risk of domestic and interlisted stocks is
different. Moreover, Foerster and Karolyi (1998) find that the large abnormal returns prior
to cross listing and loss after the listing are consistent with the market segmentation
hypothesis and with Merton’s (1987) investor recognition hypothesis. Furthermore,
Foerster and Karolyi (1998, 1999) document the positive impact of cross listing on the
firm’s stock price, liquidity, and transaction cost. Foerster and Karolyi (1999) also conclude
that American depository receipts are potentially good investments for international
diversification purpose. More importantly, he concludes that cross listing reduces the
exposure to domestic systematic risk. Overall, these studies conclude that there are
significant gains for the firm to cross list and that cross listings can be an efficient way to
 IJMF diversify for both the investor and the firm. However, the more recent literature is
5,3 questioning these results. In fact, Mittoo (2003) investigates whether the trend toward
globalization entails a decreasing number of cross listings and whether globalization has
long-run effects on the performance of cross listings. She finds that Canadian firms list in
the USA when they have above average performance but underperform the domestic
index in the subsequent years. Also, her results suggest that the valuation effect of cross
250 listing depends on liquidity and the industry. Furthermore, Karolyi (2006) highlights new
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findings in the literature on cross listings suggesting that globalization implies a more
complex source of risk for cross listed firms. Karolyi (2006) also documents agency costs
related to cross listing and argues that they can be important issues for investors.
In this paper, we use a Fama and French arbitrage pricing model (APT) framework to
test financial market integration in North America. We use a multivariate approach,
similar to the methodology adopted by Mittoo (1992), to test several forms of integration.
Moreover, an extensive cross-sectional study is performed in order to explain the
average returns of domestic portfolios and of interlisted stocks, using both a domestic
and an international empirical model. Our paper makes four main contributions.
First, we revisit financial market integration between Canada and the USA on the basis
of Fama and French framework augmented with momentum. To this end, three
hypotheses are formulated and tested, namely a partial, mild, and a strong form of
financial integration. Reliance on the Fama and French risk factors augmented with
momentum could be arguable. Indeed, concerns have been expressed in the literature
about the accuracy of those pricing factors (Petkova, 2006; Shanken and Weinstein, 2006).
These factors are used for two main reasons: first, we differ from the previous studies
which used macroeconomics factors (Mittoo, 1992; Koutoulas and Kryzanowski, 1994)
since we prefer to use financial risk factors. In this regard, Fama and French factors and
momentum have been used frequently since the publication of Fama and French (1992).
Second, to the best of our knowledge, those factors have been rarely used in the Canadian
context. Indeed, only two studies use them on Canadian monthly financial data[1]: Griffin
(2002) and L’Her et al. (2004). Given this lack of evidence on the Canadian market, our study
will be able to improve our understanding of Canadian aggregated risk.
Second, we study financial market integration using both the domestic and
international four factor models. We do so in order to bridge the gap between the asset
pricing model literature, such as Griffin (2002), and previous works on financial market
integration such as Mittoo (1992). Griffin (2002) tests Fama and French factor model in
time series on several countries (including Canada) for the 1981-1995 period. He compares
the performance of the international Fama and French model versus a domestic one. He
finds that the addition of foreign factors to the domestic model leads to less accurate
pricing both in and out of sample. The present paper tests financial market integration
with both domestic and international risk factors, even though Griffin (2002) found that
international factors were not useful in pricing. We do so for two reasons. First, our
objective is to test financial market integration by assessing whether coefficients on the
Fama and French factors are equal. In this context, the international factor provides a new
angle of study. Indeed, the equality of Canadian and American risk premiums on a single
international factor is a more restrictive definition of integration than the equality of the
premiums attached to domestic risk factors. Second, an extension of Griffin (2002) to
the Euro zone, by Moerman (2005) finds that although the domestic model still
outperforms the international one, the later’s performance improves with time.
 Third, we compare the results using both domestic portfolios and a subset of Analysis of
Canadian cross listings. The 1990s literature suggested that cross listings are: financial market
.
a good diversification vehicle (see Karolyi (1998) and the references therein); integration
.
an efficient way to increase the investor base (Sarkissian and Schill, 2004);
.
a way to decrease transaction cost and increase liquidity (Foerster and Karolyi,
1998; Karolyi, 1998); and 251
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. priced differently than domestic stocks (Jorion and Schwartz, 1986; Mittoo, 1992).

However, the more recent literature surveyed above raises questions about the
long-term capacity of cross listings to remain attractive investments in the actual
context of globalization. In view of those limitations, we inquire whether the degree of
financial integration of such an investment has changed over time. Note that Griffin
(2002) excludes cross listings from his analysis because the results in Mittoo (1992) and
Jorion and Schwartz (1986) suggest they are priced differently. Given that these studies
also found stronger evidence of financial integration for cross listings, this paper
studies whether the international multifactor asset pricing model would fare better
when interlisted stocks are included in the analysis. Indeed, Foerster and Karolyi (1999)
documents that the domestic systematic risk is reduced by cross listings while the
global market risk is slightly increased. This finding could suggest that an
international asset pricing model may be more appropriate for interlisted stocks.
Fourth, we address the econometric shortcomings associated with two-pass
estimations. This paper aims to improve the procedure used in Mittoo (1992) by
correcting for the well known error in variable problem (see Dufour (2003) for a recent
survey of the econometric literature) encountered in a two-pass estimation of risk
premiums (Chen and Kan, 2004; Shanken and Weinstein, 2006; Shanken and Zhou,
2007). While the financial literature on portfolio efficiency (Shanken, 1996; Campbell
et al., 1997; Dufour and Khalaf, 2002; Beaulieu et al., 2007, 2009) acknowledge that
attention must be given to the testing procedure paired with an asset pricing model, in
the context of financial market integration, interest in econometric improvements is, by
contrast, relatively limited. In this context, a split sample methodology is introduced.
This simple method introduced by Angrist and Krueger (2001) and Dufour and Jasiak
(2001) has not yet received attention in empirical finance.
Results are presented using a cross-sectional analysis. They support the following
conclusions. First, mild integration is supported by the data in both domestic and
international models while the evidence is mixed for the partial and strong forms. Second,
interlisted stocks appear to be more integrated than domestic portfolios but this result can
be attributed to the poor explanatory power of the model for interlisted stocks. Once the
cases where the model does not generate meaningful risk premiums for both countries are
ruled out, the evidence on integration is similar in both groups. This finding suggests that
cross listings are more subject to firms’ idiosyncratic risk as highlighted in Karolyi (2006).
Third, results show that the domestic and international models have similar explanatory
power, although the domestic model performs marginally better for Canadian interlisted
stocks. This finding differs from the one presented in Griffin (2002) who concludes in favor
of the domestic model. Our study has several implications for portfolio managers. Indeed,
Canadian stocks interlisted in the USA offer a similar diversification opportunity than
Canadian portfolios, ignoring the agency costs problems described in Karolyi (2006).
 IJMF Also, in an international setting, a benchmark including size, book-to-market, and
5,3 momentum as well as the market factor (MKT) is more appropriate to assess the portfolio’s
performance in cross section than MKT alone.
The remainder of this paper is organized as follows: Section 2 presents our test
methodology and the integration hypothesis tested. Data are presented in Section 3.
The empirical analysis is reported in Section 4 and Section 5 concludes.
252
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2. Models and methodology

