Relationship Between Stock Markets

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JOURNAL OF APPLIED MATHEMATICS AND DECISION SCIENCES, 8(4), 201–218 Copyright c 2004, Lawrence Erlbaum Associates, Inc.

The Relationship Between Stock Markets Of Major Developed Countries And Asian Emerging Markets WING-KEUNG WONG† Department of Economics, National University of Singapore JACK PENM Faculty of Economics and Commerce, Australian National University RICHARD DEANE TERRELL National Graduate School of Management, Australian National University KAREN YANN CHING LIM Department of Economics, National University of Singapore

Abstract. With the emergence of new capital markets and liberalization of stock markets in recent years, there has been an increase in investors’ interest in international diversification. This is so because international diversification allows investors to have a larger basket of foreign securities to choose from as part of their portfolio assets, so as to enhance the reward-to-volatility ratio. This benefit would be limited if national equity markets tend to move together in the long run. This paper thus studies the issue of co-movement between stock markets in major developed countries and those in Asian emerging markets using the concept of cointegration. We find that there is co-movement between some of the developed and emerging markets, but some emerging markets do differ from the developed markets with which they share a long-run equilibrium relationship. Furthermore, it has been observed that there has been increasing interdependence between most of the developed and emerging markets since the 1987 Stock Market Crash. This interdependence intensified after the 1997 Asian Financial Crisis. With this phenomenon of increasing co-movement between developed and emerging stock markets, the benefits of international diversification become limited. Keywords: Developed market, emerging market, stock index, unit root test, cointegration.

1.

Introduction

In recent years, new capital markets have emerged in many parts of the world, and some foreign capital controls have been relaxed to a certain † Requests for reprints should be sent to Wing-Keung Wong, Department of Economics, National University of Singapore.

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W-K WONG, J. PENM, R. D. TERRELL, AND K. LIM

extent. This relaxation of capital controls started with the stock market liberalization when the United States took an important step by passing the U.S. Securities Act Amendments of 1975, which deregulated stock brokerage commission rates. Following the passing of this Act, the world stock markets experienced a series of deregulations and internationalization. In October 1979, exchange controls on capital outflows were eliminated in the United Kingdom. This easing on both the inflow and outflow of capital is significantly observed after 1980 (Taylor and Tonks, 1989). The Japanese capital market, conventionally known to be under stringent control (until the 1970s), also carried out a brief deregulation in 1978-1979 where foreign capital controls were slightly relaxed. With the implementation of the Foreign Exchange and Foreign Trade Control Law in December 1980, most capital controls in Japan were virtually abolished. As a result, trade of foreign financial assets by Japanese security firms and Japanese securities by foreign companies were permitted. As for the Asian emerging markets, they have been liberalized at different times as summarized in Table 11 . Three different indicators of liberalization: the Official Liberalization Date, the First Country Fund and the First ADR are shown. The latter two indicators signify indirect ways of foreign participation in local stock markets, which are usually available before the lifting of various restrictions on foreign investors. From these signals of liberalization, the Asian countries had either liberalized or started the process of liberalization by the early 1990s. However, it should be noted that although these emerging countries have officially liberalized their stock markets, various...
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