ABSTRACT
Our initial hypothesis can then be stated as follows. As capital markets increase in size the variance-to-market cap ratio falls (i.e., "σ2K < 1). There are four reasons why this might be so:
(1) the industry effect: or, more fully, the inter-industry effect, whereby negative covariances between different industries rise as the economy and the market cap become larger (Silicon Valley booms as Detroit rusts);
(2) the competition effect: or the intra-industry effect, whereby industry variances decline as competition becomes more intense with larger market size (as competition increases, the ability to generate discretely different profits declines);
(3) the derivative asset effect: derivative assets, which allow firms to preserve mean returns whilst reducing variances, are more widely available in larger than in smaller capital markets;
(4) the asset pricing effect: asset prices of the same classes of assets are more stable the deeper is the capital market, hence markets with a larger cap have a lower volatility of asset prices and, so, lower variances of returns.
