Time‐Varying World and Regional Integration in Emerging European Equity Markets

• Published date: 01 September 2013
• DOI: http://doi.org/10.1111/j.1468-036X.2011.00623.x
• Date: 01 September 2013
• Author: Ming‐Chieh Wang,Feng‐Ming Shih

European Financial Management, Vol. 19, No. 4, 2013, 703–729

doi: 10.1111/j.1468-036X.2011.00623.x

© 2011 John Wiley & Sons Ltd

Time-Varying World and Regional

Integration in Emerging European

Equity Markets

Ming-Chieh Wang

Department of International Business Studies, National Chi-Nan University, Puli, Taiwan

E-mail: mcwang@ncnu.edu.tw

Feng-Ming Shih

Department of International Business, Ching-Yun University, Jhongli, Taiwan

E-mail: fmshih@cyu.edu.tw

Abstract

This study investigates time-varying world and regional integration in emerging

European markets. Categorising global and regional effects into return and

volatility spillovers, we also examine the impact of time variation in these spillover

effects based on the conditions of economic growth. Our results show that growth

and currency depreciation can predict the degree of integration and spillover

effects for these markets. The impact of growth on the level of regional integration

is greater in countries with floating exchange rate regimes than in those with

exchange controls. The world effect on European returns is stronger when the

developed European region is in a recession. However, regional effects on the

volatility of emerging Europeanmarkets are greater during faster growthor weaker

than expected economic growth.

Keywords: volatility spillover;world and regional integration;economic growth;

exchange rate

JEL classification: G12, G15

1. Introduction

This study investigates the impact of economic growth and exchange rateson the deg ree

of financial integration and volatility spillover in emerging European equity markets.

The degree of integration of financial markets is important for international investors.

Because it is solely influenced by local information, a completely segmented market

The authors are grateful to the anonymous referees and John Doukas, the editor of the

journal, for their comments on earlier versions of this paper. Any remaining errors are solely

the responsibility of the authors. Correspondence: Feng-Ming Shih.

Ming-Chieh Wang and Feng-Ming Shih

704

© 2011 John Wiley & Sons Ltd

providescountr y-specific returns to investors. However, when a local market is integrated

with foreign markets, its conditional mean and variance should be influenced by foreign

impacts. Most studies agree that the degree of world integration has increased over time

(Bekaert and Harvey, 1995, 1997); however, early studies on integration only examine

markets with a constant degree of integration. Therefore, this paper aims to provide

dynamic measures of integration for emerging European markets.

Furthermore, if financial markets are eff icient, the movementsof stock markets should

reflect the transmission of price information between markets. Understanding the origins

and drivers of volatility is also important for pricing securities, determining the cost of

capital, implementing global hedging strategies, and making asset allocation decisions

(Bekaert and Harvey, 1997). To investigate the transmission of volatilities in emerging

European markets, we break down the world (region) effect into mean and volatility

spillover effects and then test the world (regional) integration on volatility.

Transmission between markets is often seen as comovement, spillover, or integration.

Spillover occurs when a switch in the regime of a dominant market leads to a change

in the regime of the dominated market (Gallo and Otranto, 2008). Integration between

markets exists when assets with the same risk characteristics have the same expected

returns. This study defines the conditional beta with the world (region) as a measure

of world (regional) integration. Although the degree of financial market integration is

difficult to measure, Bekaert and Harvey (1997) study volatility spillover and argue that

the increasing impact of world factors on volatility in some markets is consistent with

increased market integration. Our study of world (regional) market volatility integration

follows the same concept.

This paper makes the following contributions. First, it focuses on emerging European

markets, which are very new and make an excellent case study because of their rapid

and successful transformation from communist to market economies. Over the last few

decades, the liberalisation and integration of financial markets have increased the capital

flow of emerging economies. Stock returns in emerging markets are usually influenced

by those of developed markets.Other emerging markets, such as those in Asia, have been

extensively studied (Yu et al., 2010), but the behaviour of emerging European markets

may be different. This study examines market integration and volatility transmission in

emerging European markets to determine their degree of market integration with the

developed European and global markets.

Second, as for Asian markets, the European markets are appropriate for regional

analysis due to their differences in culture, economy, geography, and politics. This

study’s method allows for time-varying parameters and makes it possible to address

world and regional (developedEuropean market) effects on emerging European markets.

Our model, which nests two models, comprises a pricing formula that extends the

framework of Bekaert et al. (2005) in three stages, using world equity returns and a

European regional portfolio as benchmarks. Unlike Bekaert et al. (2005), this study

allows for different impacts on the mean and volatility effects driven by world and

regional markets. Combining local factors, we also examine asset pricing descriptions

using asymmetric univariable generalised autoregressive conditional heteroskedasticity

(GARCH) processes, from Glosten, Jagannathan and Runkle (GJR, 1993). Because

spillover is more pronounced in the case of bad news than good news (Koutmos and

Booth, 1995; Booth et al., 1997), we infer that negative news increases the volatility of

equity returns in emerging European markets.

This study adds economic instruments to local and regional information sets that

contain additional information on excess returns as proxies for local and regional risk