We derive a model in which a standard international capital asset pricing model (ICAPM) is nested within an ICAPM with market imperfections. In the latter model an idiosyncratic stochastic factor affects the return of risky government bonds (over a risk-free rate) on top of the systematic component that is common to all countries (and that is interacted with a time-varying idiosyncratic “beta”). We introduce asymptotic convergence from the full ICAPM with imperfections to the standard model by multiplying the idiosyncratic factor by convergence operators. The model is then estimated using weekly government bond returns for Belgium, France, Italy, Germany, and the Netherlands over the period 1995-2006. We find that the idiosyncratic components have converged towards zero for all countries over the sample period. By the end of the sample period the government bond markets considered are almost fully efficient, with the exception of Italy.
(Joint work with Guido Wolswijk (European Central Bank), December 2008.)