Honours Thesis - Empirical Finance

The University of Queensland
Faculty of Business, Economics & Law

School of Business
Market Linkage in the Pacific-Basin: A

VAR and Cointegration Analysis
A thesis submitted to the School of Business, the
University of Queensland, in partial fulfillment for the
requirements for the degree of Bachelor of Commerce
with Honours
By Grant Colthup
02 November 2004
Supervisor: Dr. Maosen Zhong
DISCLAIMER STATEMENT
The work presented in this thesis is, to the best of my knowledge and belief,
original, except as acknowledged in the text. The material has not been
submitted, in either whole or in part, for a degree at this or any other
university.
Signed:
2004
Date: 02 November
Grant Colthup
ABSTRACT
The equity markets of the Pacific-Basin tend to display comovements with one
another. Thus giving rise to the possibility that these markets are actually linked to
each other. This thesis uses cointegration analysis, persistent profile analysis,
generalised variance decomposition and impulse response functions and block
exogeneity tests, to establish the fact that the exhibit some level of market linkage.
The same procedures will also be employed to determine whether the relationship
fluctuates through time. Lastly, this thesis attempts to identify a set of variables that
can possibly explain the level of market linkage.
The results tend to suggest that the markets of the Pacific-Basin are closely linked to
one another in both the short and long run. In addition, the evidence also seems to
support the notion that the relationships are not constant over time. Certain variables
were found to help describe the level of market linkage is the result from the final
section.
ACKNOWLEDGMENTS
First and foremost, I would like to thank my supervisor Dr. Maosen Zhong for his
invaluable advice, guidance and encouragement through out the year. Without his
enthusiasm and commitment and I am certain this thesis would not have been
possible. I am also appreciative to Bin who was an immense help with the statistical
programming.
To everyone in honours this year I am thankful for making such a difficult year
incredibly enjoyable. To Brent it has been a pleasure to work on numerous
assignments and other activities together. I would also like to extend my sincere
thanks to Tim for his great advice pertaining to job applications; Michael for his good
natured sense of humour; Matt for our engaging conversations about wrestling; Jono
for thinking I have an idea about econometrics; Vince for his unique views on the
world and Pat and Ed for always being there to share a beer or feed. To all the other
friends I have made during my five year trek through the academic wilderness that is
university I am thankful. Special mention must go to Patty, a person whom I am lucky
to call a close friend.
To my family and friends thank you for all your support and encouragement. To my
mum and dad, this is as much my achievement as it is yours. Without your support
(both emotional and financial), none of this would have been possible. For that, I am
ever grateful
.
Table of Contents
List of Figures..................................................................................................................... iv
List of Tables ........................................................................................................................v
Chapter 1: Introduction......................................................................................................1
1.1 Research Question and Objective...................................................................... 1
1.2 Motivation .............................................................................................................. 4
1.3 Contribution........................................................................................................... 6
1.4 Thesis Structure ................................................................................................... 7
Chapter 2: Literature Review ............................................................................................ 9
2.1 Literature on the use of long term measures of market linkage................... 9
2. Literature on the use of short run measures .................................................... 15
2.3 Literature regarding the time evolution of market linkage.......................... 18
2.4 Literature regarding the determinants of market linkage............................. 24
Chapter 3: Hypothesis and Theory Development...................................................... 26
3.1 Introduction ......................................................................................................... 26
3.2 Description of the Pacific-Basin Economies................................................. 26
3.3 Linkage Hypothesis ............................................................................................ 37
3.3.1 Cointegration Analysis .................................................................................... 38
3.3.2 Persistent Profile Analysis .............................................................................. 41
3.3.3 Generalized Variance Decomposition......................................................... 43
3.3.4 Generalized Impulse Response Function ................................................... 44
3.3.5 Block Exogeneity ............................................................................................. 44
3.4 Time Varying Hypothesis.................................................................................. 47
3.5 Factors Responsible for explaining market linkage ...................................... 49
Chapter 4: Sample Data................................................................................................... 59
4.1 Introduction ......................................................................................................... 59
4.2 Data........................................................................................................................ 59
4.3 Descriptive Statistics........................................................................................... 67
Chapter 5: Empirical Results and Findings.................................................................. 68
5.1 Introduction ......................................................................................................... 68
5.2 Cointegration Results ......................................................................................... 63
5.2.1 Bivariate and Multivariate Cointegration Analysis for the full period.... 63
5.2.2 Bivariate Recursive........................................................................................... 76
5.3 Persistent Profile Analysis ................................................................................. 79
5.4 Generalised Impulse Response Functions Results ....................................... 80
5.5 Generalised Variance Decomposition Results .............................................. 84
5.6 Block Exogeneity ................................................................................................ 90
5.7 Probit and Regression Analysis Results .......................................................... 92
Chapter 6: Conclusion ..................................................................................................... 95
6.1 Contribution......................................................................................................... 95
6.2 Limitations............................................................................................................ 96
6.3 Future Research................................................................................................... 97
ii
Reference List.................................................................................................................... 98
Appendix A: Weekly Recursive Bivariate cointegration tests........................................
Appendix B: Persistent Profiles ..........................................................................................
Appendix C: Generalised Impulse response functions ..................................................
Appendix D: Generalised Variance Decomposition ......................................................
Appendix E: Block Exogeneity Tests ................................................................................
Appendix F :Univariate Regression Results......................................................................
Appendix G : Probit regression reults ...............................................................................
...................................................................................................................................................
iii
List of figures
3.1 Log Stock Indexes of Australia, New Zealand and the US.....35
3.2. Log Stock Indexes of Hong Kong, Japan, Korea
and Taiwan ............................................................................................36
3.3 Log Stock Indexes of Indonesia, Malaysia, the Philippines,
Singapore and Thailand.......................................................................37
3.4 Recursive Cointegration Test between Australia
and Hong Kong....................................................................................48
6.2a The impact of the East Asia crisis on market linkage ............72
6.2b The impact of the September 11 on market linkage..............72
6.2c The impact of both the East Asia crisis and
September 11 on market linkage........................................................73
iv
List of tables
3.5 Expected Relationship between market linkage and the ............
factors proposed...................................................................................49
4.1 Augmented Dickey-Fuler and Phillips-Perron unit root ............
tests (p-values) ................................................................................59-60
4.2 Augmented Dickey-Fuler and Phillips-Perron unit root ............
tests for interest rates...........................................................................61
4.3 Unit root tests for industrial production statistics in log.............
levels .......................................................................................................64
4.4 Unit root tests for the log differenced industrial ..........................
production statistics .............................................................................64
4.5 Turnover Ratios for all 12 markets .............................................66
4.6 Descriptive Statistics:Stock index returns for the full period..67
5.3.1 Cointegration Tests for the presence of long run......................
market linkage between the nations of the Pacific-Basin...............73
5.3.2 Cointegration Test Results for the presence ..............................
of Long-Run Equity Market Linkage in the Pacific-Basin on...........
the full period (January 5, 1998 - September 7, 2004) ..................74
5.3 Cointegration Test Results for the presence..................................
of Long-Run Equity Market Linakge in the Pacific-Basin.............79
CHAPTER 1: Introduction
1.1 Research Objectives and Question
The introduction of the theory of portfolio diversification heralded a new era in investment
management. Diversification pundits expounded the benefits obtained through its application.
Since then controversy has surrounded the true benefits generated through diversification.
The advantage of diversification diminishes in the presence of market linkage. In this study,
market linkage refers to common comovements between markets in either the short of long
run. The past several decades has played witness to immense change in the worlds financial
markets. Changes have stemmed from the removal of capital restrictions, the floating of
currencies, improvements in information technology, the superior level of investor education,
the increased mobility of labour, the escalation and participation in trade organisations and a
general shift towards a global economy and community. These structural changes have led to
markets displaying a greater level of linkage. Therefore, potential rewards garnered through
diversification have subsequently have been reduced.
The effect of market linkage is not an issue only concerning diversification. It has broad
consequences for both the academic and practical worlds. From an academic standpoint, it
invalidates many of the assumptions underpinning theories related to finance. For a
practitioner, it affects the pricing of securities across countries, investment strategies of
international asset portfolio managers and global hedging opportunities (Darrat and Zhong
2004). Bekaert and Harvey (1995) point to a number of papers from the developmental
economics literature that highlights the importance of financial market integration as a
conduit of economic growth. Cooper and Kaplanis (2000) even argue that the level of
financial market linkage influences optimal corporate capital structure through differing costs
of capital. The issue of market linkage has wide-ranging consequences in several different
fields and is of some importance in the modern world.
During the last fifteen years, a vast array of literature regarding short and long-term market
linkage has emerged. Early papers by Eun and Shim (1989) and Kasa (1992) supported the
assertion of market linkage over a long-term time horizon. The advancement of econometric
techniques in the early 1990s saw a number of pieces surface that contradicted the original
findings. Chan, Gup and Pan (1992) and DeFusco, Geppert and Tsetsekos (1996) find no
evidence to support long run market linkage. More recently papers by Leong and Felmingham
(2003), Manning (2002), Masih and Masih (2000), Phylaktis and Ravazzolo (2002) and
Phylaktis (1999) all seem to point to an increase in the level of long run financial market
linkage in the Pacific-Basin region (PBC herein).
Several authors have also examined the potential short run dynamics in the Pacific-Basin.
Papers by Forbes and Rigobon (2002), Phylaktis (1999), Dekker, Sen and Young (2001) and
Johnson and Soenen (2002) all seem to point to considerable linkage over the short run.
Considering the spate of mixed empirical evidence and importance of the subject, the first
research question proposed in this thesis is one of market linkage between the markets of the
PB over short and long time horizons. It is important to distinguish between the short and
long relationships as they have vastly different consequences for market participants and
interested parties.
Papers by Bekaert and Harvey (1995), Lognin and Solnik (1995) and Karolyi and Stulz
(1996) all suggest that short run market linkage has a time determinant characteristic. Silkos
and Ng (2001), Leong and Felmingham (2003) and Yang, Kolari and Sutanto (2004) reach a
similar conclusion regarding long run market linkage. By employing cointegration
techniques, generalised variance decomposition, generalised impulse response analysis,
persistent profile analysis, and block exogeneity tests, this thesis attempts to address the
questions surrounding the strength, direction and development of the market linkage in the
Pacific-Basin region. In this analysis, there will also be an examination of how large
unanticipated shocks such as the East Asian currency crisis (EA crisis henceforth) and the
September 11 2001 terrorist attacks (September 11 henceforth) have affected market linkage.
This thesis based upon prior empirical evidence and finance theory proposes a third research
question that the short and long-term relationship intensifies in the period immediately
preceding market disturbances1.
This phenomenon is commonly referred to as contagion and has been widely discussed in both finance and
economic literature.
The last section of this study will attempt to identify the factors responsible for the increase in
market linkage. This section is the most important and breaks new ground in several areas. To
estimate the level of market linkage, tests of cointegration are completed and three test
statistics extracted. The use of these test statistics represents a contribution unique to this
study. Darrat and Zhong (2004), Kouparitsas (1997), Roll (1992) and Bracker, Docking and
Koch (1999) all highlight the importance of integration in the goods market when considering
equity market linkage.
Ng (2000) highlights that many countries in the PB region are effected by volatility spillovers
caused by the US and Japan. Furthermore, Ng finds evidence to support the proposition that
market linkage intensifies during times of high volatility, this supporting market contagion.
This study hypothesizes that a common volatility process acts as a transmission mechanism
through which market linkage can develop.
The use of three unique measures ensures the accurate estimation of the effect of market
development on market linkage. Market development is likely to have a positive effect on
market linkage is the proposition argued in this thesis.
Cheung and Hung (1995), Silkos and Ng (2001) and other researchers suggest that exchange
rates impact upon the level of market linkage. Bilateral exchange rate volatility assists in
examining the proposition. Ammer and Mei (1996), Bracker et al (1999) and Dekker, Sen and
Young (2001) all suggest that geographical location is an important factor in determining
market interactions. The use of multiple proxies fro this variable ensures the robustness of the
results.
Lastly, capital market integration is considered. Countries that have capital markets linked to
one another are likely to share significant capital flows and exhibit monetary policy
dependence. The link between capital flows, monetary policy and economic performance has
been widely discussed in the economic literature. Therefore, this thesis supposes that capital
market integration influences the prevailing level of market linkage.
1.2 Motivation
The motivation of this thesis arises from several issues. The question of market linkage has
not adequately been addressed in the existing literature appears to be valid. Many prior
studies have used inappropriate sample periods and incomplete econometric procedures.
Therefore, motivation arises from the desire to use more robust and complete econometric
testing.
This thesis draws motivation from examining the subject of market linkage from both a short
and long run perspective. Several previous studies have conducted a complete analysis, but
never in the same context as of this thesis. Continuing along this line, there will be an attempt
to identify which markets are dominant in the Pacific-Basin region. That is, does the US or
Japan dictate market behaviour, is there a strong link between Singapore and Malaysia? The
role individual markets play in the region is an interesting goal of this thesis.
As discussed in section 1.1 there is legitimate interest from the practical and academic world
surrounding the existence of cointegration between equity markets. Consequently, motivation
for this thesis derives, in part by this interest. Furthermore, by adding evidence to the existing
body of literature the true relationship between the equity markets of the PB is more likely to
reveal itself.
There is a relative lack of literature examining market linkage from an Australian perspective.
The majority of the literature focuses upon the linkage between the US or Japanese markets
and the developing markets of South East Asia or the US and Latin American markets or
between the established European markets. The inclusion of markets that are important from
the Australian perspective helps to differentiate this thesis from prior works.
Thirdly, the fifteen year plus time horizon provides a unique opportunity to examine the East
Asian crisis and events of September 11, 2001. These events are likely to have a considerable
effect upon the relationship between world markets. In times of market disturbances, it is
likely that investors and markets behave differently. Evidence from the 1987 crash suggests
markets exhibited higher levels of linkage in the post-crash period. These studies fail to
control for the fact that in the late 1980s that a number of other events occurred that
dramatically shaped financial markets. This thesis attempts to isolate the effect of market
crashes and corrections by examining multiple events across developed and developing
financial markets. The question pertaining to the level of linkage prior to market disturbances
is one that requires some investigation. Through analysing markets both pre and post market
shocks it provides a complete picture about market behaviour. During the 1990s the US
equity market experienced abnormal growth and returns, while the Japanese market was
relatively stagnant. The vast difference in performance of the two largest markets in the PB
region is likely to have considerable ramifications for market linkage, thus making for an
interesting comparison.
Many pieces point to a time varying relationship between markets. Earlier pieces examined
the changes in contemporaneous correlations or other short run measures to establish a time
deterministic trend. More recently some literature has emerged which observes the change in
long run market interactions. However, most of the literature measures evolution through
examining the differences between two sub periods of the sample employed. The result of this
is there is a noteworthy motivation in mapping the evolution of the market linkage in the PB
region using higher frequency testing.
Following on from the discussion above, recent events such as regulatory reforms, improved
financial infrastructure and floating of currencies in the Pacific-Basin are likely to have
significantly affected the way in which markets interact. This provides justifiable interest for
policy makers to see how reforms affect market integration.
The motivation behind determining factors driving financial market linkage arises from two
sources. The first is that in the current literature less than a handful of papers have attempted
to identify a full set of deterministic factors. Furthermore, those that have used a full set of
factors have estimated the level of market linkage using short run proxies as opposed to the
long run orientation of this thesis. Secondly, there exists considerable interest from both the
academic and practical worlds. In the academic world knowing which variables are
responsible for intensifying market integration is desirable for helping to formulate and
further theories in international finance and trade. For practitioners it could help to identify
which markets offer the best opportunities for diversification, situations when the domestic
version of CAPM is invalid for multinational firms computing their cost of capital, optimal
hedging policy and the pricing of securities.
1.3 Contribution
This thesis aims to add to the current academic literature in three aspects:
1. Are the equity markets of the Pacific-Basin region linked to one another in either the
short or long run;
2. If so, has this relationship varied over time; and
3. Which variables have been responsible for markets becoming more integrated with
one another
Regarding the first proposition, this study contributes in several ways, through the utilization
of robust, comprehensive and unique econometric testing. Innovations include the use of a
recursive Johansen-Juselius test to establish market cointegration, which is absent from the
existing literature. To examine the differing interaction affects, the test for both the bivariate
and multivariate systems requires completion. Generalised variance decomposition and
impulse response functions and persistent profile analysis are all procedures that sparingly
employed in the existing literature regarding the PB. The sample employed in this thesis is
longer and more diverse than that employed in prior studies, thus giving greater power to the
statistical procedures presented in this study. Finally, this thesis attempts to consolidate the
findings of past studies to provide a definitive answer regarding the question of market
linkage.
The contribution by this thesis to the possibility of a time varying relationship arises from
several issues. Following the procedure outlined in Darrat and Zhong (2004), cointegration
tests are re-run with dummy variables included in the cointegrating vector representing events
such as September 11 and the EA crisis. This methodology has rarely been used in previous
studies and never applied in a study considering the Pacific-Basin.
The use of a recursive JJ test for cointegration is a new method proposed in this area. This
thesis expects that a more complete picture of market linkage will be the result. The
combination of testing methods provides a unique and substantial contribution to the existing
literature considering the comprehensive nature of the methods employed and analysis
conducted.
A long sample period allows the examination of several large and unanticipated shocks. Most
studies tend to focus on the impact of only one event. This study contributes in the fact that it
compares and contrasts the effects of a major shock originating from a developing market
(e.g. EA crisis) to that of a developed (e.g. September 11) market. Again, in opposition to
other studies the usage of both long and short measures to establish the time variation is a
contribution made by this thesis. Examining both is necessary as they have distinct
implications for financial markets.
The contribution of this study in relation to identifying which variables are responsible for
causing markets becoming linked is quite extensive and represents a true contribution to the
existing material. This is largely based on the lack of research conducted in this area. The
contribution made to this area is considerable. Secondly, the use of a new approach to analyse
the linking relationship adds a considerable contribution. The first contribution is the new
approach taken to analyse the relationship. This study proposes to employ a Probit and OLS
model to inspect the cross sectional relationship. The use of multiple measures to evaluate the
level of market linkage ensures the results from this thesis are robust. The set of variables
presented in this thesis are unique, thus making a significant contribution. The use of a new
methodology and set of variables ensures the contribution made by this thesis to the current
academic literature is noticeable.
1.4 Thesis structure
The structure of this thesis is as follows: Chapter 2 provides a review of the literature relevant
to long and short run linkage, time varying linkage and the factors possibly responsible for
causing market linkage. The first section of Chapter 3 provides a detailed examination of the
major events and policies that have affected markets in the PB over the last sixteen years. The
second part of the chapter expands upon the theory presented in section one and presents the
market linkage hypothesis. This is followed by a discussion on the methods and techniques
required to examine the relationship. The third section of chapter 3 covers the time variation
hypothesis, and details how this study plans to attempt to answer this question. The last
section of chapter 3 develops the model used to try to determine which factors are responsible
for driving market linkage in the PB.
Chapter 4 offers a description of the data and its stochastic properties. This section also
contains a comprehensive discussion about how several variables were computed. The last
section of chapter 4 displays the descriptive statistics for the sample employed. The empirical
findings and conclusions are examined in chapter 5. Last of all chapter 6 presents some
thoughts on the contribution of the study to the current literature, the limitations and further
areas for research and the conclusions that can be taken from this study.
CHAPTER 2LITERATURE REVIEW
CHAPTER 2: Literature Review

