150 Years of Segmentation, Integration, and Exchange Rate Exposure: The Case of Canada and the U.S.

 

Warren Bailey, Francesca Carrieri, Ines Chaieb, and Vihang Errunza

 

(Cornell University and Fudan Univeristy, McGill University, University of Geneva, and McGill University)

 

Centaur Theatre, former Montreal Stock Exchange, 2015

Abstract

The aim of our paper is to examine capital flow barriers and exchange rate risk between a pair of the world’s largest economies, Canada and the U.S. Given the strong trade, investment, and migration links, the similarity of their political and economic institutions, and their common origins as British colonies, we cannot imagine a closer pair of economies. Our prior is that the two economies are so closely linked that capital market segmentation and the effect of exchange rate fluctuations on stock values is minimal. Confirming this prior demonstrates the power of trade and capital flows to integrate two economies. On the other hand, rejecting this prior is a strong demonstration of the significance of capital flow barriers and exchange rate fluctuations to even the closest, most developed economies.

Aside from the size, importance, and economic closeness of the U.S. and Canada, an advantage to studying this pair of countries is the availability of data for empirical analysis. We will use monthly common stock indexes that stretch back to the middle of the 19th century. Furthermore, monthly records of exchange rates between the two economies are available, as are precise descriptions of changes in the policies and regulations that have governed capital market flows and currency trading in the two economies.

There are only a handful of published papers that have exploited data from this pair of countries to address questions in international finance. In an early study of integration versus segmentation of securities markets, Jorion and Schwartz (1986) find that the market for Canadian stocks appears segmented from that of the US, even for Canadian stocks cross-listed in U.S. markets. Mittoo (1992) finds evidence that the market for Canadian stocks is integrated with that of the U.S., particularly when a multiple-factor pricing model is applied in later periods and for cross-listed Canadian stocks. In a study of the exchange rate exposure of stock returns, Bodnar and Gentry (1993) find substantial exposures of Canadian industry portfolio returns to Canada’s (USD heavy) trade-weighted exchange rate. Exposures are correlated with industry characteristics (importer, exporter, non-traded) as predicted.

We will estimate sets of equations that stack approximately 150 years of monthly data for three series, the U.S. stock index return, Canadian stock index return, rate of change of Canada-U.S. exchange rate. When combined with other monthly financial and macroeconomic series and dates of critical legal and regulatory events, we seek to understand the evolution of the degree of segmentation and the significance of exchange rate exposure in, and across, the two economies.