Financial Market Integration

1. Financial Market Integration ECB Notes, October 2004 Geert Bekaert Columbia University

2. FMI: What it is and what it is not • Financial market integration: situation where securities of similar risk command the same expected return => for most securities: joint test problem • Cleanest test: one security trading in two places => ADRs => closed-end funds (Nishiotis, 2004)

3. FMI: What it is and what it is not Financial market integration has wide-ranging effects: • Expected Returns, Correlation and Volatility [International Finance] • Consumption Risk Sharing, Efficacy of Macroeconomic Policy[International Economics] • Investment, Economic Growth[Development Economics] Initial Focus Presentation: Equity Markets

4. FMI: What it is and what it is not Integration ≠ Correlation • Individual stock price discount ratecash flows financial integration economic integration business cycle synchronization • Cash flow variation is an important source of price/dividend or price/earnings variation

5. FMI: What it is and what it is not Integration ≠ Correlation • Country Stock Level discount ratecash flows financial integration economic integration industrial/style mix business cycle synchronization industrial/style mix • Discount rate variation is most important source of price/dividend or price/earnings variation

6. The Industry-Country Debate • Example: Country-Industry Model • Heston-Rouwenhorst (1994 JFE) Implementation: • γik = 1 if i in country k, zero otherwise δiℓ = 1 if i in industry ℓ, zero otherwise βi = 1, for all i

7. The Industry-Country Debate

8. Country factors versus Industry factors from Cavaglia, Brightman, Aked, FAJ, 2000, 41-53

9. The Industry/Country Debate • Interpretations and big questions: • Is the effect permanent? • Globalization • Regional integration (NAFTA, EU, ASEAN) • Trend in idiosyncratic volatility (Campbell et al., Journal of Finance, 2000) • Or might it be temporary? • TMT bubble • Roaring bull, then bear market (increased volatility) • Heston-Rouwenhorst model inadequate: • unit betas • constant betas

10. The Industry/Country Debate Final Thoughts: • Bekaert, Hodrick, Zhang: ongoing project • daily return data 1980-2003, July • 23 MSCI countries, 26 industries • an average of 17,000 individual stocks • Graphs: 1. Did correlations between U.S. and other countries increase? (1 year of weekly data, rolling) 2. Did correlations between European countries increase? 3. Did correlations between industries decrease? 4. Did the country volatility ratio (volatility of an average country relative to the world volatility) decrease relative to the industry volatility ratio?5. Did the correlation between Merck and Novartis increase?

11. The Industry/Country Debate

12. The Industry/Country Debate

13. The Industry/Country Debate

14. The Industry/Country Debate

15. The Industry/Country Debate

16. Crises and Market Contagion

17. Market Integration and Contagion Contagion • Markets move more closely together during periods of crisis However… • Forbes and Rigobon (2001) • “…there is no consensus on exactly what constitutes contagion or how it should be defined” • Rigobon (2001) • “paradoxically, ... there is no accordance on what contagion means ”

18. Market Integration and Contagion Bekaert, Harvey, Ng (JB, 2005): We define contagion as excess correlation – that is, correlation over and above what one would expect from economic fundamentals. • We use an asset pricing model to link fundamentals to asset correlation => will depend on degree of market integration

19. Market Integration and Contagion Intuition: • For a given factor model, increased correlation is expected if the volatility of a factor increases. • The size of the increased correlation will depend on the factor loadings. • Contagion is simply defined by the correlation of the model residuals.

20. Market Integration and Contagion Benefits: • Avoid the problem with the bias correction for correlations that Forbes and Rigobon (2002) propose • The bias correction does not work in the presence of common shocks.

21. Market Integration and Contagion Costs: • Must take a stand on the global, regional and country specific fundamentals, as well as the mechanism that transfers fundamentals into correlation • Any statements on contagion will be contingent on the correct specification of the factor model

22. Market Integration and Contagion Model: - Asymmetric GARCH

23. Market Integration and Contagion where: the excess return on the national equity index of country i in U.S. dollars the conditional expected excess returns on the U.S. and regional markets the idiosyncratic shock of any market i the negative return shock of country i

24. Market Integration and Contagion The sensitivity of equity market i to the foreign news factors is: where market capitalization of the U.S., relative to the total world market capitalization information variables that capture the covariance risk of market i with the U.S., the region and world

25. Market Integration and Contagion Nested Models: p2,i=0=qi=δi p1,i=0=qi=δi p1,i=0=p2,i=δi CAPM, US= CAPM, region= world CAPM benchmark benchmark (regional integration)

26. Market Integration and Contagion Contagion tests: Estimated idiosyncratic shock of market i Estimated idiosyncratic shock of region g, where G represents a particular country-group, i.e. Asia or Latin America Dummy variable

27. Market Integration and Contagion Contagion tests: • Dummy variable representing five periods: • Second half of sample • Mexico crisis • Asian crisis • Abnormally negative U.S. unexpected returns • Abnormally negative regional unexpected returns

28. Market Integration and Contagion Results: Integration • First half vs. second half: betas, correlations and variance ratios with respect to the U.S. and the region increasesuggests greater linkages among the various countries. • Mexican crisis: there is no significant increase in the regional beta or correlation during the crisis. The model suggests no change in correlation during this crisis period.