2.1 Literature on the use of long term measures of market linkage
The extension of Engle and Grangers work in the field of cointegration by Johansen and
Juselius (JJ) heralded the beginning of numerous pieces of literature incorporating
cointegration analysis. The majority of these papers attempted to discern whether or not
international equity markets were cointegrated with one another.
Kasa (1992) represents the most important and controversial contribution to the early
literature on cointegration. Kasa (1992) uses the procedure outlined by Johansen (1990) to
test for the presence of a common stochastic trend between the equity markets of the US,
Japan, Canada, Germany and England. Monthly and quarterly data from January 1974
through August 1990 on Morgan Stanley's Capital International indices are used to compute
Johansen (1990) tests for cointegration. The results indicate the presence of a single common
trend driving these countries' stock markets. Estimates of the factor loadings suggest that this
trend is most important in the Japanese market and least important in the Canadian market.
This result sparked great debate among academics and spawned countless papers either
verifying or disproving Kasas work.
Chan, Gup and Pan (1992) are one of the first groups of researchers to reject the findings
purported by Kasa (1992). Using daily and weekly data a period from February 1 1983 to
May 18, 1987 is sampled for the equity markets of the US, Japan, South Korea, Taiwan, Hong
Kong and Singapore. Chan et al find that prices are non-stationary but when differenced (i.e.
transformed into returns) the series become stationary, thus satisfying the first order condition
for cointegration. Pairwise and higher-order cointegration tests are performed for these
markets. No evidence of cointegration is found. Neither the stock price of a single country nor
that of a group of countries can be used to predict the future stock price of another country.
The conclusions are robust for both daily and weekly data. The conclusion reached by the
authors is no longer persuasive for a number of reasons. The first being the absence of the
Johansen-Juselius test for cointegration. Secondly, considering the period and countries
selected the result is not surprising due to the level of capital market restrictions that were in

place at the time of the study. In the time since the study, markets in the Pacific-Basin region
have significantly relaxed capital market restrictions and are highly likely to exhibit market
linkage. Lastly, it is a well-known fact that cointegrating relationships are hard to find over
such a short time horizon as in the sample used by Chan et al.
Blackman, Holden and, Thomas (1994) use monthly data on 17 different equity indices
obtained from Morgan Stanley's Capital International to conduct tests for cointegration using
Johansens (1988) procedure. Blackman et al test two different sets of markets. The first set
contains ten national stock markets2. For the period 1970-1979, there is no evidence of
cointegration, while for the period 1984-1989 two cointegrating vectors are discovered. The
second set also comprises ten markets3. Blackman et al find two cointegrating vectors for the
1970-79 period and four vectors in the 1984-89 period. While this study includes only four
markets common to this thesis it provides evidence that certain equity markets were
cointegrated as early as 1979.
Cotsomitis, Kwan and Sim (1995) use Engle-Grangers cointegration technique to examine a
series of nine equity market indices from January 1982 to February 1991. Monthly index
levels are obtained from the DX Database for nine stock markets4. Cotsomitis et al find that
when the series of markets are tested as a whole that a cointegrating relationship is present.
Furthermore, it is found that the Four Little Tigers and the US are cointegrated as a series as
is Japan, Hong Kong, South Korea and Taiwan. . Probably the most surprising result is that
when the four major G-7 countries and Four Little Tigers are tested as separate systems there
is no evidence of cointegration. Cotsomitis et al provides some useful evidence on which to
base this thesis. The usefulness of the results is limited considering only the Engle-Granger
cointegration test is employed and the study is dated.
Richards (1995) provides the some of the most compelling and robust evidence in favour
against the possibility of cointegration. Richards essentially reviews the paper by Kasa (1992)
and shows that the results obtained are misleading. Richards employs Monte Carlo simulation
2
First set of markets examined includes US, UK, Japan, Australia, Austria, Belgium, Canada, Denmark, France
and Germany.
3
The second set is comprised of the US, Hong Kong, Italy, Japan, UK, Netherlands, Norway, Spain, Sweden
and Switzerland
4
Markets examined include Hong Kong, Japan, Australia, Singapore, South Korea, Taiwan, UK, US and West
Germany
10

techniques to demonstrate that Kasas findings are the result of failing to account for the small
number of degrees of freedom that remain in the Johansen multivariate cointegration
procedure. Richards proposes methods by Cheung and Lai (1993) and Ahn and Reinsel
(1988) to correct the asymptotic critical values for the limited degrees of freedom. Using the
procedure detailed by Ahn and Reinsel, Richards finds that the critical values should be
scaled up by a factor of 8.14. Cheung and Lai maintain that Ahn and Reinsel procedure results
in an overestimated scaling factor, while Richards asserts that the Ahn and Reinsel factor is
actually understated in his analysis.
Quarterly data from Morgan Stanley's Capital International indices denominated in US
dollars is collected. Unlike most other studies Richards (1995) uses indices for total returns
(capital gains and dividends) instead of price levels. Richards (1995) sample includes
seventeen stock indices5 spanning a period from the end-December 1969 to end-December
1994. Richards tests the system as a whole and finds little evidence to support the presence of
cointegration. Based on the Engle-Granger test, Richards then conducts one hundred and
twenty pairwise cointegration tests. Six pairs are found to be cointegrated at the five percent
level and eighteen at the ten percent level. The results, which can be taken from Richards, are
that cointegration tests are biased when small samples are employed and that Kasas findings
are likely to have been overstated6. This thesis will employ the small sample correction factor
developed by Cheung and Lai (1993) to maintain the robustness of the results.
Cheung and Hung (1995) contend the result obtained from Chan et al (1992) by noting that
they denote returns in domestic currency terms and therefore ignores currency risk. Secondly,
Chan et al used pairwise cointegration tests, such limited testing disregards the possibility of a
cointegrating relationship between multiple equity markets. Cheung and Hung also note that
the use of daily data can lead to erroneous conclusions due to nonsynchronous trading and
various other phenomena. As a result, Cheung and Hung use the Johansen-Juselius (1990)
procedure on weekly data ranging from January 1981 to December 1991 to examine the
relationship between Hong Kong, South Korea, Malaysia, Singapore and Taiwan. When
denominated in domestic currencies, Cheung and Hung fail to find any cointegrating
5
Markets included are the US, UK, Japan, Australia, Austria, Belgium, Canada, Denmark, France, Germany,
Hong Kong, Italy, Netherlands, Norway, Spain, Sweden and Switzerland
6
As will be discussed in Chapter 5 the critical values for cointegration used in this thesis require no for small
sample size adjustment
11

relationship over the whole period, or the two sub periods (1981-87 and 1987-1991). When
returns are denoted in US dollar terms, Cheung and Hung find a strong cointegrating
relationship for the whole period (1981-1991) and the period 1987-1991 reporting the
presence of three cointegrating vectors. After obtaining this result, the authors suppose that
exchange rate fluctuations rather than equity price movements are driving the cointegrating
relationship. Cheung and Hung then test the five Asian currencies against the US dollar for
the presence of cointegration. The results proved Cheung and Hung hypothesis to be true
finding four cointegrating vectors for the entire period and three vectors for 1987-1991
period.
DeFusco, Geppert and Tsetsekos (1996) use weekly data obtained from the International
Finance Corporation for thirteen emerging markets. The sample ranges from January 1989 to
May 1993, with price indices given in US dollar terms. The 13 markets are then split into
three groups. The only group of interest to this thesis is the Pacific-Basin group comprised of
the US, South Korea, the Philippines, Malaysia and Thailand. DeFusco et al (1996) use the JJ
(1990) procedure to assess the possibility of cointegration between the five markets. DeFusco
et al find no evidence of cointegration but also very low levels of correlation with any average
of 0.216 among the four Asian markets. The only real caveat in the work from DeFusco et al
is the relative short time horizon of sample employed and its timing. Both these issues could
be a major reason as to why no cointegrating relationship and low correlation was discovered.
Using end of month interest rates instead of stock market indices, Phylaktis (1999) employs
bivariate and multivariate JJ (1990) cointegration tests. Phylaktis examines capital market
integration among six Pacific-Basin countries7 and the US. Significant cointegration is found
for all bivariate tests8, except between Japan and the US for the period January 1974
December 1980. The trivariate tests (i.e. PBC, US and Japan) for the February 1982September 1993 period find the presence of two cointegrating vectors for all tests except for
when Korea is included, in which case only one vector is found. The final cointegration test
completed is a multivariate test with all markets included except Korea. The author cannot
7
The six Pacific-Basin countries include; Hong Kong (January 1976September 1993), Singapore (August
1973September 1993), Malaysia (January 1982September 1993), Taiwan and Korea (February 1972
September 1993) and Japan (January 1974September 1993). The bracketed dates represents the periods for
which data could be collected.
8
Phylaktis conducts a series of bivariate cointegration tests between the US and a Pacific-Basin market and
Japan and a Pacific-Basin market.
12

reject the hypothesis that five stochastic trends are present, an alternative interpretation is that
there is one single stochastic common trend. Therefore, it can be concluded that integration is
present amongst the capital markets of the Pacific-Basin economies, Japan and the US. It is
important to note that, Phylaktis uses a correction factor for small sample bias developed by
Reimers (1992). The use of this procedure makes the results even more robust and persuasive.
Masih and Masih (2001) examine the stock market indices for nine countries9 for a period
ranging from January 1982-June 1994. They use monthly averaged stock-price indexes
obtained from International Financial Statistics published by the IMF. The authors employ
the JJ (1993) procedure to conduct a series of multivariate cointegration tests. Masih and
Masih cite Gonzalo (1994) as providing empirical evidence to highlight the relative
superiority of the JJ method when testing for the order of the cointegration rank compared to
other procedures available. Masih and Masih find the presence of a single cointegrating
vector among the markets included in the system. The authors go further to note that Cheung
and Lais (1993) correction for small sample bias does not affect their finding.
Manning (2002) examines weekly and quarterly data for the returns of ten10 equity indices
denominated in domestic and US dollar terms sourced from DataStream. When a lag length
of one week is, selected Manning (2002) detects the presence of a single cointegrating vector
and eight common trends and finds no difference in the results between the domestic and US
dollar series. When the lag length is extended to twenty-six weeks, a significantly stronger
relationship is unearthed. For both the domestic and US dollar series, seven vectors and two
common trends are evident. Manning recomputes the cointegration tests using quarterly data.
Similar results to the weekly tests with a lag of twenty-six weeks are achieved. After several
tests, the author concludes that the result is even stronger when the quarterly data is used.
Furthermore, the results are slightly altered when the tests are conducted using domestic and
US dollar series. Manning found that Japan, Hong Kong and the US were the dominant
markets in one trend11, while Malaysia and Singapore lead the other. The author notes that the
pairwise tests yield no evidence of cointegration except for two pairs12.
9
The countries include the UK, Germany, the US, Japan, Hong Kong, Taiwan, Australia, Korea and Singapore.
The sample contains the US, Hong Kong, Indonesia, Japan, Korea, Malaysia, Philippines, Singapore, Taiwan
and Thailand.
11
It must be noted that the US plays a significantly larger part in this trend.
12
The two pairs found to be cointegrated were Malaysia and Indonesia and the US and Indonesia.
10
13

Using the framework proposed by Ammer and Mei (1996), Phylaktis and Ravazzolo (2002)
decompose excess stock return innovations between different countries into news about
excess returns, dividend growth rates, interest rates and exchange rates using Campbell and
Schillers (1988) approximate present value model.
The results relevant to this study are those for the period 1990-1998 covering nine markets
(the same as those outlined in footnote 9) in the Pacific-Basin region plus the US.
Comovements between dividend growth rates is taken as an indicator of real economic
integration, while excess return movements represent the level of financial integration. The
authors find that the covariances pertaining to future dividend news were significant (at the
five percent level) in forty-one out of forty-five cases, while for excess returns they were all
found to be significant. It was found that there was significant correlation in thirty-nine out of
forty-five pairs regarding future dividend news and in thirty-eight cases for future excess
returns news13. Phylaktis and Ravazzolo found that the EA crisis reduced global economic
integration but increased regional economic and financial integration. The main result that can
be taken away from this study is the high level of financial and economic integration in the
Pacific-Basin region.
Using daily data denoted in domestic currency terms for five Asian stock price indices14
obtained from DataStream, Leong and Felmingham (2003) conduct a series of pairwise and
multivariate cointegration tests under the procedure described by Gregory and Hansen (1996).
The methodology proposed by Gregory and Hansen differs from the standard JJ test in that it
allows for structural breaks in the data. When structural breaks are not allowed Leong and
Felmingham find no evidence of bivariate cointegration at the five percent level, while at the
ten percent level ten pairs are identified. A multivariate test for cointegration on the system as
a whole provides evidence supporting the existence of a single cointegrating vector between
the five markets. When the Gregory and Hansen test is reapplied, results that are more robust
are obtained. The authors find three pairs to be significant at five percent and a further two at
ten percent.
13
It must be noted that in all cases when an insignificant relationship was discovered it was between a PacificBasin economy and the United States.
14
The five stock price indices include Japan, Singapore, Taiwan, Hong Kong and South Korea.
14

The main conclusions that can be drawn from the literature concerning long-term measures of
market linkage:
1. There is a need for a large sample period (five years or longer) to be able to accurately
discover cointegration
2. The presence of cointegration does not seem to be sensitive to what currency prices
are denominated in
3. The use of high frequency data (e.g. weekly rather than monthly) in general allows for
a cointegrating relationship to be identified more easily
4. Capital and exchange rate controls do not necessarily segment markets from the world
economy
5. The majority of the recent evidence tends to support the hypothesis of market
cointegration and linkage in the Pacific-Basin region since the early 1990s.
Furthermore, it appears that there is significant links between Japan, the US and Hong
Kong.
6. The US and Japan are independent of all other markets in the Pacific-Basin region.
7. Economic integration seems to be a major contributing factor driving financial market
linkage.
2.2 Literature on the use of short run measures

Stretching back to seminal pieces by Levy and Sarnat (1970), Grubel and Fadner (1971),
Lessard (1973) and Solnik (1974) it has been well accepted that contemporaneous correlations
between markets are relatively low. In the last decade, a myriad of papers has addressed this
issue. Traditional correlation analysis and a variety of other measures including Geweke
feedback and Granger causality tests have been employed.
Using cross correlation Forbes and Rigobon (2002) addresses the issue of contagion
following the Asian crisis. Forbes and Rigobon define contagion as a significant increase in
cross-market linkages after a shock to one or more countries. The first major point made by
Forbes and Rigobon is that during crises, markets are more volatile and consequently
correlation coefficients are upwardly biased. The authors show that once the correlation
coefficients are corrected for heteroscedasticity that any evidence of contagion post Asian
15

crisis disappears. They note that high cross-market correlations during the sample period are a
continuation of strong linkages that exists in all states of the world rather than an increase in
these linkages (contagion). This result provides considerable weight to the hypothesis
presented in this thesis that markets are linked to one another in the short run.
To measure the extent of financial market integration (defined as greater comovement on the
same day or a stronger lead/lag relationship across days) Bracker, Docking and Koch (1999)
use Geweke measures of feedback. Bracker et al compute a series measures for nine national
equity indexes15 using daily returns for a period 1972 to 1993 based on data provided by
Morgan Stanley Capital International. Bracker et al finds that the US significantly affects all
other eight markets contemporaneously for the entire sample period. Bracker et al even finds
some evidence of Australia, Hong Kong, Singapore, Germany, the UK and Canada
significantly affecting the US in a contemporaneous manner16.
Hon, Strauss and Yong (2004) examine the impact of the September 11 tragedy upon
international equity markets. Building on the work of Forbes and Rigobon (2002), Hon et al
estimate a series of cross-market correlations that have been adjusted for heteroscedasticity.
Hon et al obtain daily returns for 25 economies from the CEIC Data Company Limited
database from September 11 2000 to March 11 2002. The first step taken by Hon et al is a
series of Granger causality tests from which they find the US exerts significant causality over
eighteen economies prior September 11 and twenty-one of the twenty-four markets post
September 11.
After adjusting for heteroscedasticity twelve markets exhibit significant increases in market
comovements for the three and six months post September 11. Findings pertinent to this study
is the relatively low (less than 0.17) level of correlation between the US and Australia, Hong
Kong, Indonesia, Japan, Korea, Malaysia, New Zealand, Philippines, Singapore, Taiwan and
Thailand for the twelve months pre September 11. Post September 11, Hong Kong, Japan and
Korea become significantly correlated with the US with coefficients in excess of 0.6.
Australia, Singapore, Malaysia and Taiwan range from 0.2 0.3 while New Zealand,
15
The nine markets examined include Japan, Australia, Hong Kong, Singapore, Switzerland, Germany, the UK,
US and Canada.
16
Significant results are found for Australia in 1980 and 1991, 1985 for Hong Kong and 1980 and 1982 for
Singapore.
16

