What would you expect to happen to the risk-free rate and equity returns when a segmented country opens its capital markets to foreign investment?

Question

What will be an ideal response?

Answer 1

When a country unexpectedly opens its capital markets to foreign investors, we expect the real interest rate to decrease, and the stock market to rise in value. The real interest rate in the country should fall because the country's residents are now free to borrow and lend internationally (which may reduce domestic demand for local funds), and there is additional foreign supply of capital. It is conceivable that before the liberalization, the government may have kept interest rates artificially low—for instance, through interest rate ceilings—in which case the interest rate may rise upon liberalization.
The equities of the country will now be priced globally, rather than locally. Using the intuition from the CAPM, equity discount rates will now be based on their covariances with the return on the world market portfolio and no longer on their covariances with the local market. The latter covariances are likely to be much larger than the covariances with the world market; hence the liberalization should lead to a lower risk premium for domestic stocks. Together with the lower risk free rate, the discount rates for local stocks should decrease, and, consequently, their valuations should increase. Simply put, foreign investors will bid up the prices of local stocks in an effort to diversify their portfolios, while all investors will shun inefficient sectors. Thus, equity prices should rise (as expected returns decrease) when a market moves from a segmented to an integrated state.