2.1 The cross-section analysis of the four factor model
The approach described below is based on the APT framework proposed by Mittoo
(1992), modified as follows, in view of our stated research objectives. First, we use an
observed risk free rate (hence, we evaluate the model in excess return). Moreover, the
risk factors used are financial rather than macroeconomic. Given the latter
modification, we are also led to adjust the definition of the integration hypotheses
tested. Whereas Mittoo (1992) tests the joint equality of the risk premiums (which
makes sense given macro-economic factors), we will test a wide range of hypotheses on
individual risk premiums as well as joint hypotheses. Furthermore, we introduce an
alternative approach to deal with the non-observability of the BETAS. Let us first
review the theoretical APT model presented in Mittoo (1992).
The APT theory assumes that several risk factors intervene in the evaluation of an
asset. The basic APT model where Rit and Eit represent, respectively, the actual and
expected return of asset i at time t; dkt is the kth risk factor at time t; bik is the
sensitivity of asset i to risk factor k; and uit is the error term at time t, which is often
assumed to be normal with mean zero, is the following:
Xs
Rit ¼ E it þ bik dkt þ uit : ð1Þ
k¼1

In order to test integration within the latter model, similar portfolios from Canada and
the USA will be evaluated. If markets are integrated, it implies that similar assets
respond in a similar way (in the same magnitude) to the same risk factors.
If there are no arbitrage possibilities, the expected return of an asset can be written
as a linear function of the risk factor sensitivities where RFt is a scalar representing the
risk free rate at time t; lk is the risk premium associated with risk factor k and bik (as
defined above) is the sensitivity of asset i to risk factor k:
Xs
E it ¼ RFt þ lk bik : ð2Þ
k¼1

Combining equations (1) and (2) will generate the empirical model of interest where
J ¼ (C), (U) refers, respectively, to Canada and the USA; in other words, the return of
asset i (Canadian or American) at time t is the scalar RFtJ , the risk free rate (Canadian or
American) is the scalar RFtJ , lkJ is the risk premium (sensitivity of the BETA) for the kth
risk factor (Canadian or American), bikJ represents the sensibility of asset i (Canadian or
American) to factor k at time t:
X
s
RitJ ¼ RFtJ þ lkJ bkJ þ eitJ ; i ¼ 1; . . . ; n; t ¼ 1; . . . ; T; ð3Þ
k¼1
 with an error term: Analysis of
X
s financial market
eitJ ¼ bik dkt þ uit : ð4Þ integration
k¼1

The composition of the error term reflects the fact that factors are not observable.
Moreover, the American dollar is always used as a numeraire. 253
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The empirical problem with this model is that the “BETAS” are not observable but are
estimated with error. Typically in this case, it is necessary to adopt a two-step procedure:
(1) estimate the asset sensitivity to the risk factor (the “BETAS”); and
(2) evaluate the risk premium associated with each risk factor.
BETAS are obtained by regressing the asset returns on the risk factor without a
constant (a standard multivariate regression). Then, risk premiums are estimated by a
maximum likelihood procedure on the following Seemingly Unrelated Regression
Equations (SURE) system of equations where RCi and RUi are the sample mean excess
return of portfolio i½i ¼ 1; . . . ; n
over the period of estimation:
X
s
C X
s
U
RCi ¼ a C þ b^ik lCk þ vCi ; RUi ¼ a U þ b^ik lUk þ vUi : ð5Þ
k¼1 k¼1

In this paper, equation (2.5) is estimated four times. In order to compare the results for the
Canadian portfolio and the Canadian interlisted stocks, the model is estimated using
domestic and international risk factors and two different sets of dependent variables are
used. In fact, both models are first estimated using Canadian and American Fama and
French 25 portfolios as dependent variables. Then, both models are estimated again using
the mean return on Canadian cross listings and an American stock in the same industry
and of similar size. Formally, the domestic (2.6) and international (2.7) models are
estimated where Ri J is either the mean excess return on portfolio i in country J or the mean
excess return on the Canadian interlisted stocks and their American domestic
counterparts and a J is the intercept of the model in country J.
J J J J
lMKT ; lSMB ; lHML ; and lMOM (SMB, small minus big; HML, high minus low; MOM,
momentum) are the estimated risk premium coefficients for country J associated,
J
respectively, with the pre-estimated BETA on each portfolio i of the market ðb^iMKT Þ, size
J J J J
ðb^iSMB Þ, book-to-market ðb^iHML Þ, and momentum ðb^iMOM Þ. Finally, vi is the error term
associated with the estimation of the model for portfolio i in country J. The model is:
J J J J
Ri J ¼ a J þ lMKT
J J
b^iMKT þ lSMB J
b^iSMB þ lHML J
b^iHML þ lMOM b^iMOM þ vi J ; ð6Þ
J J J J
Ri J ¼ aIJ þ lMKTI
J J
b^iMKTI þ lSMBI J
b^iSMBI þ lHMLI J
b^iHMLI þ lMOMI b^iMOMI þ viIJ : ð7Þ
As the literature review outlined, the two-step procedure is a major problem encountered
in two-pass estimation. Indeed, pre-estimating the BETAS leads to contemporaneous
correlation between the regressors and its error terms in the second pass, since the same
sample is used to evaluate the parameters in both steps (the sensitivities and risk
premiums). Given the seriousness of this econometric issue, different methodologies have
 IJMF been proposed to correct the error-in-variable. For example, Mittoo (1992) used the same
5,3 sample of observation in both steps but the pre-estimation of the BETAS is accounted for
with an adjusted hotelling test statistic (Shanken, 1985; Shanken and Zhou, 2007).
A contribution of the present paper is to propose an alternative correction for the
error-in-variable problem. In order to bypass this problem, the econometric method used is
the “split sample”.
254 The split sample methodology was recently introduced in econometrics for a
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different (although related) test problem involving error-in-variable (Angrist and