Indonesia and the Philippines all remain below 0.13. The results of Hon et al presents
evidence that the September 11 attacks caused a dramatic shift in market linkage in the short
run.
To examine the level of equity market comovements between thirteen economies17 Johnson
and Soenen (2002) obtain daily returns from Morgan Stanley Capital International from 1988
through 1998. Similar to the procedure employed by Bracker et al (1999), the authors
calculate a series Geweke measures between Japan and the twelve other markets for each of
the ten years. For Australia, China, Hong Kong, Malaysia, New Zealand and Singapore
significant (5% level) contemporaneous comovement was found for at least 82% of the years
1988 to 1998 and an average Geweke measure of 26.318. Indonesia (36%), Korea (18%), the
Philippines (55%) Taiwan (45%) and Thailand (55%) were linked with Japan less often at the
five percent level and had an average Geweke measure of 5.9. Johnson and Soenen add
weight to the notion of time varying linkage through plotting the average Geweke measures
for all twelve markets over the ten years. The authors find that the relationship peaks in 1991
and by 1993 has declined to its lowest point and by 1998 had reached the levels present in
1991.
The long run methods employed by Phylaktis (1999) have already been discussed in an earlier
section of this chapter. To establish capital market integration the author also uses two
methods to examine the short run dynamics. The impulse response analysis shows that for the
January 1974 December 1980 period both Singapore and Korea are closely integrated with
both the US and Japan, while Taiwan is only related to the US. In the second period (February
1982-September 1993), all five markets are more closely linked to Japan compared to the US.
The author conducts several multivariate Granger causality tests between the US, Japan and
each Pacific-Basin country. The US and Japan Granger cause real interest rates in Singapore,
Korea, Malaysia and Hong Kong, while only Japan exerts causality over Taiwan.
Furthermore, reverse causality is found to exist between Japan and Malaysia and Japan and
Hong Kong.
17
Australia, China, Hong Kong, India, Indonesia, Japan, Korea, Malaysia, New Zealand, the Philippines,
Singapore, Taiwan and Thailand are the thirteen markets examined
18
The higher the Geweke measure the greater the contemporaneous relationship between the two markets
17

The conclusions that can be drawn from the literature pertaining to the use of short run
measures include:
1. Correlation coefficients are biased in the presence of heteroscedasticity and therefore
need to be corrected. This situation is likely to occur when examining periods of
market distress, where volatility is higher than usual.
2. The events of September 11 resulted in an increase in correlation between the US and
the select markets in the Pacific-Basin region for up to six months after the event.
However, at the same time the results show the relatively low level of correlation
between the US and markets in the Pacific-Basin
3. The US displays considerable contemporaneous influence over Australia, Hong Kong
and Japan and to a lesser extent Singapore and Malaysia. The other less developed
markets of the Pacific-Basin seem to be only weakly linked to the US in the short run.
By contrast, Japan exhibits considerable effect over Hong Kong, Malaysia and
Singapore and greater influence over the developing markets compared to the US.
There also is more evidence to support the existence of a block between the US, Hong
Kong and Japan.
2.3 Literature regarding the time evolution of market linkage

In an effort to explain why expected returns vary across global equity markets, Bekaert and
Harvey (1995) address the issue of market integration. Asset pricing studies and models can
be divided into three broad groups. The first assumes markets are completely segmented, the
second supposes full integration and lastly that markets are somewhat segmented (and fixed at
that level forever). Using a regime-shifting model, the authors construct a measure that allows
the level of market integration to fluctuate through out time. In the study, twelve emerging
markets are examined, only the results for Korea, Malaysia, Taiwan and Thailand are relevant
to this thesis. For the sample period (1977-1992) Korea averages over a 95% chance of being
integrated, Malaysia in excess of 75%, Taiwan over 80% and from the beginning of 1986
Thailand obtains a score of 100%. Bekaert and Harvey present one of the first and most
influential pieces regarding time varying market integration. This study provides much of the
impetus towards the third hypothesis presented in this thesis and shows that the relationship is
likely to vary across time.
18

Longin and Solnik (1995) present one of the most widely cited pieces within the last ten years
on the evolution of correlation among international equity returns. Using the monthly excess
returns for seven major stock indices19over the period 1960-90, Longin and Solnik find that
correlations between markets have strengthened. The authors attempt to describe the
evolution of the conditional covariance structure through employing a multivariate GARCH
(1, 1) model with constant conditional correlation. Variance is found to have changed over
time and the hypothesis of constant conditional correlation is rejected. This allows Longin
and Solnik to conclude that over the last thirty years the correlation between international
markets has intensified. Another major finding in the paper is that correlation rises during
periods of high conditional volatility. The findings of this paper as well as the Bekaert and
Harvey study act as a cornerstone for this thesis, concerning the hypothesis of time varying
relationship between international equity markets.
Several papers examined in section 2.2 also identified a time varying relationship in the short
run. Johnson and Soenen (2002) using Geweke measures of contemporaneous feedback and
Phylaktis (1999) with impulse response functions both find evidence of a change in the
linking relationship over time. Using cross correlations Forbes and Rigobon (2002) and Hon
et al (2004) examine the months immediately preceding the events of the EA crisis and
September 11 respectively. As noted earlier Forbes and Rigobon find no evidence of
increased correlation post crisis, while Hon et al found considerable evidence to suggest that
post September 11 that the short run linkage between markets strengthened.
There exists a lack of literature that has attempted to examine the time varying relationship in
a long run setting. Silkos and Ng (2001) collect monthly stock market data for six PacificBasin countries20 and the US from the World Stock Exchange Fact Book for the period
January 1976 to August 1995. The authors conduct a number of JJ tests for cointegration over
five year rolling samples. The most pertinent results to this thesis are those from the 1988 to
1993 and 1991 to 1995 periods. With all seven countries included in the test, six cointegrating
vectors are found in period one and five in the second. Five vectors are found in period one
and four in period two when the US is excluded from the test. Similar results are found when
19
20
The seven included in the sample are the US, Germany, Switzerland, Japan, France, Canada and the UK.
The six countries examined include Hong Kong, Japan, Korea, Singapore, Taiwan and Thailand
19

the US is reinstated and Japan excluded. Finally, when both the US and Japan are excluded
from the sample four vectors are discovered in both periods.
To further study the evolution of market integration Ng and Silkos, apply the rank constancy
test developed by Qunitos (1993, 1997). The rank constancy test is conducted by testing the
hypothesis that the number of cointegrating vectors in sub-sample one is equal to the number
from the whole sample, which is also equal to the number from sub-sample two. The authors
find that in almost every case that the null hypothesis of rank constancy is rejected. In
addition, it is found that the market crash of 1987 and the Gulf War (1990) significantly
affected the long term relationships among the developing Asian markets and those of the US
and Japan.
Similar to Ng and Silkos (2001), Kolari, Sutanto and Yang (2004) conduct a number of rank
constancy tests based upon the procedure devised by Hansen and Johansen (1993, 1999). The
authors conduct a number of bivariate cointegration tests between the US and developing
markets. Pairings relevant to this study are those including Korea, Malaysia, Taiwan and
Thailand. For Korea the relationship strengthens from the early nineties to late 2000 and then
declines in early 2001, however a significant relationship is never discovered. Both Taiwan
and Thailand exhibit a similar pattern to that of Korea, except for part of 1998 when a
significant relationship is found to exist between Thailand and the US. Malaysia displays a far
more volatile relationship when compared to the other three markets. From 1990 to 1997, the
relationship strengthens slowly, in mid 1997 it rapidly declines before quickly rebounding and
displaying significance multiple times in 1998 and 1999. Similar to the other markets from
the beginning of 2000 the linkage begins to weaken. Lastly, Kolari et al conduct a constancy
test on the Asian group (includes India plus the other markets discussed above) of countries as
a whole over the seventeen year sample period. The cointegrating relationship is found to be
significant for times in 1990, 1991 and 1992 after which it begins to deteriorate until it
reaches a minimum in late 1996/early 1997. From mid 1997 to early 1998, a significant link is
present, followed by a quick decline and lack of significance for the remainder of the period
except for a brief moment in 1999.
Bracker et al (1999) tackle the issue of time variation by including a time trend variable in
their regression analysis. In four out of six cases, the trend is found to be significant at the one
20

percent level. The main conclusion that can be drawn from the literature presented in this
section is that the relationships between markets exhibit considerable variation in both the
short and long run.
2.4 Literature regarding the determinants of market linkage

The issue of what causes market linkage has not been widely addressed in the current
literature. The most commonly proposed factor is economic/good market integration.
Roll (1992) hypothesizes that the industrial structure of a countries economy significantly
affects stock price. Starting in April 1988 and finishing in March 1991 Roll, collects daily
returns for 24 countries from the FT Actuaries/Goldman Sachs International Indexes
published daily in the London Financial Times. Through a series of time series regressions
Roll establishes that industrial composition is an important factor in determining stock prices.
Roll also proposes that exchange rates play a considerable role in explaining the volatility in
stock market returns. After a series of tests, Roll discovers that industrial composition and
exchange rates combined explain almost fifty percent of the volatility in returns and
individually account for forty percent and twenty-three percent respectively21.
Phylaktis and Ravazzolo (2002) using return decomposition find significant evidence to
suggest that the economies of the Pacific-Basin region are integrated in an economic sense
between themselves and with Japan and the US. Furthermore, the authors find that variations
in news about dividends (proxy for economic integration) are the main source of stock return
variance in all of the markets included in the sample. Overwhelming evidence is found to
suggest that economic integration acts as a channel through which financial integration can
travel.
Using more traditional measures of economic integration Bracker et al (1999) finds evidence
to suggest its importance in explaining contemporaneous market linkage. Four measures are
employed in an effort to capture economic integration22. In the three regressions the measures
21
The adjusted R2 figures are unable to be added together because exchange rates are correlated with foreign
industry indices.
22
The four measures used are:
21

are included in, significance is found in eight out of twelve cases. Using similar measures to
Bracker et al, Johnson and Soenen (2002) finds that bilateral import dependence to have a
negative significant affect upon contemporaneous feedback. In addition, Johnson and Soenen
include the differential in GDP growth finding it exerts substantial influence over the level of
short run market linkage. Dekker, Sen and Young (2001) support the findings of the other
papers noting that markets with close economic ties account for a greater proportion of
forecasted error variance.
Ammer and Mei (1996), Dekker et al (2001) and Bracker et al (1999) all find evidence to
support the importance of geographical location in determining market integration. For
example Ammer and Mei find significant financial integration between Switzerland and
Germany and the US and Canada, while Dekker et al discover that markets like Australia and
New Zealand and Singapore and Malaysia exert considerable influence over one another.
Bracker et al considers the importance of geographical location through two different proxies
in their regression analysis. The first proxy uses the distance between markets and as expected
finds a significant negative relationship. For their second proxy several dummy variables are
employed (one for the Pacific Rim, Europe, UK-US and US-Canada), all coefficients are
found to be positive and significant.
There exists a substantial amount of literature documenting the effect of returns volatility
upon market linkage. Papers by Longin and Solnik (1995) and Karolyi and Stulz (1996) find
that the correlation between markets increases during periods of high volatility. Building on
these findings and using the methodology proposed by Bekaert and Harvey (1997), Ng (2000)
presents the most relevant paper to this thesis. Ng observes the effects of high volatility
periods in the US and Japan upon the correlations with markets in the Pacific-Basin region.
Weekly data is compiled for the S&P 500, Tokyo Stock Price Index, Hang Seng, Korean
Composite stock price index, Kuala Lumpur Stock Exchange, the Stock Exchange of
Singapore All Share Index, the Taiwan Stock Exchange Weighted Price Index and the Stock
Exchange of Thailand in US dollar terms for the period 1975 to the end of 1996. Ng finds that
the correlations between the US and Japan and the Pacific-Basin markets increases
1.
2.
3.
4.
exports from country i to country j as a percent of is total exports, during year t

exports from country j to country i as a percent of js total exports, during year t
imports from country i to country j as a percent of is total imports, during year t
imports from country j to country i as a percent of js total imports, during year t
22

considerably in times of high volatility. The only peculiar result was between the US and
Korea. When the volatility in the US rose, the correlation weakened and even displayed low
levels of negative correlation during the most volatile periods. Ng then employs a volatility
spillover model to fully investigate the magnitude and changing nature of spillovers
originating from the US and Japan upon the Pacific-Basin. Both world (the US) and regional
(Japan) factors are found to be important in explaining volatility in the Pacific-Basin.
The effect of exchange rates upon market linkage has been addressed in several publications.
Silkos and Ng (2001) find that exchange rate volatility has a significant influence over the
number of cointegrating vectors found. As discussed above Roll (1992) found that exchange
rates accounted for twenty-three percent of variation in stock return volatility. By contrast
Bracker et al (1999) find that neither exchange rate volatility nor the percentage change
significantly explain contemporaneous market movements. Johnson and Soenen (2002) who
find that neither variable (exchange rate volatility or the percentage change) influences the
intensity of market linkage reinforce these results.
Market development in relation to stock market linkage is a variable that has been discussed
in a number of studies in the current literature. Many papers have used market development to
proxy for market integration. That is, poorly developed markets23 are not likely to be linked
with other markets. However, Bekaert (1995) and Bekaert and Harvey (1995), find that many
developing markets are not segmented from the world. Therefore, this raises the question as to
how the level of development affects the level of market linkage. Bracker et al (1999) use the
absolute size differential between two markets to proxy for market development. Holding
everything else constant, a larger differential indicates the greater the likelihood that the
markets are not linked with one another. In all six regressions conducted, the variable as
expected is found to be negative and significant at the five percent level. Again, Johnson and
Soenen (2002) utilize a similar metric in their analysis and find it to be both economically and
statistically insignificant.
Hon et al (2004) find evidence to support the hypothesis that better developed and more
liquid markets have closer links to the US post September 11. They find that for the quarter
23
Development in this sense refers to a poorly developed legal system, investment barriers and markets that are
not deep and liquid.
23

post September 11, the US on average explained seventeen percent of the variation in returns
in the European markets as opposed to three percent prior to the crisis. Furthermore, it is
discovered that Malaysia, Indonesia, the Philippines and Thailand are not closely linked to the
US.
Karolyi and Stulz (1996) attempt to explain market comovements by investigating return
comovements between Japan and the US. Intraday and overnight return correlations between
a portfolio of Japanese ADRs and US stock portfolio are computed for various sub samples
related to different information variables24. Fisher Z tests are then employed to determine if
there has been a significant change in correlation. The authors find that the higher the absolute
overnight and daytime return of the S&P 500 and Nikkei the higher the level of correlation
between the two portfolios. Connolly and Wang (2003) report similar results.
Connolly and Wang (2003) use linear and non-linear news models to examine the causes of
equity comovements between the US, the UK and Japan. The authors find that
macroeconomic news announcements do not economically or statistically affect intraday or
overnight comovements in a significant manner. By contrast, the previous day return from
foreign markets exerts significant influence on the subsequent day return in the domestic
market. That is, the prior day returns appear to contain unique information not captured in
economic fundamentals.
The effect of interest rates upon international capital flows has been well documented in both
the finance and economic literature. Three papers that have been discussed above examine the
effects of interest rates on market linkage. Bracker et al (1999) and Johnson and Soenen
(2002) include the absolute difference between real interest rates of the markets included in
their sample. A negative relationship is expected as the larger the difference then the greater
the deviation away from interest rate parity. As expected Johnson and Soenen find a negative
relationship that is statistically and economically significant. The evidence from Bracker et al
is a little more muddied. In five out of six regressions, the variable is found not to be
significant and displays little economic significance in any of them.
24
Examples include the Yen/Dollar exchange rate, the US Treasury bill futures or the Nikkei and S&P 500 index
returns.
24

Forbes and Rigobon (2002) extract conditional correlations from a VAR with lagged returns
and interest rates as the explanatory variables. The authors rationalise the inclusion of interest
rates by stating that they control for any aggregate shocks and monetary policy coordination.
The results are found to be insensitive to whether or not interest rates are controlled.
There are several major conclusions that be drawn from the literature reviewed in this section:
1. Economic integration appears to be an important factor when considering market
linkage. A number of variables can be used to proxy for economic integration
ranging from import/export independence, industrial production statistics and future
excess returns.
2. Geographical location appears to influence the level of market comovements. That
is, markets that are closer to one another are more likely to move in the same
direction.
3. Periods of high volatility appear to be linked to periods of high correlation.
Furthermore, volatility spillovers from the US and Japan significantly affects the
volatility processes of markets in the Pacific-Basin.
4. There is mixed evidence with regard to the influence of exchange rates over market
linkage. It is interesting to note that the two papers in which exchange rates do not
explain comovements are those that employ short run measures. By contrast, the
strongest evidence to support the effect of exchange rates is when a long run
measure is used.
5. The level of market development is an important factor in explaining market
linkage. However, there appears to be conjecture as to what is an appropriate proxy
to accurately capture the relationship.
6. The empirical evidence regarding the effect of interest rates on market linkage odes
not provide convincing evidence regarding the true relationship.
25
CHAPTER 3HYPOTHESIS AND THEROY DEVELOPMENT
Chapter 3: Hypothesis and Theory Development

