Financial development and stock returns∗ Harris Dellas† Department of Economics University of Bern CEPR, IMOP Martin K. Hess‡ ITAM, Mexico March 21, 2002 Abstract We study the relationship between financial development (F D) and stock returns in a panel of emerging and mature markets using both banking and stock market indicators of F D. We find that while banking development lowers, stock market development increases mean returns. That a higher ”quality—size” of the banking sector constraints volatility in the less financially developed countries but has the opposite effect in more financially developed countries. And that the international diversification value of a country’s stocks decreases with F D. ∗ We are grateful to E. Baltensperger, V. Koubi and C. Wyplosz for valuable comments and to Ecoscientia Stiftung for generous financial support. † Gesellschaftsstrasse 49, CH—3012 Bern, Switzerland. Tel: (+41) 31—631—3989, Fax: (+41) 31—631— 3992. Email: [email protected], Homepage: http://www-vwi.unibe.ch/amakro/dellas.htm ‡ Instituto Tecnológico Autónomo de México, División Académica de Administración, Av. Camino a Santa Teresa #930, Col. Héroes de Padierna, Del. Magdalena Contreras, C.P. 10700 México, D.F. MÉXICO, Tel (+52) 56-28-4000 ext. 6525, Fax: (+52) 54-90-4665, Email: [email protected], Homepage: http://ciep.itam.mx/~mhess. Part of this paper was written while Hess was affiliated with Studienzentrum Gerzensee. 1