Stock market integration and risk premium: Empirical evidence for emerging economies of South Asia

a r t i c l e i n f o JEL classification: G12 F31 C32 Keywords: Time-varying integration Asian markets Risk premium ICAPM GDC-GARCH This article investigates the dynamics of regional financial integration and its determinants in an international setting. We test a conditional version of the International Capital Asset Pricing Model (ICAPM) accounting for the deviations from Purchasing Power Parity (PPP) as well as temporal variations in both regional and local sources of risk. Using data from five major South Asian markets (Malaysia, Thailand, Singapore, Indonesia, and Sri Lanka), our results support the validity of an ICAPM and indicate that the risk is regionally priced. Furthermore , we show that changes in the degree of regional stock market integration are explained principally by the U.S. term premium, and the level of market openness, whatever the measure of currency risk. Finally, and as expected, the degree of stock market integration varies considerably over time and from one market to another. As intense market integration induces both benefits and risks, our findings should have significant implications for economic policies and market regulations in emerging, frontier-emerging and transition countries, particularly for countries from the same region. While the empirical literature has shown the potential benefits of international diversification into stock markets, global investors often face both direct and indirect barriers (Bekaert and Harvey, 1995). Geographical distance between domestic and foreign markets is often an important barrier, limiting most cross-border investment opportunities. The heterogeneous characteristics (e.g., level of financial market development and trade openness) among the different economic regions also matter greatly. Financial integration is, first of all, the gradual elimination of direct and indirect barriers that impede free movement of goods, services and capital. These stylized facts have given rise to the establishment of several large geographical centers that offer very different risk-return profiles. Grouping by major geographical clusters should lead to financial integration as well as to the validity of the law of one price under the impetus of trade and investment between countries in the same region. We would expect adjustments in the foreign exchange markets for this law to be applied. However, as far as international portfolio diversification in emerging countries is concerned, the hypothesis of unique price of risk across markets is usually violated insofar as exchange rate regimes are likely to be subject to more or less stringent regulations imposed by local authorities. Several studies have …