Krueger, 2001; Dufour and Jasiak, 2001; Dufour, 2003)[2]. The intuition for this method
as it applies to the present problem is to use one part of the available sample to estimate
the BETAS and the remaining part to evaluate the risk premium. It is usually
recommended to save a larger sample for the second pass.
In this paper, different sample splits are tested. First, we follow Gultekin et al.
(1989), and split the sample in two sequential parts: the first sub-sample is used to
estimate the BETAS and the second one to evaluate the risk premium. Two
breakpoints will be tested; 30 and 40 percent of the sample used for BETAS and the
70 and 60 percent for the risk premium. However, a problem with this approach is that
BETAS are likely to change over time. Then, it is possible that BETAS estimated in
the 1984-1989 sample period are not representative of the BETAS in 2000s. We thus
consider an alternative split sample, using the observations of March, June, September,
and December of each year to estimate BETAS and the remaining months to estimate
risk premiums. Finally, the last type of split sample considered is to use the months of
April, August, and December of each year to estimate BETAS and the remaining
months to estimate risk premiums. Given that no difference was found in the results
using different splits, only one will be reported where 40 percent of the sample is used
for the BETAS and 60 percent for the risk premiums. The hypotheses of integration
tested in equations (2.6) and (2.7) are now presented.

2.2 Testing methodology

In both domestic and international models, results are obtained using a two-pass
estimation method. The first pass consists in estimating the BETA coefficients for each
portfolio using a country per country multivariate system of equations. The second
pass estimates the country risk premium associated with those BETAS using a SURE
model with one equation for each country. In the second pass, the average excess
returns of each portfolio are regressed on their BETAS in order to get risk premium
estimates. In order to avoid the error-in-variable problem, the split sample procedure
discussed above is applied. The first 40 percent of the data in each subperiod is used in
order to estimate the BETAS in the first pass and the remaining 60 percent of the data
to estimate the risk premium. Table I presents the list of integration hypotheses tested.
Several hypotheses of integration on two APT models are tested in order to
qualitatively assess the degree of financial integration in North America. Given that
some hypotheses are more restrictive than others, we divide them in three categories
that suggest different degrees of financial integration. Indeed, three forms of
integration are tested: mild, partial, and strong. Partial integration is assessed through
the hypothesis that the coefficients of the risk premiums are individually equal. The
mild integration hypothesis tests that the sum of the effect of all four factors is the
same but does not require that any individual risk premium be equal. Finally, strong
 Analysis of
Hypotheses Domestic model International model Integration degree tested
financial market
H0MKT lCMKT ¼ lUMKT lCMKTI ¼ lUMKTI Partial integration
H0SMB lCSMB ¼ lUSMB lCSMBI ¼ lUSMBI Partial
H0HML lCHML ¼ lUHML lCHMLI ¼ lUHMLI Partial
H0MOM lC ¼ lU lC ¼ lU I Partial 255
PK MOMC PMOM K PKMOMIC PMOM K
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U U
H0SUM k¼1 lk ¼ k¼1 lK k¼1 lk ¼ k¼1 lK Mild
C U C U
H0JOINT lk ¼ lk ; ;k lk ¼ lk ; ;k Strong
Notes: This table presents the six hypotheses tested, H0MKT, H0SMB, H0HML, and H0MOM test the Table I.
equality of each estimated risk premium in the two countries the non-rejection of these individual List of the null
hypotheses are defined as evidence of partial financial integration; H0SUM states that the sum of the hypotheses tested against
risk premiums is the same for both countries; the non-rejection of the latest hypothesis is defined as their two-sided
evidence for mild financial integration; the non-rejection of the joint hypotheses of equality of the risk alternative in the
premiums H0JOINT is defined as evidence of strong financial integration; all hypotheses are tested domestic and
successively in the domestic (2.6) and international models (2.7); all six hypotheses are tested against international four factor
their respective two sided alternative models

integration requires that the coefficients are jointly equal. In particular, a non-rejection
of H0MKT, H0SMB, H0HML, or H0MOM (as defined in Table I) suggests partial integration
because it implies that the risk premium associated with a given risk factor is the same
in both countries. Also, the non-rejection of H0SUMC (as defined Table I) suggest a case
of mild integration, given that it is a joint hypothesis on all risk factors requiring that
their total effect is the same in the two countries, excluding the constant. Finally, a
non-rejection of the joint hypothesis of integration, H0JOINT (as defined in Table I),
suggests strong financial integration given that both countries’ average returns react
in the same way to a change in each BETA.
Moreover, tests performed on the domestic and the international models have
different implications in term of financial integration. In fact, the hypotheses tested in
the context of the international model are more restrictive than the ones tested in the
domestic model. The higher restriction is necessary because the international model
requires that both countries’ average returns react in the same way to the same change
in BETAS, whereas the hypotheses in the domestic model only imply that both
countries have the same risk premium attached to a given domestic risk factor. In this
context, non-rejection of the null hypothesis of integration in the international model is
considered stronger evidence of integration than in the domestic model. The next
section presents the data and descriptive statistics.