3.1 Introduction
The focus of this chapter is threefold; the first section provides a brief history of the
economies and stock markets of the Pacific-Basin countries. The second section building on
the facts presented in section one presents why Pacific-Basin markets are likely to display
strong linkage with one another and why it is probable that the relationship has varied over
time. The third section develops the theory behind the factors proposed that are responsible
for driving market comovements.
3.2 Description of the Pacific-Basin Economies

During the last several decades, the Pacific-Basin region was one of the most dynamic regions
in the world. Starting in the 1960s and 70s new economic policies, cultural and social
change and a shift in political regimes saw the region blossom. Discussed in the section below
is the background of the financial markets and economic performance of Hong Kong,
Indonesia, Korea, Malaysia, the Philippines, Singapore, Taiwan and Thailand. Bekaert and
Harvey (1998), the Economist, the CIA World Fact book 2003 and the IMF deserve special
mention for the information presented below, while Silkos and Ng (2001) provided some
further insights.
A. Hong Kong
Hong Kong is a market that has enjoyed a far greater level of economic and financial market
development compared to some of its Asian counterparts due to its close links to the Western
economies. In the wake of the 1973-74 crash, the Office of the Commissioner for the
Securities was established. During the 1980s the economy of Hong Kong flourished with an
average GDP growth rate of 6.83%. The level of international activity in the Hong Kong
market mirrored that of the growth in the economy.
In May 1989, a new body formed in light of the crash of 1987. The Securities and Futures
commission consisted of full-time professional regulators whom had wider reaching powers
to investigate and enforce breaches. The EA crisis did not adversely affect Hong Kong until
the middle of October 1997. The government intervened in August 1998, to fend off
26

manipulators in the currency, futures and stock markets. However, throughout this time the
government was still able to maintain a strong banking and financial sector. Post crisis, Hong
Kong quickly rebounded before taking another hit in 2001 and once again currently. Since
2001, the economy has displayed strong growth. The lack of restrictions pertaining to foreign
ownership, strong regulatory presence, prudent economic policy and the level openness in the
Hong Kong economy provides sufficient evidence to support the hypothesis that it would
exhibit significant links with other financial markets.
B. Indonesia
During the thirty years of president Suharto GDP per capita grew from 70 USD to 1000 in
1996, inflation ranged between 5-10% and the rupiah was generally relatively stable. Several
policies introduced in the 1980s served to attract foreign investment into the financial and
external sectors. With the relaxation of regulations, investors from the US, Japan, Korea,
Hong Kong and Taiwan all contributed significant amounts of capital to the Indonesian
economy. The Indonesian stock market was officially liberalised in September 1989 and the
First country Fund was launched in February of the same year. Foreigners were able to own
up to 49% of all company listing shares on the domestic exchange25. In 1992, more changes
took place, making Indonesia even more receptive to foreign investment. These changes
included the launching of the first American Depository Receipt (ADR herein), the allowance
of foreign investors to own 49% of banks, and the creation of a foreign board for trading
stocks by foreign investors.
The road towards integration continued throughout the mid-1990s with the reduction of
import tariffs, increases in foreign investment approvals, the listing of an Indonesian firm on
the NYSE and most importantly growing investor confidence in the Indonesian economy.
However, the rapid development in the Indonesian economy did not match improvements in
the practices and regulations of the banking sector or legal framework. When the Thai Baht
suffered a sharp decline in July of 1997, the rupiah lost close to 7% against the USD. The
following month the rupiah depreciated by a massive 39.8%. The Indonesian government
desperately tried to stabilize the economy, but failed to do so as foreign capital flew out of the
25
This was excluding financial firms which was capped at 25%
27

country with great velocity. Real GDP growth declined by 13.7% in 1998 and late 1999 the
economy begun its recovery.
During this time the IMF employed a number of reforms aimed at stabilizing the macro
economy and the rupiah, and improving the banking and legal frameworks. Since 2000,
economic growth has hovered around 4%, interest rates have dropped and the rupiah
stabilized. Foreign investment has improved but never returned to the levels prior to 1997.
Political turmoil has continued to stifle attempts to fully complete required reforms. However,
considerable progress has resulted in a substantial improvement in investor confidence. The
US and Japan continue to be the largest trading partners and sources of capital to Indonesia,
while Hong Kong, Korea and Singapore also remain key parties. Recently, China has
emerged as an important player by contributing sizeable amounts of foreign direct investment
to Indonesia.
C. South Korea
Described by the World Bank as one of the most outstanding success stories of international
development (Harrison, 1991, p. 141), the South Korean economy has developed immensely
over the last 30 years to currently become the 11th largest economy in the world. In 1977, The
Securities and Exchange Commission and Securities Supervisory Board came into existence.
The Korea Fund launched on the NYSE in 1984, followed by the abolition of exchange rate
controls in 1989 and the first ADR being announced in late 1990. The announcement of major
reforms to the South Korean stock exchange took place in early 1991. The reforms made
foreign participation easier and removed barriers concerning the repatriation of capital. When
the stock market opened to foreign investors in January 1992, a 10% ownership limit was
enforced and over 500 investors registered with the Securities Supervisory Board. Foreign
ownership continued to grow and by the end of 1993, it accounted for 9.8% of market
capitalisation. In addition, most firms had reached their 10% threshold. By May 1997, the
foreign investors could hold up to 23% of South Korean companies.
As the EA crisis swept across from Indonesia and Thailand, the South Korean economy took
a sizeable hit. In November 1997 the Seoul stock exchange depreciated by more than 20%.
From 1998 to 2002, the Korean economy averaged real GDP growth of 4.2% thanks in part to
assistance from the IMF. The most encouraging signal from the Korean government has been
28

the extensive banking reform that took place in the post crisis period. Ailing banks were
recapitalised and a number of mergers occurred eliminating the weaker institutions.
Furthermore, the index derivatives market has evolved to become the second most liquid
behind that of the US. South Korea maintains strong trade ties with the US, Japan, China,
Hong Kong, Taiwan and Australia. South Korea is likely to pursue further reductions
regarding foreign ownership in the near future. Therefore, greater integration with the world
capital and financial markets is expected.
D. Malaysia
Similar to South Korea, Malaysia has proven to be a marvel of modern economic planning,
going from a one dimensional commodity producer to a developing multi-sector industrial
economy. In 1970, foreign investment accounted for around 55% of the Malaysian economy.
The following year a new reform program aimed to reduce the level of ownership to 30% by
1990. During the early 1980s the fixed exchange rate was abandoned and other controls
regrading foreign exchange loosened. The Malaysia Fund began trading on the NYSE in the
December of 1987 and followed by the first ADR in August 1992.
The creation of the Kuala Lumpur Options and Financial Futures Exchange, changes in listing
requirements (in an effort to improve transparency and regulation) and the issuance of
guidelines pertaining to the lending and borrowing of securities, during 1995, all helped
strengthen Malaysian financial markets. From the period 1992-1996, the market capitalisation
of the KLSE tripled, to represent 325% of GDP. Until the onset of the EA crisis in mid-late
1997, the Malaysian economy had averaged real GDP growth of around 8% for the last
decade and its financial markets had been relatively open and advanced compared to its peers.
With the onset of the EA crisis, market confidence plummeted and large portfolio flows took
place. In addition, foreign exchange speculators exerted considerable pressure on the ringgit
leading to subsequent devaluations of the ringgit. Late in 1997, the KLSE dropped 856 points
in a single days trading, reaching its lowest point since 1993. Initially the Malaysian
government raised interest rates and tightened fiscal policy. These policies proved to be
ineffectual and during 1998, the KLSE and economic growth continued on a downward
spiral. The lack of stabilisation prompted further action by the Malaysian government. In
September 1998 several policies were introduced, these included; the ringgit becoming
29

pegged to the USD coupled with other exchange rate and capital restrictions and a fiscal
stimulus package to increase the level of capital expenditure. The initiatives were successful
and interest rates could be reduced, and reforms in the financial and corporate sectors
implemented26. 1999-2000 saw the Malaysian economy and stock market quickly rebound as
investor confidence recovered in the face of reductions in capital restrictions, strong economic
growth and decreased vulnerability of the financial sector.
The major problem facing Malaysia in the post crisis period has been the inability to regain
the lost foreign direct investment. FDI equalled 43.1% of nominal GDP in 1997, while in
2002 it laid around 23%. Recently the Malaysian government signed a new bilateral trade and
investment agreement with the US in an effort to reignite once strong bonds. The cumulative
effect of reforms over the last six years has made Malaysia more open to foreign investment
and has actively promoted foreign participation. Japan, Singapore, China, Taiwan, Thailand
and Hong Kong retain close economic and trade ties with Malaysia.
E. The Philippines
The Philippines economy is largely based on agricultural and some natural resource
production. Unlike many of its Asian neighbours, the Philippines did not enjoy high single
digit growth rates in the 1980s. This was largely due to poor economic policy in the late
1970s and early 80s. To rectify the problem a number of reforms took place in the late 80s
and early 90s to improve the economic situation. One of these policies allowed for 100%
foreign ownership in certain businesses. For most of the early 90s low growth was achieved,
however for the four years 1994 to1997 growth averaged 5%.
During the late 1980s and early 90s several events occurred making the Philippine economy
and stock exchange readily accessible to foreign investment. These reforms included the
lifting of import restrictions, the launch of the first large scale Country Fund, and the
announcement of the first ADR. More importantly, restrictions pertaining to capital and
dividend repatriation were removed and foreign investors only had to register with the
Securities and Exchange Commission to be eligible to own 100% in most sectors of the
economy.
26
The reforms included a bank consolidation program and improvements in prudential regulation to bring it
inline with best practice and procedure.
30

When the Asian Flu reached, the Philippines its impact was relatively mild compared to that
of its neighbours. In mid-late 1997, interest rates were increased in order to defend the peso
from being devaluated. When the Thai Baht was floated, the pressure became unbearable and
the peso followed suit on July 11. Fiscal, monetary and structural reforms accompanied the
float in an effort to stabilise the economy. Moving into the 1998 the effects of the EA crisis
coupled with poor weather conditions saw the Philippines economy contract by 0.5% and the
stock exchange drop to below 120027. By 1999 the Philippines was back on track on the back
of strong import demand from the US and the policies of 1997 bearing fruit. Subsequently,
the economy grew by 3.4%, the peso appreciated, the stock market stabilised, and prices rose
twofold.
Since the EA crisis, the deficiencies in the Filipino economy have been bought to light. A
number of inherent weaknesses plague the public sector, resulting in the failure to collect
considerable quantities of tax revenue. The level of domestic savings and investment remain
critically low and the legal system requires extensive reform. Despite this, the economy has
grown at around 4% for the last four years, and several reforms are in place to address the
issues mentioned above. There still exist only few restrictions on foreign investment into the
Philippines either directly or through the stock exchange. This makes it incredibly easy for
international investors to participate in the market. The US and Japan continue to be dominant
trading partners, while Taiwan and Singapore also contribute significantly.
F. Singapore
The growth and development of the Singaporean economy has been unrivalled over the last
40 years. After gaining independence in 1965 the government actively pursued a probusiness, pro-foreign investment, export orientated economy with government control of
select industries. The results of the policy were a resounding success, with average real GDP
growth of 8% from 1960 to 1999. The development of the banking and financial sectors has
been focal point of government policy since the 1970s.
27
This was a considerable decline considering in January 1997 that it had been around the 3400 level.
31

The EA crisis of 1997/98 was largely ignored by the economy of Singapore. During 1998, the
reduced level of trade and loss in investor confidence saw GDP drop sharply from 8% in 1997
to 1.5% in 1998. The stock market also contracted but it was only mild compared to the other
Asian economies. By mid 1999 any fears of a long-term economic slowdown had been
alleviated by strong demand in the US28 and in 2000 GDP growth of close to 10% was
observed.
To further the development of the financial sector the Stock Exchange of Singapore (SES)
and Singapore International Monetary Exchange (SIMEX) were demutualised and merged in
1999 to form the Singapore Exchange (SGX). Additional policies were implemented to
improve the transparency and disclosure of companies and promote the investment fund
industry and bond market. The Singapore market has been made even more accessible to
international investors through alliances and cooperation with the American, Australian and
Indian stock exchanges.
During 2001, Singapore was adversely affected as the slowing of the US and Japan and the
continuation of the global slump in the electronics market. Consequently, the economy
contracted by 2.37%. The resiliency and strong structure of the Singapore economy ensured
the downturn was short lived and as expected growth was observed in 2002. The economy
has continued to expand and high industrial production so far this year indicates the
likelihood of high single digit growth. Currently Singapore is one of the most open markets in
the world, with over some 3000 multinational corporations operating within its borders.
Significant levels of FDI continue to flow in from the Western economies, while over the last
five years Singaporean companies have made sizeable investments into China, Malaysia,
Hong Kong and Indonesia. From a trade perspective the US and Malaysia continue to be its
main partners, while Japan, Taiwan and Thailand also warrant mention.
G. Taiwan
The economy of Taiwan has performed in line with that of South Korea and Singapore over
the last thirty years. Aggressively pursuing a policy of trade and openness the Taiwan
economy was transformed from a labour intensive agricultural producer to a sophisticated
28
Singapores total level of trade rose by 21% between 1999 and 2000.
32

manufacturer of high-tech items. During the 1980s wide sweeping reforms saw a
considerable reduction in the level of tariffs, the removal of foreign exchange controls, the
launch of the Taipei fund on the London Stock Exchange (LSE herein) and the ability for
foreign stockbrokers to open offices in Taiwan.
The theme of reform continued into the early 1990s. Textile and agricultural production
shifted to mainland China as diplomatic relations between the two countries improved and
was replaced by a expanding manufacturing industry, the first ADRs were announced and
new legislation made it possible for foreign investors to invest directly in Taiwan securities29.
Taiwanese capital also began to flow into South-East Asia and mainland China. In 1996, the
Taiwan stock exchange (TSE henceforth) further relaxed restrictions and allowed individual
investors into the market, with holdings limited to 50 million USD. The EA crisis of 1997/98
only slightly slowed the economy of Taiwan. Its close links to the US and Japan coupled with
a well developed stock market and banking sector allowed Taiwan to avoid the troubles
suffered by the other Asian economies and in contrast real GDP growth of 4.5% was
obtained.
Taiwan continued to display robust performance throughout 1999 and 2000 with growth rates
of 5.42% and 5.86% respectively. The global slowdown in 2001 and the decline in demand
for technological goods saw the economy contract by 2.18%. This was the first period a
negative growth since records had been kept. Even in the face of reduced consumer
confidence and the downturn in the US, growth returned in 2002. During the last five years,
Taiwan has shifted its focus away from the US and to its peers in Asia. As a result, more and
more capital has flowed into the region from Taiwan, with the bulk of it going to mainland
China. The TSE has recently eradicated the investment quota placed on foreign institutional
investors and made foreign participation simpler by only requiring investors to register with
the exchange. The US and Japan still remain the major trading partners with Taiwan, while
Hong Kong, South Korea, China and the EU are of growing importance.
H. Thailand
29
Participants had to have SEC approval as a Qualified Foreign Institutional Investor. Furthermore, repatriation
was not allowed within the first three months, while ownership was limited to 5% of listed companies, with total
foreign investment not able to exceed 10% of anyone company.
33

