International Journal of Theoretical and Applied Finance Vol. 3, No. 1 (2000) 85–100 c  World Scientiﬁc Publishing Company MARKET SEGMENTATION AND NOISE TRADER RISK VIHANG ERRUNZA McGill University, Montreal, Canada KED HOGAN Barclays Global Investors, San Francisco, USA MAO-WEI HUNG Department of International Business, College of Management, National Taiwan University, No. 1, Section 4, Roosevelt Road, Taipei, Taiwan E-mail : hung@handel.mba.ntu.edu.tw Received 16 April 1999 A simple asset pricing model is developed to take into account two important charac- teristics in global investments: market segmentation and noise trader risk. Our results show the removal of international investment barriers and cross-border listings have not led to a fully integrated international capital market. We also show that diﬀerent degree of investor rationality across borders induces an additional component of risk premium which is related to the “noise spill-over eﬀect”. Keywords : Asset pricing, market segmentation, noise trader. 1. Introduction Global capital market segmentation has been the focus of a signiﬁcant body of international asset pricing literature. For example, Stulz [9], Errunza and Losq [4], Eun and Janakiramanan [6], Padmanabhan [8] and Basak [1] have shown that obstacles to free ﬂow of capital will in general lead to an additional risk premium on securities that are not freely accessible. Over the past decade, many types of investment barriers that limiting foreign capital ﬂows to emerging markets have been removed. Bekaert and Harvey [2] present evidence which suggests that the transition from segmentation to integration has been anything but smooth. Despite the removal of investment barriers and signiﬁcant cross-border listings, substantial market segmentation remains. It is also widely believed that investors may diﬀer in terms of investment horizon and their abilities to price securities rationally and thus induce an additional com- ponent of risk premium. DeLong, Shleifer, Summers, and Waldmann (DSSW) [3] argue that under irrational price behavior and ﬁnite investment horizon, irrational noise traders will induce a risk premium in security prices. In the context of U.S. 85