3. Data
In this section, the data used to conduct our analysis are presented. The focus of this
paper is on the 1984-2003 period and the analysis is performed on four sub periods of five
years: 1984-1988, 1989-1993, 1994-1998, and 1999-2003. We have opted for Fama and
French (1992, 1993) factors augmented with momentum (Carhart, 1997). Those four
factors are: MKT, a factor related to size (SMB), a factor related to the ratio of
book-to-market (HML), and a factor related to MOM. In fact, the four factors are expected
to proxy the common risk factors in asset pricing. MKT is a portfolio that mimics the
excess return on the domestic market. The SMB factor is the difference between the
 IJMF return of portfolios constituted of small firms and portfolios constituted of big firms.
5,3 Fama and French (1993) found a negative relation between size and average return,
although they document the inverse relationship in the 1980s. As for the book-to-market
ratio, firms that have a high book-to-market equity (BE/ME) ratio (a low stock price
compared to its book value often associated with value stocks) tend to have low
earnings. The HML factor is the differential between portfolios with high BE/ME ratio
256 and portfolios with low BE/ME ratio. Finally, momentum is the differential between
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stocks with high past returns and stocks with low past returns. While these factors were
readily available for the USA through Kenneth French’s web site, they had to be
constructed for the Canadian market. The Canadian data are extracted from Compustat
and the Toronto Stock Exchange (TSE) Western database. Canadians factors are formed
in the same fashion as the American ones described in Fama and French (1993) and on
Kenneth French web site. Finally, we form four global North American risk factors:
international market (MKTI), international size (SMBI), international book-to-market
(HMLI), and international momentum (MOMI). The international factors are a value
weighted average of the USA and Canada’s domestic risk factor. Given that the USA
market represent on average 92 percent of the total value in North America, the
international factors closely resemble the American domestic ones.
In addition, two sets of dependent variables are used, namely Kenneth French’s
25 portfolios and Canadian interlisted stocks. French’s portfolios consist of stocks
sorted first by size and BE/ME with breaks at each 20th percentile. This operation
generates five groups sorted by size and five groups sorted by BE/ME. The
intersection of those two sortings provides us with a total of 25 portfolios in which the
individual stocks are ranked by size and BE/ME. In the American case, portfolios are
retrieved from Kenneth French’s web site and we form their Canadian counterpart.
Portfolio returns are in excess of the domestic risk free rate for both countries. As for
the interlisted stock, we match Canadian cross listings with a domestic American stock
using their industry’s SIC codes and market values. To be included in the sample, a
Canadian cross listing had to fulfill three conditions:
(1) be listed on the TSE Review of interlisted stocks and not be traded over the
counter;
(2) show five years of historical data; and
(3) have a credible American domestic match not traded over the counter.

Stocks from the financial sector are excluded in order to avoid double counting. Given
these constraints, we have in each subperiods, respectively, 18, 21, 23, and 44 cross
listings in our sample. For our entire database, the American data are extracted on
Kenneth French’s web site, CRSP and Bloomberg while Canadian data are constructed
from Compustat and the TSE Western series.
Table II reports descriptive statistics for the risk factors used in this paper.
The average monthly return for each risk factor and its associated standard deviation
are reported. All the descriptive data associated with the risk factors are computed for
the whole sample period (1984-2003). On average, the American market factor reveals a
higher return than the Canadian one (by 0.28 percent a month), with a similar variance.
On an annual basis, the Canadian average excess return over the period is about 4.9
percent whereas the American average excess return is 8.5 percent for an average
differential of 3.60 percent annually. This is in accordance with Jorion and Goetzmann
 Analysis of
Av. rtn SD
financial market
MKTC 0.40 4.58 integration
MKTU 0.68 4.59
MKTI 0.66 4.54
SMBC 2 1.31 3.35
SMBU 0.06 3.17 257
SMBI 2 0.01 3.08
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HMLC 2 2.30 3.84

HMLU 0.23 3.72
HMLI 0.09 3.63
MOMC 1.47 6.04
MOMU 1.30 4.44
MOMI 1.31 4.24
Notes: The first column presents the average monthly return in percent for each Canadian, American Table II.
and international factor; the second column shows the standard deviation associated with the average Descriptive statistic for
return; the Canadian data are extracted for Compustat and the TSE Western database while the the risk factors in percent
American data are from Kenneth French web site for the 1984-2003 period

(1999) who find that American market returns are substantially larger than most others
in developed countries. The average monthly return of the size factor is higher in the
USA than in Canada by 1.25 percent. Moreover, big firms generate on average higher
returns than small ones in Canada, given that the average return on the SMB factor is
2 1.31 percent whereas the converse holds in the USA with an average return of 0.06
percent. Furthermore, the Canadian book-to-market factor is strongly negative with an
average return of 2 2.30 percent comparative to 0.23 percent in the USA. Finally, the
momentum factors are similar on average in both countries with a monthly return of 1.47
percent in Canada and 1.30 percent in the USA. Although the signs attached to the
average return of size and book-to-market are different from the American risk factor
and from the existing literature on the Canadian case[3], they are consistent with the
intuition originally presented in Fama and French (1992, 1993). Moreover, we believe the
difference between our estimates and those reported in the existing literature on Canada
can be explained by two features. First, we have more observations. Indeed, our sample
contains on average 350 firms while L’her et al. (2004) has 297 firms on average. Given
that Canadian portfolios contain fewer stocks than the American ones (Table III), they
are very sensitive to changes in their composition[4]. Second, the average returns
associated with size and book-to-market vary in time. Given that the previous work on
the four factor model in Canada does not concentrate on the same period, it is difficult to
compare average returns obtained from each of them. At first glance, average returns for
size and book-to-market factors are different in the two countries, whereas the market
and the momentum factors are similar in sign and magnitude. Whether or not the
comparison of the risk premiums attached to those risk factors will reflect this
observation is an empirical question. Finally, a qualitative comparison of the standard
deviation associated with the average return of each factor shows that the standard
deviations associated with the average return on Canadian risk factor are larger than
their American counterpart, except in the market case where it is almost the same for the
two countries.
 IJMF
Ave. no. Ave. size Ave.
5,3 firm (millions) BE/ME Ave. rtn (%) SD (%) Sharpe ratio
CAN US CAN US CAN US CAN US CAN US CAN US

