IMPERFECTIONS IN INTERNATIONAL FINANCIAL MARKETS: IMPLICATIONS FOR RISK PREMIA AND THE COST OF CAPITAL TO FIRMS

THE EFFECTS OF DIVERSIFICATION on portfolio efficiency have been examined extensively over the past decade since the pioneering works of Markowitz [10], and later Sharpe [12] and Lintner [7]. The great majority of the empirical work has been limited to common stocks in the U.S. capital market. Recently papers have begun to appear examining the merits of diversifying across international boundaries ([1], [2], [4], [5], [6], [11]). The purpose of this paper is to examine several theoretical implications of such international diversification, with particular attention to the effects of imperfections in international financial markets on risk premia for capital assets, the cost of capital to firms, and the efficiency with which capital is allocated.