Thailand like most of its neighbours has enjoyed significant growth during the last thirty
years because of trade and willingness to accept foreign investment. From 1985 to 1995,
economic growth averaged over 9% and was the highest throughout the world for this period.
The Securities Exchange of Thailand commenced trading in April 1975 as a not for profit
organisation, that was controlled by the Ministry of Finance (Park, 1993). During the 1980s
several reforms made the Thai economy and stock market more open to foreign investment.
These policies included the decision to abandon the fixed exchange rate against the USD
(instead a pegged regime was instigated), the launch of the Bangkok Fund on the LSE and the
creation of the Alien Board on the stock exchange30.
The production of high-tech components31 was a strategy pursued in earnest by the Thai
government in the early and mid 90s. The strategy was a success as the Thai economy
continued to experience record growth. The stock exchange continued to be reformed with the
removal of restrictions pertaining to companies paying dividends to foreigners and the
lessening of controls and reporting requirements in relation to the repatriation of dividends,
capital gains, foreign currency and share certificates. However, like its Asian counterparts the
rapid expansion masked deep underlying weaknesses in regulation and best practice. As the
US dollar begun to appreciate in the middle of 1996, Thai exports lost competitiveness in the
global market. An overvalued Baht also led to excessive external borrowing and considerable
exposure to foreign exchange risk in the corporate and financial sectors. The increased
borrowing and declining exports caused the Current Account Deficit (CAD) to widen. The
combined result of this situation saw massive speculative attacks launched against the Baht in
the May of 1997. In the face of mounting pressure, the government was forced to float the
Baht in July 1997. The Baht continued on a downward spiral through the remainder of 1997
and hit rock bottom in 1998, while the stock market depreciated by 75% in 1997.
Consequently, the economy contracted by 1.4% in 1997 and a massive 10.5% in 1998,
leading to the IMF launching a bail out package in excess of 19 billion US dollars.
The Thai government also reacted by restructuring distressed financial institutions, tightening
fiscal policy to improve the CAD, encouraging private sector involvement in the economy
30
The Alien Board allows foreign investors to trade stocks on those companies that have reached their foreign
investment limits.
31
These included computer accessories and motor vehicle parts
34

and employing new reforms to attract foreign investment. By September 1999, the policies
outlined above had been successful in reducing interest rates to pre-crisis levels, the Baht had
been stabilised and growth in the order of 4% was returned. Furthermore, significant and
meaningful policy reform in areas pertaining to bankruptcy, foreclosure procedures and
foreign investment restrictions strengthened the institutional framework.
Since 1999, the Thai economy has experienced a period of steady growth. In 2001, the
economy slowed as international export demand declined and the US economy begun to
contract. During 2002, the economy recovered and still experiences steady growth.
Consequently, the Thai stock market has appreciated considerably in the post crisis period
and is readily accessible to foreign investment. Like most of the Pacific-Basin, the US and
Japan are Thailands major trading partners, while Malaysia and Singapore are also worthy of
mention.
I. Australia, Japan, New Zealand and the US
Figure 3.1 Log Stock Indexes of Australia, New Zealand and the US
8
Log Stock Indexes
5/01/88 13/06/89 20/11/90 28/04/92 5/10/93 14/03/95 20/08/96 27/01/98 6/07/99 12/12/00 21/05/02 28/10/03
date
AUSP
NZSP
USSP
Asian Crisis
Sep-11
All four are open markets in which trade and investment is encouraged. Japan and the US
represent the two largest economies in the region with both importing and exporting large
quantities of goods in the Pacific-Basin. They are also the main source of FDI and provide
35

substantial amounts of aid. In the last decade, the influence of Australia in the Pacific-Basin
has expanded. Australia plays an important role in promoting trade, investment, economic
cooperation and political stability. There are few foreign ownership restrictions, welldeveloped legal and prudential regulatory bodies, strong banking sectors, floating exchange
rates, political stability, low levels of corruption and wastage and advanced stock exchanges
in all four economies.
Figure 3.2 - Log Stock Indexes of Hong Kong, Japan, Korea and
Taiwan
10.5
log of stock index
9.5
8.5
7.5
6.5
5.5
5/01/88 13/06/89 20/11/90 28/04/92 5/10/93 14/03/95 20/08/96 27/01/98 6/07/99 12/12/00 21/05/02 28/10/03
date
HKSP
JPSP
KOSP
TASP
Asian Crisis
Sep-11
For the majority of the 1990s and early this decade Australia, New Zealand and the US all
enjoyed steady and stable growth. This saw a considerable appreciation in the stock markets
of all countries. The EA crisis provided little concern for the three markets discussed above.
While there was a downturn in the economies and stock markets, it was only slight and
quickly passed through. The economic slowdown and events of September 11 saw markets
decline by a noticeable amount. However, recent robust growth has seen markets approach
previous record levels.
The Japanese economy did not fair so well and suffered a prolonged period of low growth in
the 1990s averaging only 1.7%. The Japanese stock market peaked early in 1990 and has
contracted since. Substantial reforms put into place, have yet to bear fruit. Over the last year,
36

the Japanese market has experienced a minor resurgence and appears to have freed itself from
the static that has restricted growth for the over the last decade.
3.3 Linkage hypothesis

Building on the previous section there is a significant amount of evidence to support the
proposition of market linkage. Figures 3.1-3.332 help support the notion of linkage.
Figure 3.3 Log Stock Indexes of Indonesia, Malaysia, Singapore and
Thailand
9
Log Stock Indexes
5/01/88 13/06/89 20/11/90 28/04/92 5/10/93 14/03/95 20/08/96 27/01/98 6/07/99 12/12/00 21/05/02 28/10/03
date
IDSP
MYSP
PPSP
SGSP
THSP
Asian Crisis
Sep-11
From the plots it is obvious that over the last sixteen years that there appears to be some
common influence among the markets of the Pacific-Basin. From Figure 3.1 it obvious that
Australia, New Zealand and the US have shared an upward sloping trend over the last sixteen
years33. Furthermore, around nine months after the East Asian crisis all three markets display
a noteworthy depreciation. Lastly, since mid-2003 Australia and New Zealand have closely
traced the US in light of the global recovery.
There are several interesting points from Figure 3.2. Prior to the East Asian crisis, Hong Kong
and Taiwan had been on an upward trend while, Japan and Korea were much more stagnant.
32
The two vertical lines in Figure 3.1, 3.2 and 3.3 represent the beginning of the East Asian Crisis ( 21/10/1997)
and September 11 2001 respectively.
33
It will be discussed in the following chapter, but the stock indexes used for Australia and New Zealand are not
their national indexes. Indexes constructed by DataStream were employed in place of unavailable data. .
37

In the six to nine months post the EA crisis, all four markets display a certain level of
comovement between each other. It appears that Hong Kong led the recovery followed by
Korea. Japan and Taiwan experienced only a minor adjustment due to the lack of impact the
crisis had upon them. In the post September 11 period, there appears to be considerable
covariance between the four markets.
Figure 3.3 represents the Southeast Asian block. Up until late 1996, Indonesia, Malaysia, the
Philippines and Thailand exhibit noticeable comovement between one another while sharing
an upward sloping relationship. During this period similar to Korea and Japan, Singapore is
static. Following the East Asian crisis and right up to September 11 all five markets display
substantial comovements. This trend continues after the events of September 11, as the series
of markets appear to be sharing a common long run path.
Previous empirical evidence based with the facts presented above leads to the possibility that
market linkage exists. However, the question of importance is, whether or not the relationship
is a spurious coincidence or there is an actual statistically and economically significant
relationship binding these markets to each other. To this end, the following hypotheses are
presented:
H1 : The equity markets of the Pacific - Basin are linked to one another in the long run
H 2 : The equity markets of the Pacific - Basin are linked to one another over a short - run time horizon
3.3.1 Cointegration Analysis

To examine the possibility of market linkage over a long run time horizon, the use of
cointegration analysis is the most appropriate methodology. The use of cointegration to proxy
for a long run relationship is extensively used through out the current literature. Therefore, no
questions as to the credibility of the results are raised. The concept underlying cointegration is
that there is a long equilibrium relationship between a series of variables. Significant
cointegration indicates that markets will display considerable linkage over a long run time
horizon. The first condition required for cointegration to exist between a system of variables
is that they are integrated of the same order. The methodology used to establish that the stock
price indexes are of the same order is outlined in Chapter 4.2.
38

Once it has been established that the respective markets are integrated of the same order, the
test for cointegration can be completed. Engle-Granger (EG henceforth) (1987) developed the
original test for cointegration. The usefulness of EG's procedure is severely limited by the fact
that it could only determine cointegration but not the number of cointegrating vectors.
Secondly the EG method employs a two stage estimation process, therefore any error made in
step one is carried over into the second stage. Lastly, the EG methodology cannot be used to
test for cointegration in a multivariate setting. Johansen (1988) developed a new procedure
based upon maximum likelihood estimation that can discern the number of cointegrating
vectors between multiple variables. Developments by Johansen and Juselius (1990, 1992),
Johansen (1991, 1992 and 1995), and Hansen and Johansen (1993, 1999) have made the
procedure even more robust.
Enders (1995) provides the procedure used to conduct a JJ test. The first step in completing a
JJ test for cointegration is to determine an appropriate lag length. An undifferenced VAR
should be estimated and then a Sims log likelihood test conducted to determine the optimal
lag length. Alternatively the AIC or SBC can be used to determine lag length. This step is
important, as the results can be sensitive to lag length. In order to ensure the robustness of the
results a number of different lag lengths are employed and the test re-conducted.
The next step is to estimate the model and determine the rank of the coefficient matrix.
Consider a VAR of order p:
xt = A0 + Ai xt i + t
(1)
i =1
where xt is a n 1 vector of nonstationary I (1) dependent variables, A0 is a n 1 vector of

intercepts, Ai is a n n coefficient matrix and t a n 1 vector of disturbance terms.
Equation (3) can be written in its Vector Error Correction (VEC herein) representation:
p 1
xt = A0 + xt 1 + i xt 1 + t
(2)
i =1
where
39

p
= Ai I ,
i = A j
i =1
(3)
j = i +1
Grangers original theory proposed that if the coefficient matrix has a reduced rank, such
that r < n then there is r n matrices and each with rank r. Furthermore, = and
xt is I (0) where each column of the matrix is an error correction term and the speed
of adjustment. Johansens technique allows the matrix to be estimated from an unrestricted
VAR. If the rank equals 0 then a VAR in the differences is the correct specification. When the
rank equals n (number of equations contained in the VAR) then the VAR is stationary and no
correction is required. A rank equal to 1 indicates a single cointegrating vector, when the 1 <
rank < n there are multiple cointegrating vectors. Assuming 0 < rank < n, a test for the
number of cointegrating vectors is required. To conduct the test two test statistics are
computed:
trace (r ) = T ln(1 i )
(4)
max (r , r + 1) = T ln(1 r +1 )
(5)
i = r +1
where i is the estimated values of the characteristic roots (referred to as eigenvalues)

obtained from the estimated coefficient matrix, T is the number of usable observations, and r
is the number of cointegrating investors contained in the null hypothesis. The trace statistic
tests that there is r or less cointegrating vectors against a general alternative
(e.g. H 0 : r 1, H A : r > 1 ). The max statistic tests that there is r cointegrating vectors against
the alternative of r + 1 cointegrating vectors (e.g. H 0 : r = 1, H A : r = 2 ). The test statistics are
compared against the critical values developed by Osterwald-Lenum (1992). The small
sample correction factor discussed in chapter 2 is not necessary when using the OsterwaldLenum critical values. Monte Carlo analysis conducted by Cheung and Lai (1993) found
evidence to support the claim that the trace statistic is more robust compared to the max
statistic and will only be used to establish significance. To ensure the results presented in this
thesis are of the highest quality, the small sample correction factor proposed by Cheung and
40
Lai will be applied to all test statistics generated. The correction factor adjusts the tests
statistics using the following computation:
T np
Adjusted trace = unadjusted trace
(6)
where T is the total number of observations, n is the number of equations in the VAR and p is
the lag length. As discussed above the first step in conducting any test for cointegration is to
select an appropriate lag length using selection criteria. The lags must also be long enough to
remove any traces of serial correlation in the residuals of the VAR. All the cointegration tests
have been completed with differing lag structures in order to maintain the robustness of the
results. The first series of tests completed are bivariate tests between the sixty-six unique pairs
of markets34 based on the full sample period (5/01/1988 to 7/09/2004).
The second set of cointegration tests are weekly recursive bivariate tests based on a 416-week
moving window. For week 0, all sixty-six tests of cointegration are completed based on data
from week -415 to week 0. The window then moves one week and the tests are re-computed
based on the data from week -414 to week 1. The procedure repeats until it reaches week 454.
3.3.2 Persistent Profile Analysis
Persistent profile analysis is a methodology developed by Pesaran and Shin (1996) that can be
used to examine the speed of convergence in response to a system-wide shock in the price
cointegrating relation. Darrat and Zhong (2004) note that the estimated profiles are unique
and do not require the prior orthogonalisation of shocks. As the time horizon increases, the
profile will approach zero as the effect of a shock on the cointegrating vectors is transitory by
nature and dissipates as the system returns back to equilibrium. The procedure used by Darrat
and Zhong and designed by Pesaran and Shin is outlined below. The first step is to estimate
the VECM as seen in equation (2):
p 1
xt = A0 + xt 1 + i xt 1 + t
(7)
i =1
where xt is a 12 1 vector of stock price indices, xt is a 12 1 vector of continuously

compounded returns, A0 is a 12 1 vector of intercepts, and are 12 12 coefficient
34
There is only sixty-six unique pairs, because the test for cointegration between the US and Korea is the same
as the test between Korea and the US.
41
matrices and is the 12 r long run coefficient matrix. Equation (2) is estimated using the JJ
method to derive an approximation of the coefficient matrix and the covariance matrix of
the residuals, .
The Beveridge and Nelson (1981) procedure is used to decompose the price vector xt , such
that:
xt = t + t
(8)
where
l =0
l =0
j =0
t = C l t l , and C l = Al + Bl , and Bl = A j
t = + t 1 + A0 t + A1 t 1
(9)
(10)
The price cointegrating relation can be written as:
xt = t = 0 + ( )t + Bl t 1
(11)
l =0
With r cointegrating vectors, the unscaled ( i, j ) elements of the persistence profile matrix t
are given by:
H ij = iBn Bn j , where i j , and for i, j = 1,2,....., r n = 0,1,2,....
(12)
where i , j and are obtained from (8), and Bn is the cumulative effect matrix defined
in (10) and is computed from the following recursive relation:
Bn = 1 Bn1 + 2 Bn 2 + ... + p Bn p , n = 1, 2 and p is the order of the VAR
(13)
where B0 = I 1212 , Bn = 0 for n 0 and the i ' s come from the matrices and such that:
= I1212 1 2 ... p
(14)
Therefore, the scaled measure of the persistent profile matrix of t is obtained as the elements
of:
hZ (n) = GH Z (n)G = {hij (n)}, where G = diag{H11 (0) 1/ 2 , H 22 (0) 1/ 2 , H rr (0) 1/ 2 }
(15)
Following a unit composite shock to the cointegrating vectors in a stationary system,

convergence to zero will occur.
.
Using a variety of measures, the short run linkage hypothesis is studied. The most obvious
choice would be to measure the level of correlation between the returns in the twelve markets.
42
However, as discussed in Chapter 2 the presence of heteroscedasticity causes correlation

coefficients to become upwardly biased. The present solution to this problem is not
acceptable, requiring the imposition of a number of assumptions by the user. This thesis
proposes three alternative measures of short run linkage in place of using correlation analysis.
3.3.3 Generalised Variance Decomposition
Generalised forecast error variance decomposition (GVD henceforth) developed by Pesaran

and Shin (1998) is used to further examine the behaviour of market linkage. When markets
are not linked, a shock in one market will not be transmitted to others. Conversely, as the
level of market linkage intensifies, return innovations in one market explained by their
domestic variation should decline, while shocks from other markets assume greater
importance. The traditional method to conduct forecast error variance decomposition is the
Choleski procedure. The major weakness of the Choleski methodology is that the results are
sensitive to the ordering of the VAR. Furthermore, there is no firm theoretical or empirical
evidence to suggest how the variables should be ordered. The generalised form of variance
decomposition is unaffected by the order of the variables and produces unique results that
fully take account of the historical patterns of correlations observed amongst the different
shocks (Pesaran and Shin, 1998, p.4).
Another estimation issue needs to be addressed at this stage. The issue is whether or not to
conduct the GVD using a Vector Error Correction model (if needed) or an unrestricted VAR
in differences. Dekker et al (2001) provide an excellent discussion on the topic. They cite a
paper by Naka and Tufte (1997) who find that imposing the cointegrating vector does not
necessarily improve performance over short time horizons. In fact, Clements and Hendry
(1995), Engle and Yoo (1987) and Hoffman and Rasche (1996) found that an unrestricted
VAR is superior (in terms of forecast variance) to a restricted VECM over short time
horizons. Since the GVD is conducted over a 20-day horizon this thesis will use employ the
unrestricted differenced VAR. This also applies to the Generalised Impulse Response
functions outlined below.
Following the procedure from Darrat and Zhong (2004), the first step is to obtain estimates of
expected returns. The estimates are generated through using the VAR to forecast observed (or
43
actual) returns. The forecast errors are taken to represent the unexpected returns (shocks), the
VAR model of returns is as follows:
k
rt + k = + l rt + l 1 + t
(16)
l =1
where rt is a vector of continuously compounded stock returns of the twelve equity markets in
period t. is a vector of intercepts, l is a matrix of autoregressive parameters and t is a
white noise vector of disturbance terms. The n-period forecast error of returns is represented
by the following equation:
n 1
rt + n E t rt + n = Dl t + n l
(17)
l =0
The GVD of the n-step forecast error of return i explained by innovation, j is derived from the
following computation:
n
GVDij (n) =
(eD e )
l =0
n
ij (eiDl Dlei )
l =0
(18)
where ei is an 12 1 selection vector with unity as its ith element and zeros elsewhere, is the
sum of squared residuals, E (vt vt ) and ij is the residual variance in the ith equation in the
VAR.
3.3.4 Generalised Impulse Response Functions
An alternative measure of market linkage is to examine the speed at which a market adjusts to
an innovation in another market. The argument put forward is that the greater the level of
market linkage then the impact of an innovation in a foreign market will quickly decay in the
domestic market. Bivariate generalised impulse response analysis will be considered. For the
bivariate analysis, the effects of innovations in the Japanese and US markets upon each other
and the PB countries will be examined. Like variance decomposition, Choleski decomposition
has traditionally been used to orthogonalise the innovations. As discussed above there are
several inherent deficiencies related to Choleski decomposition. Building on the work by
Koop, Pesaran and Potter (1996), Pesaran and Shin (1998) provide the procedure required to
conduct the generalised form of impulse response (GIR herein) analysis in the linear setting35.
35
Koop et al (1996) originally developed GIR analysis for non-linear multivariate models.
44
Consider the following VAR of order p:

p
xt = + Ai xt i + t for t = 1,2,..., T
(19)
i =1
where xt is a n 1 vector of dependent variables, is a n 1 vector of intercepts and Ai is a
n n coefficient matrix. Pesaran and Shin make the following assumptions:

1.
E ( t ) = 0, E ( t t) = for all t, where = { ij , i, j = 1,2,..., n} is an

n n positive definite matrix E( t t ) = 0 for all t = t
(20a)
2. All the roots of I n Ai z i = 0 fall outside the unit circle
(20b)
3. xt 1 , xt 2 ,..., xt p , for t = 1,2,...,T are not perfectly collinear
(20c)
i =1
Assumption 2 ensures that xt is a covariance stationary process. Equation (19) can be rewritten as an infinite moving average (VMA) series:
xt = i t i , t = 1,2,...,T
(21)
i =0
where i is a n n coefficient matrix estimated from the following recursive estimation

process:
i = A1 i 1 + A2 i 2 + ... + Ap i p , i = 1,2,...,
(22)
with 0 = I n and i = 0 for i < 0 , and Gi = i .
The GIR function of xt at horizon k as stated in Koop et al (1996) is defined as;