M1B1 11 763 23.25 53.32 0.13 0.22 21.00 2 0.88 9.33 8.42 20.11 2 0.10
M1B2 8 446 22.20 57.82 0.57 0.48 20.49 0.79 9.95 7.09 20.05 0.11
258 M1B3 10 452 24.41 55.34 0.81 0.67 22.21 0.88 9.16 5.49 20.24 0.16
M1B4 15 524 23.31 49.66 1.16 0.90 22.82 1.14 6.88 5.04 20.41 0.23
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M1B5 26 831 24.62 35.83 9.17 1.60 23.22 1.07 5.50 5.21 20.59 0.21
M2B1 13 226 64.89 275.13 0.28 0.21 1.14 0.30 7.51 7.62 0.15 0.04
M2B2 13 153 62.97 277.89 0.57 0.44 4.36 0.61 6.55 5.83 0.67 0.10
M2B3 14 152 68.76 283.77 0.82 0.63 20.22 0.92 5.36 4.85 20.04 0.19
M2B4 15 124 70.50 280.20 1.14 0.84 21.07 0.94 5.44 4.76 20.20 0.20
M2B5 15 90 81.88 271.57 2.90 1.42 22.69 0.88 6.39 5.32 20.42 0.17
M3B1 15 158 149.87 682.35 0.29 0.21 1.74 0.47 7.13 7.10 0.24 0.07
M3B2 16 104 162.16 692.30 0.57 0.44 1.03 0.74 5.78 5.39 0.18 0.14
M3B3 14 93 166.55 694.89 0.82 0.63 0.18 0.70 4.89 4.62 0.04 0.15
M3B4 12 75 183.53 698.06 1.15 0.87 20.42 0.86 4.86 4.57 20.09 0.19
M3B5 13 52 181.09 715.61 2.46 1.38 21.03 1.07 4.95 4.93 20.21 0.22
M4B1 17 117 417.90 1808.30 0.29 0.22 2.29 0.75 8.81 6.37 0.26 0.12
M4B2 14 83 469.43 1800.53 0.57 0.44 1.11 0.75 4.95 5.05 0.22 0.15
M4B3 15 70 527.33 1805.79 0.81 0.63 0.55 0.79 4.86 4.91 0.11 0.16
M4B4 12 59 539.44 1817.67 1.15 0.90 0.25 0.91 4.46 4.38 0.06 0.21
M4B5 10 41 539.66 1797.24 2.77 1.37 20.92 0.92 5.54 4.91 20.17 0.19
M5B1 15 118 4313.41 16817.70 0.31 0.22 2.02 0.73 6.53 5.03 0.31 0.15
M5B2 20 70 4481.56 12216.96 0.57 0.44 1.05 0.81 4.23 4.08 0.25 0.20
M5B3 16 54 3608.60 10546.42 0.81 0.64 0.95 0.74 4.01 4.49 0.24 0.16
M5B4 13 48 3121.37 8300.89 1.11 0.86 0.15 0.72 4.25 4.33 0.20 0.17
M5B5 4 31 2184.70 7983.18 2.12 1.29 20.37 0.74 5.82 4.96 20.06 0.15
Notes: This table presents the average number of firms, the average size, average book-to-market,
average monthly return, its associated standard deviation and the Sharpe ratio for each portfolio in
Table III. both countries, the notation used with these portfolios refers to their ranking with respect to size and
Descriptive statistics for then, BE/ME, for example, portfolio M1B1 is the portfolio within the smallest 20 percentile with
the 25 Canadian and respect to market value with the smallest book-to-market ratio; all statistics are computed for the
American Fama and whole sample period: 1984-2003
French portfolios Source: See notes to Table II

Table III presents descriptive statistics for the 25 Fama and French Canadian and
American portfolios sorted by size and BE/ME. The first important difference between
the two countries’ portfolios is that Canadian portfolios contain less firms and the
Canadian average firm’s size is smaller in each portfolio. Given the important difference
in the size of the two economies, these observations are not unexpected. However, a more
surprising finding is that Canadian portfolios have a higher BE/ME than American
portfolios in 24 out of 25 cases. Moreover, Canadian returns are lower in 16 out of 25
portfolios while the standard deviation is higher in Canada in 20 cases. The last two
observations jointly imply that the American portfolios exhibit higher risk adjusted
returns (measured by the Sharpe ratio) in 15 cases out of 25. Interestingly, the only
Canadian portfolios which have higher risk adjusted returns than their American
counterparts are the ones with low BE/ME ratios. This observation suggests an inverse
relationship between BE/ME and average return in Canada. Furthermore, statistics
 reported in Table II also show that small stock portfolios perform poorly in Canada. Analysis of
In fact, in the ten smallest Canadian portfolios (those below the 40th percentile financial market
breakpoint), only two have a positive average return during the period. However, nine of
their American counterparts have a positive average return. Again, this observation integration
suggests that the relationship between size and average return is different in the two
countries. Taken collectively, the above arguments suggest that the matching of
portfolios is not perfect. Nevertheless, our design maintains the size and book-to-market 259
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distribution within each country and controls for the intrinsic differences between the
two countries which allows for a meaningful comparison in our tests.
Table IV presents a comparison of Canadian cross listings on the overall sample.
The importance of cross listings in the overall sample in terms of value diminishes over
time (from 39 to 10 percent of the overall value). Also, Canadian cross listings are
concentrated in three main industries: mining, oil and gas and manufacturing. Even
though this is not representative of the whole Canadian economy, it is a good
approximation of the Canadian cross listings in the USA.

4. Results
4.1 Domestic factors
Table V presents results for the estimation of equation (2.6) using both the Fama and
French portfolios and cross listings. The estimates for the risk premium of each risk
factor from both countries are reported. First, we find that risk premiums in the domestic
market factor are not significant in most cases. This is consistent with the findings of
Fama and French (1992) who found no relation between average stock returns and the
associated market BETA after controlling for size. Also, we find that although size and
book-to-market risk premiums are significant for both countries portfolios, they are
often of opposite signs. Moreover, the book-to-market risk premium is not significant for
both countries in the cross listing case, while size is significant for Canada but not for the
USA. Finally, the momentum risk premium is rarely significant for both portfolios and
interlisted stocks. Given, that many individual risk premiums were not significant, an
F test of joint significance of all factors (excluding the constant) is performed in order to

No. of No. of
Sub-periods interlisted stocks % of total size Main industries of cross listings

1984-1988 18 115 39.87 Oil and gas (6), mining (5), heavy industry (2),
others (5)
1989-1993 21 173 34.93 Oil and gas (7), manufacturing (5), mining (4),
transport and comm. (2), others (3)
1994-1998 23 307 19.91 Oil and gas (6), mining (5), manufacturing (4),
transport and comm. (3), services (3), others(2)
1999-2003 44 565 10.05 Mining (12), manufacturing (12), services (6), oil
and gas (5), transport and comm. (2), others (7)
Notes: This table presents the number of interlisted stocks studied in each sub period and the total
number of firm in the domestic Canadian portfolios, the cross listings’ share of the total value in the
sample is also presented, finally, the main industries of the interlisted firms in each sub-sample are Table IV.
reported; the industry of each cross listing is based on its SIC code; data for the portfolios are from the Comparison of the cross
TSE Western and Compustat while the data for the cross listings were retrieved from the TSE listings subset to the full
Western database, Datastream, and Bloomberg sample of stocks
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5,3