29. Market Integration and Contagion Results: Integration • Asian Crisis: regional correlations, betas and variance ratios • increase by economically meaningful magnitudes and are • statistically significant • Large negative returns: While these negative abnormal returns • are usually associated with higher correlation, the increment in • correlation is substantially smaller than that experienced • during the Asian crisis.

30. Market Integration and Contagion Results: Contagion • Mexican crisis: no significant increase in residual • correlations within Latin America • Asian Crisis: significantly higher residual correlations

31. Market Integration and Contagion Conclusions: • Contagion is the level of correlation over and above the • level that is “expected” • We take a stand, using an asset pricing model, on the • “expected” correlation using an asset pricing model that • allows for world as well as regional factors and time-varying • betas. • No evidence of contagion from Mexican crisis 1994-95 • Economically meaningful increases in residual correlation • during the Asian crisis

32. Measuring and Dating Financial Integration • Many developing countries embarked on financial liberalization at the end of the 1980s and early nineties. • Capital Market Liberalization may serve to integrate the emerging market into global capital markets. but: Liberalization ≠ Market Integration

33. Measuring and Dating Financial Integration Problems: • Liberalization process is gradual and complex • Capital controls may not have been effective • Liberalization may not be credible • Indirect access may already exist • Other factors may segment the market (indirect barriers; political risk)

36. Measuring and Dating Financial Integration • One approach: Bekaert-Harvey (1995) regime switching model Local CAPM: World CAPM: Econometrician assesses probability of regimes at each point in time.

37. Measuring and Dating Financial Integration

38. Measuring and Dating Financial Integration • Alternative approach: Bekaert, Harvey, Lumsdaine (2002) structural break analysis • Test for breaks in multiple time series • Date the break and find a confidence interval for it • Strong evidence for breaks but dates do not always coincide with dates of major regularly reform. Country funds/ADRs seem important too.

39. Measuring and Dating Financial Integration

40. Measuring and Dating Financial Integration

41. Financial Effects of Equity Market Liberalization Asset Prices and Market Integration Prices Segmented Integrated PI PS Return to Integration Time High Expected Announcement Implementation Low Expected Returns of Liberalization Returns

42. Average Annual Geometric Returns Pre and Post Bekaert-Harvey Official Liberalization Dates Data through April 2002. There are no pre-liberalization data for Indonesia.

43. Average Annualized Standard Deviation Pre and Post Bekaert-Harvey Official Liberalization Dates Data through April 2002. There are no pre-liberalization data for Indonesia.

44. Correlation with World Pre and Post Bekaert-Harvey Official Liberalization Dates Data through April 2002. There are no pre-liberalization data for Indonesia.

45. Beta with World Pre and Post Bekaert-Harvey Official Liberalization Dates Data through April 2002. There are no pre-liberalization data for Indonesia.

46. Financial Effects of Equity Market Liberalization • Formal Empirical Evidence: (Bekaert and Harvey (2000); Henry (2000); Kim and Singal (2000)) • Methodology [dy, vol, cor] country control liberalization specific variables variable effect

47. Financial Effects of Equity Market Liberalization Summary Results:

48. Financial Effects of Equity Market Liberalization • Related Empirical Evidence (Foerster and Karolyi, (1996)) Abnormal Returns to ADR listings: (per week) Year before listing: 0.349% During listing week: 0.709% Year following listing: -0.190% Interpretation:  Market Integration? – Improved  Liquidity? Corporate  Larger Investor Base? Governance?

49. Financial Effects of Equity Market Liberalization • What should happen to capital flows? • rebalancing effect Bekaert, Harvey, Lumsdaine (2002, JIMF): net flowsit= a + b Libit + c Postlibit + eit with postlibit = 1-3 years after liberalization onwards Predictions: b > 0 c < 0

50. Financial Effects of Equity Market Liberalization Results for equity flows (as a % of market cap) b c All countries 0.00116 -0.00046 (7.56) (-2.75) Asia 0.00046 0.00003 (4.72) (0.23) Latin-America 0.00219 -0.00154 (5.97) (-3.72)