GI X (k , , t 1 ) = E ( xt + k | t = , t 1 ) E ( xt + k | t 1 )
(23)
where is a n 1 vector of shocks and t 1 is a non-decreasing information set that captures

the known history of the series up to time t 1 . Assume a shock is then applied to the jth
element of the error vector t . The effects are integrated out using an assumed or historically
observed distribution of the errors. A more specific form of equation (25) is the result:
GI X (k , j , t 1 ) = E ( xt + k | jt = j , t 1 ) E ( xt + k | t 1 )
(24)
If t is assumed multivariate normal, then Koop et al show that:

E ( t | jt = j ) = ( 1 j , 2 j ,..., nj ) jj1 j = e j jj1 j
(25)
45
where e j is an n 1 selection vector with unity as its jth element and zeros elsewhere, is the
sum of squared residuals, E (vt vt ) , as seen in equation (19). The n 1 vector of the unscaled
GIR of the effect of a shock in the jth equation at time t on xt + k is as follows:
Ak e j j
jj jj
, k = 0,1,2,...
(26)
The scaled GIR function is derived by setting jj = j :
gj (k ) = jj1/ 2 Ak e j , k = 0,1,2,...,
(27)
Due to the stationarity of the system, there is no concern over the responses converging to 0.
3.3.5 Block Exogeneity
The concept of block exogeneity is based upon Granger causality. X is said to cause Y if Y can
be more accurately forecast based on past values of X and Y compared to Y alone. If
substantial market linkage is discovered, then causality is expected. Furthermore, endogenous
markets like Japan and the US are likely to cause other markets, but no other markets are
likely to exert causality over them. In certain cases of strong market linkage causality could
possibly exist in both directions (i.e. market A causes market B and market B causes market
A). Consider the following VAR:
AU
rt AU a AU A1,1 K A1,12 rt AU
B1,1 K B1,12 rt AU2 t
1
+ M
O
M M + M
O
M M + M
M =
US
rtUS aUS A12,1 L A12,12 rtUS
US
1 B12,1 L B12,12 rt 2 t
(28)
To test the null hypothesis that returns in the US does not causes Australian returns, a
standard Wald test imposing the restriction A1,12 = B1,12 = 0 is no longer valid36. The
extension of the test for Granger causality to a multivariate setting is referred to as a block
exogeneity test.
36
Testing the restriction is only valid in a bivariate VAR model. This is the traditional Granger test.
46
For Australia, the block exogeneity test essentially imposes a zero restriction on the lags of
rt AU in the eleven remaining equations. The test is formally conducted using a log likelihood
test as seen below37:

(T c)(log | r | log | u |)
(29)
where | u | is the determinant from the covariance matrix from the unrestricted model, | r |
is the determinant from the covariance matrix from the restricted model, T is the number of
observations c is the number of parameters estimated in each equation of the unrestricted
system38. If the null hypothesis is rejected it implies that the variable adds significant
information to the model.
The use of three measures to examine the level of short-term market linkage in the PB, will
present a broad and complete picture of the true relationship. All three measures have been
used in the previous literature and are seen as legitimate methods to observe the dynamics of
short run associations.
3.4 The time variation of market linkage
Based on the discussed in section 3.2 it would be likely that the level of market linkage varies
over time for such reasons as changes in trade and investment restrictions, the level of
investor confidence, legal and prudential regulation, composition of the economy and trading
partners and political and social attitudes. Furthermore, the EA crisis and events of September
11 are likely to have a significant enough affect to cause either a temporary or a permanent
change to the relationship between markets. Based upon this line of reasoning the following
hypotheses are proposed:
H 3 A : The relationship between the stock markets of the Pacific - Basin has altered over time
H 3B:The relationship between the stock markets of the Pacific-Basin intensifies
following a market disturbance
37
The testing procedure is provided by Enders (1995)
38
The unrestricted model is estimated by regressing rt
against p lagged values of
HK
, rt
ID
, rt
JP
, rt
KO
, rt
MY
, rt
NZ
, rt
PP
, rt
SG
, rt
TA
, rt
TH
US
, rt
rt AU , rt HK , rt ID , rt JP , rt KO , rt MY , rt NZ , rt PP , rt SG , rtTA , rtTH , rtUS . The restricted
model is the same as the unrestricted model with the lagged values of rt
AU
excluded from all eleven equations.
47
This hypothesis requires the use of several methods to get the full picture. Weekly recursive
cointegration tests establish the fact that the cointegrating relationship has changed through
time. To enable easy interpretation of the volumes of data provided by the sixty-six pairs of
weekly tests all the trace statistics are graphed. An example can be seen below in Figure 3.4.
Figure 3.4 Recursive cointegration test between Australia and Hong
Kong
Normalised Trace Statistic
1.5
0.5
2/09/04
2/05/04
2/01/04
2/09/03
2/05/03
2/01/03
2/09/02
2/05/02
2/01/02
2/09/01
2/05/01
2/01/01
2/09/00
2/05/00
2/01/00
2/09/99
2/05/99
2/01/99
2/09/98
2/05/98
2/01/98
2/09/97
2/05/97
2/01/97
2/09/96
2/05/96
2/01/96
Date
Normalised Trace Statistic
Normalised Critical Value
Asian Crisis
Sep-11
The design of the graph is such that when the line is above one, significant cointegration
exists between the two markets. Again, all trace statistics reported in this thesis have been
adjusted for small sample bias.
A secondary technique used to determine the effect of the EA crisis and September 11 on the
level of market linkage is to include an intercept dummy variable for the East Asian crisis and
September 11, in the test for cointegration. The use of this technique represents a substantial
improvement in accurately detecting changes in the long run relationship and is only
employed for the bivariate and multivariate tests on the full period (5/01/1988 to 7/09/2004).
To determine if the level of short run market linkage fluctuates over time, the sample is
broken into three sub-samples and all the tests re-computed. The first sub-sample starts from
the beginning of the sample (1/05/1988) and runs to the 31 October 1997. The second period
runs from the 1 November 1997 to September 11 2001 and the last period extends from
48
September 12 2001 to 7 September 2004. This provides significant evidence as to how the
degree of short-run market linkage varies over time.
3.5 Factors responsible for market linkages
This thesis, postulates that several variables influence the level of market linkage. Table 3.5
summarizes the expected affect of the variables on market linkage. The following discussion
highlights the theoretical underpinnings as to how these variables influence the level of
market linkage.
Table 3.5 Expected relationship between
market linkage and the factors proposed
Proposed
Variable
Effect
Goods Market Integration
+
Trade Dummy
+
Market Development
Turnover ratio
Size Difference
Size Dummy
+
Exchange rate volatility
Returns volatility
+
Money Market
Money Market integration
+
Interest rate differential
+
Location
-
A. Goods Market Integration and Trade
Goods market integration is likely to be a dominant factor in explaining market linkage.

Referring back to economic theory, the goods market is defined as the IS curve. The IS and
LM curves combine to form the aggregate demand function (AD), AD is equivalent to the
growth of the economy. The inclusion of this variable also helps to control for any shocks in
aggregate demand. It also is a good proxy for the level of economic growth in that market.
The effect of economic growth on equities markets is obvious, that is significant appreciations
will occur during times of good growth and depreciations during contractions.
Consider two economies that are characterised by large natural resource and primary
production sectors, that is, they have a similar industry composition. If commodity prices rise,
then those companies in both economies will have higher earnings without incurring any extra
costs and therefore increase profit and cash flows to the firm. The market would interpret this
49
news favourably and subsequently the stock markets in both economies will exhibit an
appreciable increase.
Now let us extend the model further by including two other economies that produce durable
consumer and capital goods. Neither economy has any significant natural resource or primary
production. As a result, they import all their necessary production inputs from the two
economies mentioned above. The effect of an increase in commodity prices will make
production more expensive. The companies of these two economies then have two options
available to them. They can keep prices fixed, remain competitive in the global market,
absorb the cost themselves, and earn lower profits and cash flows. Alternatively, they could
increase price to retain their profit margin but lose competitiveness and again suffer a
reduction in profit and cash flows. Either option will result in a decline in profit and cash
flows. Investors in these economies will view this news with displeasure and the price of
these firms will depreciate along with the respective national stock markets. Obviously if the
price of capital goods increased, the scenario would occur the other way around but the result
would still be the same. That is, the two small open natural resource and primary producers
would move together and the industrial production economies move together.
Finally, consider the effect of a positive (negative) shock to the industrial production
economies. Production in the economy rises (declines); therefore, more (less) inputs are
required from the other two economies. In this case, the stock markets in all four economies
will experience an appreciation (depreciation).
The scenarios described above all rely upon the possibility of trade between markets. If trade
is not possible then good market integration is unlikely. The lack of international trade is an
indication of market segmentation. In segmented markets, domestic factors are the only
providers of information. As discussed in the previous section the Pacific-Basin region has a
high level of trade between each other and the world. Therefore, trade barriers do not limit the
probability of goods market integration. Most nations in the Pacific-Basin are net exporters
and therefore rely heavily upon trade to promote growth and innovation. Thus, trade is of vital
importance to these economies.
50
In this thesis, the level of goods market integration is captured by running bivariate
cointegration tests on the industrial production statistics of each economy. Since industrial
production statistics are used to measure the level of goods market production, the trace
statistic from the cointegration test must provide an insight into the long run relationship
between the goods markets of two economies. Sixty-six tests in total are conducted based on
monthly data from 15/01/1989 to 15/06/2004. Darrat and Zhong (2004) use a similar metric to
indicate the level of goods market integration between the two markets.
Two proxies are presented in this study to describe the effect of trade upon market linkage. As
per the discussion above it is theorised that trade will be a vital role in determining market
connections. The two measures employed in this thesis are dummy variables. The first
dummy considers the effect of trade organisations upon market linkage. If a pair of markets
both belongs to ASEAN then the dummy takes a value of one and zero otherwise.
B. Location
The geographical location of markets is likely to affect the level of linkage for two reasons.
The first is that, markets that are close to each other are more likely to experience economic
integration. This is because it has been shown through out the world that markets that are
close to each other display a higher than average level of trade. As discussed above, trade
provides a transmission channel between economies to transmit stock market comovements.
Secondly, markets close in geographical proximity are likely to share similar factor
endowments. That is, markets that are close to one another have a similar environment and
climate. Therefore, it is probable that they have similar deposits of natural resources and
ability to cultivate certain primary products. As argued above, markets of similar industry
composition and factor endowments are going to comove in the same direction.
The second theory as to why markets of a close geographical location are likely to comove
with each other is the home bias puzzle. Expanding this theory to an international level,
investors are more likely to invest in countries that are close because they believe they 'know'
them better39. Therefore, if market A performs well and investors from market B have an
investment in market A, they will have higher wealth. Investors from market B may then
39
For example investors from Singapore are likely to invest in Malaysia instead of New Zealand
51
consume this additional wealth in country B, consequently firms in market B perform better
and the markets display comovement.
The manner in which this variable is operationalised in this thesis is just to measure the
distance between two markets in kilometres. As seen in table 3.5 a negative relationship is
expected, however the effect of the US could significantly influence the results and a positive
relation discovered because the US is so open, but also so far away.
C. Market Development
The effect of market development upon market linkage would appear to be obvious. The
logical conclusion would be to assume developed markets are display higher levels of market
linkage. However, as markets become further developed they also become more exogenous.
Therefore, the determining factor becomes not the absolute level of development, but the
relative level of development. In the literature to date there have been numerous suggested to
describe this variable but no solid findings. Bekaert and Harvey (1997) argue that market
capitalisation is a good proxy for the level of development in a market. Expanding on this
proposition, this thesis presents two variables as proxies for size. The first is the large market
group dummy variable that takes a value of one when Australia, Hong Kong, Japan, Korea,
Taiwan or the US are in the pair and a zero otherwise. The small market group dummy
variable takes a value of one when the pair contains Indonesia, Malaysia, New Zealand, the
Philippines, Singapore or Thailand40. Another variable computed is also based on the size of
the relevant markets. Section 4.2 provides an in depth description of this size difference
variable. Lastly, a concept new to this thesis is the use of a turnover ratio to proxy for market
liquidity and ultimately market development. The effect of deep and liquid markets and their
relation to market development has been well established in the previous literature. Again,
section 4.2 provides a comprehensive discussion surrounding the properties of this variable.
D. Money Market Linkage
This thesis proposes that the level of money market linkage affects the level of market
linkage. As seen in section 3.2 the benefits and costs from capital flows are considerable and
can be long lasting. While much of the growth in the East Asian economies can be linked to
40
This thesis realizes that these markets are not necessarily small or unimportant. The large dummy variable was
created by finding the markets with the six highest market capitalizations over the 16-year period.
52
massive capital flows from Japan and the US during the 1980s, the EA crisis just as readily
highlights the pitfalls associated with unrestricted capital movements. The probability of
market linkage increases significantly in the presence of capital market integration for several
reasons.
In economics, the LM curve represents capital markets. The stance of the monetary policy
adopted by the respective monetary authority dictates the position of the LM curve.
Consequently, capital market integration has significant ramifications for the breadth and
depth of the conduct of monetary policy. Assume a country adopts a contractionary monetary
policy stance. The increased interest rate raises the cost of capital and subsequently
investment in the economy falls along with economic growth. According to the theory of
interest rate parity, the rise in interest rates will also cause the domestic currency to
appreciate. In turn, exports become more expensive and imports cheaper, leading to a
worsening of the balance of trade and ultimately a decline in GDP. The decline in aggregate
output can potentially have significant consequences for other economies.
Another way for the money market to influence the level of the linkage between markets is
through the Present Value Model (PVM herein). Essentially under PVM the value of a firm is
its future dividends discounted back to today, where the discount rate is a function of the risk
free rate. Therefore, if the risk free rate rises, so will the appropriate discount rate for that
firm. Ceteris paribus, if the discount rate increases then the price of the firm will fall. If two
markets have display money market linkage then it is highly likely that their interest rates will
move in a similar direction, thus both stock indexes will appreciate.
To examine the effect of money market linkage, two variables have been put forward. The
first is the absolute weekly interest rate differential between the two markets averaged over
the period 5 January 1993 to 7 September 2004. Under the concept of interest rate parity, it
would be assumed that any deviations away would cause substantial flows in capital. The
discussion above supposes that capital flows can cause significant linkage between markets.
However there has been some literature that has found that uncovered interest rate parity (UIP
henceforth) does not hold. If, a negative relation is found between the proxy for monry market
linkage and equity market linkage then it is proof toward the PVM. If a positive relationship
is uncovered then it is proof in the favour UIP holding.
53
The second measure used to proxy for money market linkage is the trace statistic from a test
for cointegration conducted on the interest rates of the respective markets. The use of this
measure largely extends from the work of Phylaktis (1999) that uses cointegration tests to
proxy for capital market integration.
E. Market Volatility
Extensive research has established the importance of volatility in stock markets. Therefore,
the volatility of markets will influence the level of market linkage. The market contagion
hypothesis provides the theoretical underpinning for this expectation. Market contagion
dictates that markets tend to exhibit higher linkage when they display higher volatility.
Therefore, it would be expected that volatility is positively related to market linkage if the
contagion theory is credible. However, emerging literature led by Forbes and Rigobon (2002)
have found that the EA crisis did not result in contagion between the markets of the PB. The
result of this is that either situation is legitimate considering that both are based on sound
economic theory and robust empirical evidence.
F. Exchange Rate Volatility
Exchange rates play an important part of any economy. This study supposes two ways for
exchange rate volatility to influence the level of market linkage. The first is that when
investors are making their decisions, they compute returns denominated in their own domestic
currency. Therefore, volatility in exchange rates can raises the systematic risk of that nation.
Therefore risk averse investors, are less likely to invest into the market, thus driving the two
markets apart.
Furthermore, fluctuations in exchange rates affect the level of trade in an economy through
deviations away from purchasing power parity (PPP). PPP dictates that a countries level of
exports and imports will vary according to the prevailing real exchange rate. As discussed
above trade plays a crucial role in promoting market linkage and goods market integration.
Therefore the greater the volatility in the exchange rates, the higher the probability of
deviations away from PPP and subsequently a higher level of trade However, it is important
to note that PPP has found not to hold in empirical testing. Therefore, if a positive relation is
found then it is likely that PPP is holding, as opposed to a negative relationship which
54
provides evidence toward the first argument presented above.. The two theories put forward
to explain the effect of exchange rate volatility on market linkage actually seem to oppose one
another. However, both are economically sound and valid arguments, thus making it difficult
to predict the direction of the relationship. This actually provides for an interesting
comparison to see if it is investors decision making or wider economic variables that
influence market linkage.
Based upon the above theoretical underpinnings, a cross-sectional regression model is
proposed to determine which factors significantly affect market linkage.
+
Tracei , j = + 1 IP Tracei, j + 2 Locationi , j + 3 Sdiff i, j + 4 IR Tracei, j + 5 ri , j + 6 ireturns
,j
+ 7 iX, j rate + 8TOi , j + 9 DASEAN + 10 DOECD + 11 DLARGE + 12 DSMALL + i
where,
Tracei , j is the trace test statistic extracted from a bivariate cointegration test between the
stock markets indices of country i and j. Sixty-six tests in total are conducted based on data
from the full sample (5/01/1988 to 7/09/2004). Since over 760 observations are included for
the tests of cointegration, the results obtained are highly robust and persuasive. Tracei , j is an
indication of the strength of the relationship between the two stock markets. A value in excess
of 19.96 indicates the presence of cointegration at the 95% confidence level. In general, high
trace statistics are an indication of stronger market linkage. To ensure the robustness of the
result obtained, the maximum test statistic and eigenvalues from the cointegration test will be
taken as further proxies for market linkage. Masih and Masih (2001) note that eigenvalues are
an indication of the intensity of the cointegrating relationship.
IP Tracei, j is the trace statistic extracted from a bivariate cointegration between the industrial
production indexes of markets i and j. Sixty-six tests in total are conducted based on monthly
data from 15/01/1989 to 15/06/2004. Darrat and Zhong (2004) use a similar metric to indicate
the level of goods market integration between the two markets. A value in excess of 19.96
indicates the presence of cointegration at the 95% confidence level. Similar to Tracei , j , a high
statistic represents greater goods market integration.
55

Locationi , j is the distance measured in kilometres between the cities in which the stock
exchanges are situated.