260
IJMF

Table V.

interlisted stocks
for the four domestic
factors APT model for
Risk premium estimates

the 25 portfolios and the

lCMKT lCSMB lCHML lCMOM aC Ft C lUMKT lUSMB lUHML lUMOM aU Ft U

Fama and French portfolios

84-88 1.61 (0.07) 20.72 (0.05) 20.80 (0.12) 1.41 (0.14) 21.33 (0.13) 0.05 0.09 (0.80) 20.39 (0.00) 0.47 (0.00) 1.39 (0.00) 0.61 (0.13) 0.00
89-93 20.76 (0.34) 20.76 (0.03) 21.83 (0.00) 0.10 (0.36) 1.89 (0.04) 0.00 20.91 (0.10) 0.53 (0.00) 0.58 (0.00) 21.23 (0.01) 2.18 (0.00) 0.00
94-98 3.34 (0.01) 23.42 (0.00) 23.84 (0.00) 1.44 (0.17) 22.11 (0.11) 0.00 20.68 (0.19) 20.79 (0.00) 0.22 (0.22) 0.18 (0.73) 2.06 (0.00) 0.00
99-03 20.99 (0.20) 21.17 (0.03) 21.87 (0.00) 0.51 (0.70) 1.24 (0.09) 0.00 21.26 (0.03) 1.04 (0.00) 52 (0.26) 0.60 (0.53) 0.92 (0.13) 0.00
Interlisted stocks
88-88 0.43 (0.35) 1.29 (0.04) 20.12 (0.87) 1.01 (0.20) 20.58 (0.37) 0.04 20.14 (0.77) 52 (0.03) 0.07 (0.83) 20.12 (0.71) 0.58 (0.35) 0.21
89-93 0.66 (0.27) 0.71 (0.06) 20.57 (0.49) 0.95 (0.40) 20.15 (0.82) 0.00 0.07 (0.84) 0.38 (0.17) 20.10 (0.72) 20.32 (0.45) 1.12 (0.00) 0.66
94-98 21.55 (0.04) 20.62 (0.11) 21.01 (0.11) 0.96 (0.02) 1.24 (0.24) 0.00 20.41 (0.41) 20.08 (0.86) 0.24 (0.50) 20.27 (0.37) 20.16 (0.80) 0.66
99-03 20.48 (0.42) 1.15 (0.03) 0.99 (0.09) 21.78 (0.02) 2.64 (0.00) 0.01 20.34 (0.34) 20.30 (0.27) 0.04 (0.93) 20.51 (0.18) 2.51 (0.00) 0.17
Notes: This table presents the estimates for the risk premiums lk in each countries and the constant a j as well as p-values for the F test of joint significance of the
four risk premiums in each country (constant excluded), Ft J; BETAS coefficients are obtained through a multivariate regression for each country using 40 percent of
the data, Risk premium are obtained for each country in cross section using a SURE system, the remaining 60 percent of the data is used in the second step; p-values
are shown in parentheses and refer to the F-distribution cut off point at a 5 percent level; the model is estimated in four sub-periods of five years; the Canadian data
are extracted for Compustat and the TSE Western database while the American data are for Kenneth French Database and CRSP
 assess the explanatory power of the model. The results are also reported for each country Analysis of
in Table V. This test reveals that risk factors are jointly significant in all sub-periods for financial market
both countries portfolios and Canadian interlisted stocks. However, for the American
domestic stocks, the model does not appear to explain well the variation in the average integration
return given that the joint F test in not significant. We believe this is so because the
American market has a greater diversification potential than the Canadian one. In fact,
American risk factors are extremely smooth and have less variance because they are 261
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formed with about ten times more stocks than the Canadian stocks. In this context, they
may explain well the variation in diversified portfolios and be less accurate to explain
the variation in individual stocks. Moreover, the value of the intercept for each equation
is documented. We find that the constant is not significant in more than half the cases,
including the interlisted stocks[5]. Overall, we find that taken jointly, all risk factors are
pertinent to our study of financial market integration. Moreover, our results suggest that
the four factor model is a more appropriate benchmark in the international context for
the evaluation of portfolio’s performance in cross section than the single domestic
market and that a thorough assessment of financial market integration should include
more than one factor.
Table VI presents results for the tests of financial integration performed on the risk
premiums. First, partial integration for size and book-to-market is strongly rejected in
the portfolio case. The market and momentum risk factors seem to support partial
financial integration for both the portfolios and the cross listings. However, given that
the individual significance of the risk premiums is sometimes rejected, this result must
be treated with caution. In fact, if we consider only the p-values for which at least one
country risk premium is significantly different from zero, we find little evidence of
partial integration for both the portfolios and the cross listings. However, the
hypothesis that the sums of the risk premiums are the same for both countries cannot

H0MKT H0SMB H0HML H0MOM H0SUM H0JOINT

Fama and French portfolios

84-88 0.115 * 0.386 0.017 0.985 0.964 0.049
89-93 0.868 * 0.001 0.000 0.059 0.412 0.000
94-98 0.006 0.000 0.000 0.283 * 0.534 0.000
99-03 0.776 0.001 0.005 0.959 * 0.020 0.001
Interlisted stock
84-88 0.401 * 0.238 0.801 * 0.179 * 0.077 0.253
89-93 0.362 * 0.479 0.583 * 0.295 * 0.132 0.224
94-98 0.206 0.278 * 0.080 * 0.011 0.086 0.016
99-03 0.833 * 0.012 0.160 * 0.123 0.400 0.029
Notes: This table shows the p-values for each hypothesis tested in the domestic model referring to the
F-distribution at a 5 percent confidence level, the model is estimated on domestic risk factors using the Table VI.
P J
following SURE system with two equations: RiJ ¼ a J þ sk¼1 lkJ b^ik þ viJ and the tests are performed p-values associated with
J
on the lk coefficients; the model requires the pre-estimation of the BETAS; a split sample procedure is the six hypotheses tested
used to correct the error-on-variable; the analysis is performed on Fama and French national portfolios for the four domestic
and interlisted stocks; the Canadian data are extracted for Compustat and the TSE Western database factors APT model for
while the American data are from Kenneth French web site; p-values denoted by asterisk are not portfolios and interlisted
pertinent, given that both countries risk premiums are not significant stocks
 IJMF be rejected in seven out of eight cases. This suggests that the individual risk factors
5,3 may have a different impact in the two countries, but that they price the same
systematic risk overall. Finally, the joint hypothesis of equality of all risk premiums is
rejected, except for the first two sub-periods in the interlisted analysis. Overall, we find
that once we take into account the poor explanatory power of the model on individual
stocks, the national portfolios and the interlisted stocks show similar degrees of
262 financial integration. Indeed, we find nine meaningful overall non-rejections the
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hypotheses tested with the portfolio analysis while the cross listing analysis generates
ten. In an attempt to improve the explanatory power of the model for cross listings, we
now turn to the international risk factor model.

4.2 International factors

This section presents the results from the international model. The analysis of financial
integration in the context of the four international factor models is motivated by the lack of
explanatory power of the domestic model in the interlisted case. Given that these stocks are
traded on both markets, they may be more accurately priced by a global risk factor.
Tables VII and VIII, respectively, present the estimates and the p-values for the hypotheses
tested. First, as with the domestic factor model, many risk premiums are not significant
individually. In the portfolio case, the international model’s explanatory power is similar to
that of the domestic model. In fact, the constants are not significant in more than half the
cases studied and the p-value associated with the joint test of significance is always smaller
than 5 percent, except in the earliest sub-period in Canada. Moreover, the international
model does not seem to explain the variation in the average return of cross listed stocks
more accurately than the domestic model. Indeed, the joint significance of all four factors is
rejected in all but two cases in Canada. Given this observation, we believe that the domestic
model is more appropriate to explain the variation of stocks even though both models show
mixed results. However, the international momentum seems to be much more significant
than the domestic one for Canadian portfolios. This finding suggests that the American
momentum risk factor is more relevant to explain Canadian stock returns than the
domestic one. Moreover, the international size risk factor is not significant in three out of
four sub-periods studied for Canadian portfolios whereas it was significant in all
sub-periods in the domestic model. This suggests that the domestic size risk factor is more
important than the international size factor in the Canadian case. Table VIII presents the
result for the hypotheses tested in the international four factor model. Again, our analysis
of financial integration must take into account the limitation of the underlying model. In
this context, cases where both estimated risk premiums are not significant are ruled out
from our analysis. Given this constraint, we again do not find more evidence of integration
in the cross listing sample. Indeed, the portfolios analysis has a total of eight meaningful
non-rejections of the null hypotheses of integration while the interlisted stocks had nine.
This result is similar to the one found in the domestic model. However, results show strong
evidence of partial integration for the international size risk factor. Furthermore, the mild
and strong hypotheses of integration are not rejected only in the last sub-period for the
portfolios. This significance could suggest a trend towards integration and an increasing
relevance of the international model relative to the domestic one. As mentioned above, the
non-rejection of the hypotheses of integration is more constraining in the international
model than in the domestic one. In this context, it is not surprising to find less evidence of
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lCMKTI lCSMBI lCHMLI lCMOMI aC Ft C lUMKTI lUSMBI lUHMLI lUMOMI aU Ft U

Fama and French portfolios

84-88 0.91 (0.19) 20.05 (0.86) 20.82 (0.06) 20.83 (0.25) 20.64 (0.33) 0.01 0.02 (0.95) 20.35 (0.00) 0.45 (0.00) 1.33 (0.00) 0.65 (0.09) 0.00
89-93 2.21 (0.02) 20.09 (0.82) 21.63 (0.00) 1.93 (0.00) 0.55 (0.44) 0.00 20.94 (0.10) 0.50 (0.00) 0.66 (0.00) 21.17 (0.01) 2.26 (0.00) 0.00
94-98 4.95 (0.00) 21.69 (0.00) 22.41 (0.00) 2.05 (0.00) 23.25 (0.00) 0.00 20.79 (0.11) 20.76 (0.00) 0.25 (0.14) 20.02 (0.98) 2.17 (0.00) 0.00
99-03 20.47 (0.47) 1.18 (0.19) 20.71 (0.38) 2.98 (0.00) 20.80 (0.28) 0.00 21.17 (0.04) 92 (0.00) 0.28 (0.53) 0.96 (0.29) 0.93 (0.11) 0.00
Interlisted stocks
88-88 0.90 (0.29) 0.09 (0.70) 0.55 (0.24) 0.13 (0.67) 20.59 (0.45) 0.45 0.05 (0.93) 0.49 (0.06) 0.02 (0.95) 20.15 (0.62) 0.42 (0.52) 0.33
89-93 20.43 (0.52) 22.03 (0.01) 20.14 (0.74) 1.93 (0.00) 0.94 (0.18) 0.01 20.02 (0.97) 0.40 (0.15) 20.09 (0.77) 20.29 (0.47) 1.20 (0.00) 0.64
94-98 0.52 (0.34) 21.01 (0.02) 21.01 (0.02) 1.05 (0.03) 20.96 (0.19) 0.01 20.61 (0.25) 20.21 (0.61) 0.21 (0.59) 20.43 (0.17) 0.20 (0.76) 0.32
99-03 20.13 (0.82) 20.98 (0.05) 0.39 (0.47) 20.72 (0.29) 2.64 (0.00) 0.39 20.21 (0.53) 20.22 (0.38) 0.06 (0.88) 20.51 (0.15) 2.51 (0.00) 0.34
Notes: This table presents the risk premiums’ estimated (lJk ) in each countries and the constant (a J) as well as the p-values for the F test of joint significance of the
four risk premiums in each countries (Ft J) (constant excluded); BETA coefficients are obtained through a multivariate regression for each country using 40 percent
of the data; risk premiums are obtained for each country in cross section using a SURE system; the remaining 60 percent of the data is used in the second step;
p-values for the significance tests are shown in parenthesis and refer to the F-distribution cut off point at a 5 percent level; the model is estimated in four sub-periods
of five years; the Canadian data are extracted for Compustat and the TSE Western database while the American data are from Kenneth French web site

for the four international

integration

Risk premium estimates

the 25 portfolios and the

interlisted stocks
financial market

factors APT model for

Table VII.
263
Analysis of
 IJMF
H0MKTI H0SMBI H0HMLI H0MOMI H0SUM H0JOINT
5,3
Fama and French portfolios
84-88 0.257 * 0.303 0.006 0.006 0.032 0.009
89-93 0.004 0.138 0.000 0.000 0.042 0.000
94-98 0.000 0.101 0.000 0.011 0.005 0.000
264 99-03 0.423 0.777 0.310 * 0.124 0.274 0.611
Interlisted stock
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84-88 0.395 * 0.239 0.357 * 0.521 * 0.338 0.427