Sdiff i, j is the average weekly logged market capitalisation of market i deflated by the average
weekly logged market capitalisation of market j. For further clarification, refer to section 4.2.
TOi , j is the bilateral turnover ratio between markets i and j41 . The manner in which the
statistics were computed a low ratio, indicates high liquidity.

IR Tracei, j is the trace statistic extracted from a bivariate cointegration test between the
interest rates of markets i and j. Sixty-six tests in total are conducted based on weekly data for
the period 5th January 1993 to 7th September 2004. IR Tracei, j is an indication of the level of
capital market integration between the two markets. A value in excess of 19.96 indicates the
presence of cointegration at the 95% confidence level.
ireturns
is the equally weighted standard deviations of market i and j averaged over the full
,j
period. The individual standard deviations are extracted from a bivariate GARCH (1, 1)
model. All sixty-six standard deviations are derived from returns starting the 12th January
1988 and ending the 7th September 2004.
iX, j rate is the volatility between the exchange rates of markets i and j extracted from a
univariate GARCH (1, 1) model. Sixty-six tests in total are conducted based on weekly
exchange rate returns starting on the 2nd of January 1988 and finishing the 7th of September
2004.
ri , j is the equally weighted mean return of market i and j for the period 12th January 1988 to
the 7th September 2004.
41
The method used to compute the weekly turnover ratios is discussed in Section 4.2
56
DASEAN is a dummy variable that takes a value of 1 when markets i and j are ASEAN member
nations, and 0 otherwise

DOECD is a dummy variable that takes a value of 1 when markets i and j are OECD member
nations, and 0 otherwise

DLARGE is a dummy variable that takes a value of 1 when markets i and j are a pair containing
Australia, Hong Kong, Japan, Singapore, Taiwan or the US and 0 otherwise.

DSMALL is a dummy variable that takes a value of 1 when markets i and j are a pair containing
Indonesia, Korea, Malaysia, New Zealand, the Philippines or Thailand and 0 otherwise.
Not all twelve variables will be regressed against the dependent variable in a single equation.
Several variables proxy for the same effect, therefore multiple models will be estimated with
variables certain factors omitted. Equations including slope dummy variables (interaction
terms) are also employed. To ensure the robustness of the regression several diagnostic tests
are completed. All regressions are estimated with robust standard errors using the NeweyWest procedure. Furthermore, the correlation matrix of independent ensures multicollinearity
is not an issue. A Probit model, where the dependent variable takes a value of 1 if significant
bivariate cointegration is found42 and 0 otherwise. The Probit model will have the same set of
independent variables as the OLS equation. For both models, a series of univariate and
multivariate equations will be estimated.
+
Pri , j = + 1 IP Tracei, j + 2 Locationi , j + 3 Sdiff i, j + 4 IR Tracei, j + 5 ri , j + 6 ireturns
,j
+ 7 iX, j rate + 8TOi , j + 9 DASEAN + 10 DOECD + 11 DLARGE + 12 DSMALL + i
The reasons behind using two different estimation techniques for are:
1. The OLS equation allows linkage to be measured in a continuous rather than discrete
setting. This is important distinction because there are likely to be situations where
strong linkage is discovered but is just not strong enough to qualify as significant.
2. An interesting feature of Probit models is the following relation:
probabilty = i * i
42
(30)
At the 5% significance level
57
where i is the coefficient for variable i and i is the standard deviation of variable i. The
probabilty measures the increase (decrease) in the probability of markets being linked due
to a one standard change in i with all other coefficients held constant. This allows the
economic significance of variable i upon market linkage to be examined.
58
CHAPTER 4SAMPLE DATA
Chapter 4: Sample Data

4.1 Introduction
Considering the importance of statistical testing procedures in this study, it is imperative that
the data is of the highest quality. Section 2 of this chapter outlines the data collected, any
adjustments required to ensure the integrity of the data and the methods used to compute
certain variables. Lastly, section 3 contains the descriptive statistics for the returns series of
each market.
4.2 Data and its stochastic properties
Many prior studies have shown that a long sample period is necessary to be able to discover a
cointegrating relationship. Weekly price levels were collected for the following stock
markets; the S&P500 (the U.S.), Nikkei 225 (Japan), Hang Seng (Hong Kong), Jakarta
Composite (Indonesia), KLSE Composite (Malaysia), PSE Composite (Philippines), Straits
Times (Singapore), Seoul Composite (South Korea), SET (Thailand) and the Taiwan
Weighted (Taiwan). For Australia and New Zealand indexes constructed by DataStream were
employed because of missing data, the methodology used to construct the indexes is outlined
in Appendix 1. For all markets, the sample starts on the 5th of January 1988 and finishes on
the 7th of September 2004, giving 871 observations per country. The week runs from Tuesday
to Tuesday in an attempt to avoid the bias often times associated with data from Monday or
Friday. . The returns series were generated using continuous compounding in the following
calculation:
rit = ln( Pit ) ln( Pit 1 )
(1)
where rit is the continuously compounded return on index i at time t and Pit is the price level
of index i at time t. Table 4.1 panel A and B show that in all four periods that stock prices are
found to be non-stationary, while returns are stationary at the 1% significance level. To proxy
for the market contagion effect, the equally weighted standard deviation of the pair i and j is
computed:
59
i, j =
i + j
(2)
Table 4.1. Augmented Dickey-Fuller and Phillips-Perron Unit Root Tests (p-values)
Panel A: Log Stock Price Levels
Country
Australia
ADF
PP
Hong Kong
ADF
PP
Indonesia
ADF
PP
Japan
ADF
PP
South Korea
ADF
PP
Malaysia
ADF
PP
New Zealand
ADF
PP
Philippines
ADF
PP
Singapore
ADF
PP
Taiwan
ADF
PP
Thailand
ADF
PP
US
ADF
PP
Full Period
Pre- East Asian

Period
Post - East Asian

Period
Post - September
11 Period
0.564
0.617
0.789
0.783
0.519
0.491
0.700
0.739
0.405
0.407
0.816
0.819
0.488
0.488
0.758
0.756
0.941
0.930
0.249
a
0.248
0.259
0.146
0.942
0.924
0.773
0.765
0.708
0.641
0.909
0.930
0.482
0.532
0.194
a
0.124
0.194
0.195
0.577
0.569
0.282
0.265
0.377
a
0.298
0.173
0.173
0.426
0.365
0.766
0.741
0.503
0.541
0.785
0.801
0.470
0.454
0.922
0.923
0.398
0.315
0.661
0.629
0.534
0.417
0.870
0.797
0.191
a
0.124
0.575
a
0.572
0.633
0.616
0.869
0.885
0.060
a
0.060
0.248
a
0.158
0.932
0.922
0.361
0.361
0.455
0.371
0.190
0.185
0.179
0.108
0.868
0.860
0.994
0.318
0.999
0.369
Panel B: Log Returns
0.449
0.543
0.946
0.927
60

Pre- East Asian
Post - East Asian
Post - September
Country
Full Period
Period
Period
11 Period
Australia
ADF
0.000**
0.000**
0.000**
0.000**
PP
0.000**
0.000**
0.000**
0.000**
Hong Kong
ADF
0.000**
0.000**
0.000**
0.000**
PP
0.000**
0.000**
0.000**
0.000**
Indonesia
ADF
0.000**
0.000**
0.000**
0.000**
PP
0.000**
0.000**
0.000**
0.000**
Japan
ADF
0.000**
0.000**
0.000**
0.000**
PP
0.000**
0.000**
0.000**
0.000**
South Korea
ADF
0.000**
0.000**
0.000**
0.000**
PP
0.000**
0.000**
0.000**
0.000**
Malaysia
ADF
0.000**
0.000**
0.000**
0.000**
PP
0.000**
0.000**
0.000**
0.000**
New Zealand
ADF
0.000**
0.000**
0.000**
0.000**
PP
0.000**
0.000**
0.000**
0.000**
Philippines
ADF
0.000**
0.000**
0.000**
0.000**
PP
0.000**
0.000**
0.000**
0.000**
Singapore
ADF
0.000**
0.000**
0.000**
0.000**
PP
0.000**
0.000**
0.000**
0.000**
Taiwan
ADF
0.000**
0.000**
0.000**
0.000**
PP
0.000**
0.000**
0.000**
0.000**
Thailand
ADF
0.000**
0.000**
0.000**
0.000**
PP
0.000**
0.000**
0.000**
0.000**
US
ADF
0.000**
0.000**
0.000**
0.000**
PP
0.000**
0.000**
0.000**
0.000**
Notes: This table reports the unit root tests for the log price levels and log returns of the
twelve national stock indexes. The full period is January 5, 1988 to September 7, 2004, the
pre- East Asian period is January 5, 1988 to October 21, 1997, the post East Asian period is
October, 22, 1998 to September, 11, 2001 and the post September 11 period is September
12, 2001 to September 7, 2004. The numbers reported are the p-values of the ADF and PP
tests statistics for unit roots. If not otherwise specified a constant was included in the unit root
a
test. indicates a trend term was included in the test regression. An ** indicates the rejection
of the null hypothesis that the series contains a unit root at the 5% significance level.
61
where i and j is the standard deviation of markets i and j respectively. A GARCH (1, 1)
model provided the estimates for the weekly conditional variance. The sixteen-year average
for each of the two elements was determined and the square root taken to obtain the standard
deviation.
The city distance tool hosted on http://www.geobytes.com/CityDistanceTool.htm gave the
distance (in kilometres) between the markets i and j. To determine capital market integration,
suitable interest data was required. The most appropriate rate to use would be the cash or
overnight rate set by the relevant monetary authorities. However, due to the limitations of
available data over the testing period other short-term rates had to be employed. Following
the example of Bracker et al (1999), various three-month interest rates were employed. For all
interest rates, the data was available from the 5th January 1993 to the 7th of September 2004.
Three-month T-bill rates were used for the U.S., Singapore and the Philippines. For
Indonesia, Malaysia and Thailand 3-month deposit rates were obtained, while for Australia,
Hong Kong and New Zealand three-month interbank rates were collected.
Table 4.2 Augmented Dickey-Fuller and Phillips-Perron Unit Root Tests (pvalues) for Interest Rates
Log Levels
Log Differences
ADF
PP
ADF
PP
Country
Australia
0.645
0.449
0.000***
0.000***
Hong Kong
0.488
0.224
0.000***
0.000***
Indonesia
0.592
0.322
0.000***
0.000***
a
a
Japan
0.247
0.166
0.000***
0.000***
South Korea
0.461
0.538
0.000***
0.000***
Malaysia
0.553
0.563
0.000***
0.000***
New Zealand
0.372
0.315
0.000***
0.000***
Philippines
0.115
0.147
0.000***
0.000***
Singapore
0.108
0.113
0.000***
0.000***
Taiwan
0.663
0.659
0.000***
0.000***
Thailand
0.959
0.933
0.000***
0.000***
US
0.946
0.927
0.000***
0.000***
Notes: This table reports the unit root tests for the log interest rates and the
th
th
differenced log interest rates. The full period is 5 January 1993 to the 7 of
September 2004. The numbers reported are the p-values of the ADF and
PP tests statistics for unit roots. An intercept was included in the test
a
regression. indicates a trend term was included in the test regression. An
*** indicates the rejection of the null hypothesis that the series contains a
unit root at the 1% significance level, while ** and * indicate rejection at the
5% and 1% levels respectively.
62
The Japanese three-month certificate of deposit rate, South Korean 91-day certificate of
deposit and the Taiwanese 90 day money market rate were also collected. These rates still
have a short enough time horizon to accurately reflect the monetary policy goals of the
respective authorities. Table 4.2 shows that interest rates are non-stationary in their levels, but
stationary in the first differences. Therefore, it can be concluded that interest rates are I (1)
and therefore a cointegration test can be conducted in order to extract the trace statistics
required to proxy for money market linkage. The use of the trace statistics generated from the
cointegration tests on interest rates to explain money market linkage is unique to this study.
The exchange rates for the different countries were collected from DataStream. Due to the
lack of data for the period being examined, the rates were computed using cross rates. For all
thirteen markets, the bilateral exchange rate with the US was available for the entire period.
The cross rates were computed as follows:
AUD AUD USD

=
*
HKD USD HKD
(2)
The use of cross rates is not ideal, but the level of error is extremely small and still allows for
strong comparisons. Furthermore, in practice virtually all currency traders convert their
domestic currency into USD in order to purchase other foreign currency and implicitly use
cross rates anyway.
The bilateral exchange rates were required to compute the volatility of the bilateral exchange
rate. The first step was to generate the weekly continuously compounded returns using the
procedure outlined in equation (1) for the period 2nd January 1990 to 7th September 2004. A
GARCH (1, 1) model was employed to extract the weekly conditional variance. The variance
was averaged over the sixteen years and the square root taken to derive the standard deviation.
Industrial production statistics were collected from DataStream on a monthly basis for the
twelve markets being examined, for the period 15/01/1989 to 15/06/2004. Industrial
production statistics are a good proxy for both industry composition and output of the
economy. Similar to capital market integration, the proxy for goods market integration will be
the trace statistic from a bivariate test for cointegration. The motivation for this choice of
63
statistic stems from Darrat and Zhong (2004) whom employ a similar methodology. As per
the discussion pertaining to capital market integration, cointegration tests require the system
of variables to be integrated of the same order. Table 4.3 and 4.4contains the results for the
unit root test for the industrial production statistics.
Table 4.3 Unit Root tests for Industrial Production Statistics in log levels
Augmented
Critical Values
Critical Values
Phillips-Perron
Country Dickey-Fuller
test Statistic
test statistic
90%
95%
99%
90%
95%
99%
AU
-1.4247
-2.575
-2.877
-3.466
-1.406
-2.575
-2.877
-3.466
HK
-1.2303
-2.575
-2.877
-3.466
-1.585
-2.575
-2.877
-3.466
ID
-0.2092
-2.575
-2.877
-3.466
0.047
-2.575
-2.877
-3.466
JP
-1.9762
-2.575
-2.878
-3.467
-11.383***
-2.575
-2.877
-3.466
KO
-0.3180
-2.575
-2.877
-3.466
-0.293
-2.575
-2.877
-3.466
MY
-0.5969
-2.575
-2.877
-3.466
-0.529
-2.575
-2.877
-3.466
NZ
0.3147
-2.575
-2.877
-3.466
0.308
-2.575
-2.877
-3.466
PH
-1.1725
-2.575
-2.877
-3.466
-1.580
-2.575
-2.877
-3.466
SG
-2.0599
-2.575
-2.877
-3.466
-2.272
-2.575
-2.877
-3.466
TA
-2.0521
-2.575
-2.877
-3.466
-2.373
-2.575
-2.877
-3.466
TH
-1.1342
-2.575
-2.877
-3.466
-1.116
-2.575
-2.877
-3.466
US
-0.4265
-2.575
-2.877
-3.466
-0.534
-2.575
-2.877
-3.466
Table 4.4 Unit Root tests for the log differenced Industrial Production Statistics
Augmented
Critical Values
Critical Values
Phillips-Perron
Country Dickey-Fuller
test Statistic
test statistic
90%
95%
99%
90%
95%
99%
AU
-9.49609***
-2.575
-2.877
-3.466
-13.30209***
-2.575
-2.877
-3.466
HK
-16.8483***
-2.575
-2.877
-3.466
-19.25698***
-2.575
-2.877
-3.466
ID
-7.20959***
-2.575
-2.877
-3.466
-7.52741***
-2.575
-2.877
-3.466
JP
-25.39081***
-2.575
-2.877
-3.466
-20.60083***
-2.575
-2.877
-3.466
KO
-9.46027***
-2.575
-2.877
-3.466
-15.66235***
-2.575
-2.877
-3.466
MY
-12.94404***
-2.575
-2.877
-3.466
-21.19589***
-2.575
-2.877
-3.466
NZ
-9.76598***
-2.575
-2.877
-3.466
-13.82546***
-2.575
-2.877
-3.466
PH
-15.60689***
-2.575
-2.877
-3.466
-20.9483***
-2.575
-2.877
-3.466
SG
-22.29304***
-2.575
-2.877
-3.466
-28.08833***
-2.575
-2.877
-3.466
TA
-15.63103***
-2.575
-2.877
-3.466
-24.01909***
-2.575
-2.877
-3.466
TH
-11.66317***
-2.575
-2.877
-3.466
-21.33933***
-2.575
-2.877
-3.466
US
-14.73194***
-2.575
-2.877
-3.466
-22.61475***
-2.575
-2.877
-3.466
Notes: This table reports the unit root tests for the log price levels and log returns for the industrial
production statistics for the twelve countries. Monthly data is used. The full period covers 15/01/1989 to
15/06/2004. AU ! Australia, HK ! Hong Kong, ID ! Indonesia, JP ! Japan, KO ! Korea, MY !
Malaysia, NZ ! New Zealand, PP ! The Philippines, SG ! Singapore, TA ! Taiwan, TH ! Thailand
and US ! The United States. An intercept is included in all test regressions. An *** indicates the
rejection of the null hypothesis that the series contains a unit root at the 1% significance level, while **
and * indicate rejection at the 5% and 1% levels respectively.
64
In order to calculate the size differentials between markets, the weekly market capitalisations
(denominated in US dollars) of the twelve markets was collected for the period between
3/04/1990 to 7/09/2004. This data was also required to compute turnover ratios. In this thesis,
size differentials were computed in the following fashion:
sdiff i , j =
Avg ln SI i
Avg ln SI j
(3)
where Avg ln SI i is the natural log of stock market capitalisation i computed at weekly
intervals. The average of the logged stock index i is then calculated for the full period. The
same procedure is repeated for market j. The impetus behind this proxy derives from Bracker
et al (1999) who utilize a similar metric.
Before, continuing some preliminary notes regarding this statistic are required. The first is
that the US never appears in the numerator because of the ordering. The consequence of this
is that, for the eleven cases when the US is in the denominator an average difference of
around 0.6 is returned (excluding Japan). This thesis proposes that most markets display
strong linkage the US, therefore when is smaller sdiff i , j higher market linkage is expected.
Size differences of over one likely represent cases when Australia, Japan, South Korea and
Taiwan appear in the numerator and the less developed economies of SE Asian in the
denominator. Based on past empirical evidence, economic links and information presented in
chapter 3, the proposition that Australia, South Korea, Taiwan and especially Japan do not
display significant market linkage with the less developed markets in SE Asia is reasonable.
The combination of facts leads to the conclusion that, when sdiff i , j ,is high market linkage is
expected to decline.
When the two markets are of the same size it is expected that market linkage will higher..
Values of one are expected in two situations. The first is when two large markets are
included in the computation and the second when two small markets are compared. When
considering the large markets group (Australia, Hong Kong, Japan and Taiwan and the US),
this thesis predicts that the level of linkage between these markets to exceed the average.
65
Turnover ratios serve, as a proxy for market development is a proposition presented in this
thesis. Market capitalisation and trading volume figures were obtained from DataStream.
Turnover ratios are traditionally estimated as the value of the volume traded deflated by the
market capitalisation. Data restrictions made this not possible for this thesis. In an attempt to
mitigate the effects of exchange rates and market composition, all market capitalisations
figures are denominated in USD terms. The trading volume (measured in the number of
shares not value) was also collected for the twelve markets. The major problem that arises
from using the physical number of shares traded is that in some markets many relatively
cheap stocks might be traded quite often, while in other markets more expensive stocks are
traded at a lower frequency. Thus, it would appear that the first market is liquid when in fact it
may not be. Therefore, by collecting all market capitalisation figures in USD and using
domestic trading volumes allows for greater comparability. For example, the turnover ratio
for Korea would be completed as follows:
TOKO =
Number of shares traded (in Korea)