89-93 0.587 * 0.003 0.931 * 0.002 0.504 0.012
94-98 0.143 * 0.176 0.030 0.012 0.562 0.019
99-03 0.897 * 0.168 0.582 * 0.779 * 0.618 0.706
Notes: This table shows the p-values for each hypothesis tested in the international model referring to
Table VIII. the F-distribution at a 5 percent confidence level, the model is estimated on international risk factors
P J
p-values associated with using the following SURE system with two equations: RJi ¼ a J I þ sk¼1 lJkI b^ikI þ vJi I and the tests are
J
the six hypotheses tested performed on the lkI coefficients, the model requires the pre-estimation of the BETAS, a split sample
for the four international procedure is used to correct the error-on-variable, the analysis is performed on Fama and French
factors APT model for national portfolios and interlisted stocks; the Canadian data are extracted for Compustat and the TSE
portfolios and interlisted Western database while the American data are from Kenneth French web site; p-values denoted by
stocks asterisk are not pertinent, given that both countries risk premiums are not significant

mild and strong integration in the international model. Finally, the mild hypothesis of
integration is never rejected in the cross listed case, as it was the case in the domestic model.
On balance, this analysis leads to three conclusions. First, the domestic and
international models show a similar explanatory power. Indeed, they both explain
average returns fairly well in the portfolio case but they both fail to properly explain
the variation in individual stocks’ average return, although the domestic model does a
better job in the Canadian case. We believe this lack of explanatory power is because
the factors are aggregated and thus, less appropriate for individual stock pricing.
Second, our results support stronger evidence for the mild segmentation hypothesis
than the other two. Third, the interlisted stocks are more integrated than the domestic
portfolios but it is not the case once we eliminate the cases where both models fail to
produce one significant risk premium. This finding suggests that an American
investor can diversify his/her portfolio internationally as effectively with a Canadian
stock cross listed in the USA than with a Canadian domestic portfolio.

5. Conclusion
In this paper, we study financial market integration in North America during the
1984-2003 period. The four factor model presented in Fama and French (1992, 1993)
and Carhart (1997) is used in a domestic and international context. A set of six
hypotheses is deifined to test a partial, mild and strong form of integration. Finally, the
four factor model is estimated in cross section for 25 Fama and French portfolios and a
set of Canadian interlisted stocks. Overall, the analysis reveals three empirical
findings. First, evidence is found in favor of the mild form of integration. The
international size factor shows strong evidence of partial integration, and the strong
form of integration is rejected in 75 percent of the cases studied. Second, interlisted
stocks appear at first glance more integrated then their national counterparts.
 However, the four factor models do not describe the systematic risk of interlisted stock Analysis of
returns as well as for the national portfolios, especially in the American case. Once the financial market
cases are removed where the statistical comparison of risk premiums is not
meaningful, interlisted stocks do not appear to be more integrated than the national integration
portfolios. Finally, the domestic and international four factor models are equivalent in
their fitting of the data and support similar evidence of integration.
This paper has several implications for portfolio managers. First, Canadian stocks 265
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interlisted in the USA offer a similar diversification opportunity than the domestic
portfolios, ignoring the agency costs problems described in Karolyi (2006). Second, in
an international setting, a benchmark including size, book-to-market and momentum is
more appropriate to assess the portfolio performance in cross section than MKT alone.
Third, the small-value investment strategy does not appear to be profitable in Canada,
given that we found negative average return on the size and book-to-market factors.
Our ongoing research in this area includes studying the four factor model in the time
series context in order to perform a disaggregate study of financial market integration
and improving the testing procedure in the multivariate context.

Notes
1. Liew and Vassalou (2000) enquire whether size, book-to-market and momentum can predict
economic growth. However, they do not use the same risk factors and do not use them in an
asset pricing context.
2. Formal proofs of its validity in a two-stage procedure involves the case where the fitted
values of the first stage regression are used in the second stage; here, the second pass uses
the estimated parameters (rather than the fitted values) from the first pass.
3. L’Her et al. (2004) document an average of 0.42 percent for both risk factors while Griffin
(2002) reports 0.57 percent for SMB and 0.42 percent for HML.
4. For example, we formed the size and book-to-market risk factor using the same dataset as
momentum, which is slightly smaller because 12 observations are needed to compute
momentum and because there are more missing values. Average returns were 0.2 percent for
size and 22.20 percent for book-to-market.
5. We report the constant and joint F test in the spirit of Griffin (2002) and in order to get a
general idea of the model fit. However, we realize that the study of the intercept and the joint
significance in each equation does not constitute a proper test of model fit, especially in the
multivariate context.

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About the authors

Marie-Claude Beaulieu, Département de Finance et Assurance, Centre interuniversitaire sur le
risque, les politiques économiques et l’emploi (CIRPÉE), Université Laval, Sainte-Foy, Canada
and Centre Interuniversitaire de Recherche en Analyse des Organisations (CIRANO), University
of Montreal, Montreal, Canada.
Marie-Hélène Gagnon, Département de Finance et Assurance, Centre interuniversitaire sur le
risque, les politiques économiques et l’emploi (CIRPÉE), Université Laval, Sainte-Foy, Canada.
Marie-Hélène Gagnon is the corresponding author and can be contacted at: marie-helene.
gagnon4@ulaval.ca
Lynda Khalaf, Economics Department, Centre interuniversitaire de recherche en économie
quantitative (CIREQ), Carleton University, Ottawa, Canada and Groupe de recherche en
économie de l’énergie, de l’environnement et des ressources naturelles (GREEN), Université
Laval, Sainte-Foy, Canada.

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