Market Capitalisation of Korea (in USD)
(3)
All turnover ratios are computed on a weekly basis. These ratios are then averaged over the
period 23/04/1991 to 7/09/2004, such that one ratio is obtained for each market.
Table 4.5 - Turnover ratios
for all 12 markets
Country
Turnover
Australia
2.992405
Hong Kong
3.012569
Indonesia
15.26897
Japan
0.8147
Korea
2.922903
Malaysia
3.253496
New Zealand
4.123634
Philippines
14.34273
Singapore
4.195414
Taiwan
3.985235
Thailand
13.52558
US
0.575817
The bilateral turnover ratio is the equally weighted turnover ratio between market i and j. The
lower the ratio the more advanced the market; Japan and the US have the two lowest, while
66
Indonesia, the Philippines and Thailand have the three highest. As can be seen the results
obtained appear to be fairy accurate proxies of market development.
4.3 Descriptive Statistics
Table 4.6 displays the descriptive statistics for the returns series of the twelve stock markets.
The table highlights several issues. The first is the outstanding performance of Australia and
the US over the sample period. Australia had a mean weekly return of 0.151% (4th highest)
and the lowest variance, while the US had a weekly mean return of 0.169% (3rd highest) and
the second lowest variance. By contrast, the poor performance of the Japanese market is
evident, as it is the only market to have a negative return. As expected, all markets strongly
rejected the null hypothesis of normality and kurtosis.
Table 4.6 - Descriptive Statistics: Stock Index Returns for the full period
Country
Mean
Variance
Skewness
Kurtosis
Jarque-Bera
Australia
0.00151** 0.00041
-0.21166**
3.38445**
421.72246**
Hong Kong
0.00195
0.00152
-0.96946**
8.45726** 2729.07022**
Indonesia
0.00259
0.00278
5.61822**
99.47763** 363299.578**
Japan
-0.00074
0.00090
0.10695
1.35944**
68.65168**
South Korea
0.00050
0.00193
-0.00426
1.92855**
134.82717**
Malaysia
0.00129
0.00140
0.17016**
8.18368** 2431.95431**
New Zealand
0.00094
0.00065
0.27354**
7.4037**
1997.88645**
Philippines
0.00083
0.00173
0.11595
1.69941**
106.63966**
Singapore
0.00094
0.00079
-0.16393**
2.53159**
236.22112**
Taiwan
0.00105
0.00231
-0.5785**
1.92253**
182.51053**
Thailand
0.00085
0.00198
0.20676**
3.5089**
452.52362**
US
0.00169** 0.00050
-0.18182**
2.99853**
330.72471**
st
th
Notes: The full period begins 1 January 1988 and finishes 7 September 2004.
The returns are weekly continuously compounded returns calculated as per (1). **
denotes significance at the 5% level.
Significant skewness was found in all cases except Japan, South Korea and the Philippines.
The uncharacteristic performance of the Japanese market during the sample period compared
to the other countries examined is likely to reduce the possibility of it being linked with other
markets
67
CHAPTER 5EMPIRICAL RESULTS AND FINDINGS
CHAPTER 5: EMPIRICAL RESUTS AND FINDINGS

5.1 Introduction
This chapter outlines the major empirical results of this thesis. Conclusions are made from the
results in reference to the hypotheses and propositions outlined in Chapter 3. The chapter is
divided into several major sections. Section 5.2 address the results from the cointegration
analysis, while Section 5.3 presents the findings obtained from the persistent profile analysis.
5.4 and 5.5 cover the findings regarding the generalized impulse response functions, and
block exogeneity tests. Lastly, section 5.7 contains the results from the regression analysis
concerning the factors driving market linkage.
5.2 Cointegration Analysis
This section is broken into; Section 5.2.1 examines the bivariate and multivariate tests for
cointegration on the full sample period. 5.2.2 contains, the results pertaining to the recursive
bivariate cointegration analysis.
5.2.1 Bivariate and Multivariate Tests for Cointegration for the full sample period
The tests for stationarity are contained in panel A and B of Table 4.1. For the full sample
period, all twelve markets are found to be I (1), thus satisfying the first condition required for
cointegration. Following the procedure outlined in section 3.3.1, the first step is to choose an
appropriate lag length (p). The Sims likelihood ratio test, AIC or SBC are be used to
determine the optimal lag length. Based on a mixture of evidence from the selection criteria
and previous empirical findings, the bivariate cointegration tests are completed with 10, 15,
20, 30 and 52 lags in the test VAR to ensure robustness. The results from all five-lag
structures are displayed in Table 5.1. All trace statistics were deflated by the small sample
bias correction factor as per the discussion in section 3.3.1. Due to the test VAR containing
twelve equations for the multivariate tests, the degrees of freedom rapidly decline. Therefore,
lag lengths of 5, 8, 10, 15 and 20 are employed. The use of longer lag lengths in cointegration
tests is preferred for two reasons. The first reason as mentioned above and in Chapter 5, serial
68
correlation between variables can significantly affect the performance of the JJ procedure.
Therefore, the order of the VAR should be increased until serial correlation is removed from
the residual series. Secondly, because cointegration tests are used to identify the possibility of
long run relationships, an excessively short lag length is inappropriate. Furthermore, uses of
relatively short lag lengths decrease the probability of significant cointegration being
discovered. As discussed in Chapter 2, the drawback of over-parameterization is the loss of
discriminatory power in the JJ procedure. This issue is not relevant to this thesis, due to the
full sample containing 871 observations for each series. Therefore, even with a lag length of
fifty-two weeks, some 819 observations per series are still available for testing.
For Australia, some interesting results were obtained. The first was that under all five-lag
structures no strong linkage was found to exist with Hong Kong, Malaysia, New Zealand, the
Philippines, Thailand or the US43. Significant cointegration with Indonesia was found in all
cases except when 52 lags were included. The conclusion that could be drawn from this result
is that Australia affects the short-term return in the Indonesian market over a long run time
horizon. When p = 30 and 52, Australia, exhibits significant linkage with Japan. It would be
thought that movements in the Japanese market affect Australia in the long run. At a lag,
length of 10 and 52 significant cointegration is discovered between Taiwan and Australia.
While at the 52-week lag, Korea and Singapore were found to be connected to Australia. This
thesis proposes the role of Australia in the Pacific-Basin is one of a market clearer, that is it
returns the system to equilibrium. Movements in Japan, Hong Kong and the US are
transmitted by Korea, Singapore and Taiwan into Australia.
Cointegration is found at p = 10, 15 and 30 between Hong Kong and Indonesia. It can be
safely assumed that Indonesia is influenced by Hong Kong in the long run. South Korea and
Singapore display marginal linkage44 with Hong Kong. Indonesia is found to take its lead
from multiple markets. Indonesia shows strong linkage with Japan, Korea, New Zealand,
Singapore, Taiwan and the US at lengths, 10, 15, 20 and 30. Fro all situations besides the
relationship with New Zealand it is supposed that the other five markets exert influence of
43
With 10 lags, a cointegrating relationship between Australia and the US was found to exist at the 10%
significance level. While a cointegrating relationship was found between New Zealand and Australia at the 10%
significance level, when p = 52.
44
Marginal linkage refers to significance at the 10% level.
69
Indonesia. There also appears to be weak linkage with Malaysia. Besides the results discussed
above, Japan also demonstrates weak significance with New Zealand and Singapore.
From the results obtained, South Korea appears to be one the most exogenous markets in the
Pacific-Basin. There is substantial support for the notion that Australia, Indonesia, Hong
Kong, Malaysia, New Zealand, Singapore, Taiwan, and the US are all linked with Korea in
the long run. A believable story is that shocks from Hong Kong, Singapore and the US flow
into Korea and it then transmits them to Australia, Indonesia and New Zealand. The relation
between Taiwan and Korea is not so clear. Even looking at the evidence from the GVD, both
markets seem to be important to one another.
The Malaysian market was found to have a robust relationship with Korea and Taiwan and a
less well developed relations with the US and Indonesia. Disturbances in Hong Kong, Japan
and Singapore are likely to flow through Korea and Taiwan into Malaysia then to Indonesia.
Malaysias dependence on investment from the US is likely to influence the relationship. The
behaviour of New Zealand in the Pacific-Basin is not unexpected. As discussed above New
Zealand is affected by the Indonesian and Japanese market, while the New Zealand does not
influence any other market in the Pacific-Basin.
The Philippines is likely to be endogenous because of the relative lack of development. The
bivariate cointegration tests support this proposition. Only in one case with Taiwan do the
Philippines display market linkage with any other markets in the PB. Like South Korea,
Singapore proves to be an exogenous market. As previously, discussed Singapore is proposed
to affect the Australian and Indonesian markets, while it is influenced by Hong Kong and
Japan. This thesis suggests that Singapore as a conduit to link Hong Kong and Japan with
Korea. Furthermore, Taiwan and the US appear to be linked in a less significant fashion.
Taiwan assumes a similar position to that of South Korea as a transmitter in the PacificBasin. As discussed in the section above, Taiwan is found to be linked to Australia, Indonesia,
Korea, Malaysia, the Philippines and Singapore. However, the other interesting characteristic
of Taiwan is its strong relationship with the US. From the evidence presented above, Taiwan
stands as the only market in the PB that exhibits robust ties with the US. This is likely to have
considerable consequences on the importance of Taiwan in the PB.
70
Following the procedure developed by Husted (1992) and outlined in Darrat and Zhong
(2004), the tests of cointegration are recomputed with the inclusion of two dummy variables.
The EA crisis dummy takes a value of 1 for the period October 17, 1997 to 31 December
1998 and 0 otherwise45. The choice of this period is based on the work of Forbes and Rigobon
(2002) whom use a similar time horizon. The second dummy takes a value of 1 for the four
weeks following September 11 2001 and 0 otherwise46. The choice of twenty-six weeks
derives from the findings of Hon et al (2004) whom find that correlation between the US and
Hong Kong, Japan, Korea, Australia, Singapore, Malaysia and Taiwan significantly increased
post-September 11 for the next six months. Three different specifications are estimated. The
first includes both the dummies, while the other two excludes one dummy and re-tests, for all
tests p = 52. Panel B of Table 5.2 contains the results. Caution must be employed when
interpreting the result of these tests. The inclusion of a stationary variable (i.e. the dummy
variables) is likely to lead to the true cointegrating relationship being overstated. Furthermore,
the Osterwald-Lenum critical values may not be applicable. This thesis takes a conservative
stance and only concludes that the event has caused an increase in linkage if the increase is
considerable.
The results show that the inclusion of the EA crisis dummy appreciably intensifies the
cointegrating relationship47. Figure 5.2a plots the trace statistics from the bivariate tests with
and without the dummy variable. The trace statistics have been normalized by the 95%
Osterwald-Lenum critical values, such that a value greater than 1 indicates significance at the
95% level. The increase in the strength of the cointegrating relationship produced after
including the dummy for the EA crisis period is so intense that even from a conservative
standpoint it can be concluded that the EA crisis caused a once off structural change in the
equity markets of the PB.
45
Dummy variables for four and twelve weeks post October 17 were also tested. The results did not display any
material difference and therefore are not reported. However, they are available upon request.
46
Dummy variables for twenty-six and twelve weeks post September 11 were also tested. The results did not
display any material difference and therefore are not reported. However, they are available upon request.
47
All trace statistics were adjusted using the small sample bias correction factor.
71

Figure 6.2a The impact of the East Asian crisis on market linkage
1.8
1.6
1.4
Trace statistic
1.2
0.8
0.6
0.4
0.2
0
1
11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 53 55 57 59 61 63 65
Trace with dummy
Trace without dummy
Out of the sixty-six pairs, the cointegration relationship increased for fifty-two. An interesting
result is that in seven of the cases when the relationship did not intensify Australia was one of
the markets included. This indicates the relatively small impact the EA crisis had upon the
Australian market and its standing in the PB. These findings provide further support for
hypothesis 3A and 3B. The effect of September 11 is presented in Figure 5.2b.
Figure 6.2b The impact of September 11 on market linkage
1.6
1.4
1.2
Trace Statistic
0.8
0.6
0.4
0.2
0
1
11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 53 55 57 59 61 63 65
Trace with dummy
Trace without dummy
Considering the caution with which the results should be interpreted, the effect of September
11 on the PB is still note worthy. This graph though highlights the relatively mild impact of
72
September 11 on the PB compared to the EA. Finally, both dummy variables were
simultaneously included and the tests recomputed. Figure 5.3c can be seen below.
Figure 6.3c The impact of both the EA crisis and September 11 on
market linkage
1.8
1.6
1.4
Trace Statistic
1.2
1
0.8
0.6
0.4
0.2
0
1
11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 53 55 57 59 61 63 65
Pair
Both dummies
No Dummy
Asian dummy
The most obvious result from the graph above is that the increase in the intensity of the
cointegrating relationship is mainly attributable to the EA crisis and not September 11. The
results of the multivariate results can be viewed in table 5.3.1.
Table 5.3.1 Cointegration Tests for the presence of long run market linkage between the nations of
the Pacific-Basin
Null
r=0
r1
r2
r3
r4
r5
r6
r7
r8
r9
r 10
r 11
Null
lag =5
Unadjusted
Adjusted
Trace
Trace
399.58
324.83
257.35
194.22
145.04
112.58
81.31
58.06
39.49
25.05
12.98
6.16
372.05
302.45
239.62
180.84
135.05
104.82
75.71
54.06
36.77
23.32
12.09
5.74
lag =15
Unadjusted
Adjusted
Trace
Trace
lag = 8
Unadjusted
Adjusted
Trace
Trace
403.81
324.23
252.38
198.79
151.83
114.84
80.00
57.21
41.74
26.65
13.91
6.57
375.99
301.89
234.99
185.10
141.37
106.93
74.49
53.27
38.86
24.81
12.95
6.12
lag = 20
Unadjusted
Adjusted
Trace
Trace
lag =10
Unadjusted
Adjusted
Trace
Trace
421.97
392.90
327.20
304.66
263.95
245.77
212.08
197.47
166.87
155.37
121.96
113.56
87.93
81.87
61.10
56.89
42.32
39.40
26.63
24.80
14.84
13.82
6.76
6.29
Critical Values
95%
90%
73

r=0
410.17
381.91
439.14
408.89
340.39
333.26
r1
319.27
297.28
349.47
325.40
291.40
281.63
237.35
r2
249.57
232.38
272.91
254.11
244.15
r3
199.99
186.21
213.97
199.23
202.92
196.66
r4
155.08
144.40
171.05
159.27
165.58
159.74
r5
117.28
109.20
130.02
121.06
131.70
126.71
r6
87.70
81.66
100.60
93.67
102.14
97.17
r7
63.67
59.28
74.87
69.71
76.07
71.66
r8
43.15
40.18
52.15
48.56
53.12
49.91
r9
29.39
27.37
35.88
33.41
34.91
31.88
r 10
17.36
16.16
21.85
20.34
19.96
17.79
r 11
8.41
7.83
9.54
8.88
9.24
7.50
Notes: This table reports the Johansen-Juselius (1992) trace statistics for the multivariate
cointegration tests conducted on the log of stock market indexes of all twelve markets included in the
system. Weekly data is used. The full period covers 5/01/1988 to 7/09/2004. Intercepts are included in
the estimated cointegration vectors. The small sample correction factor suggested by Cheung and Lai
(1993) is applied to all the trace statistics. A lag length of ten was used for all tests. Other lag lengths
were tested. The differences between the results were immaterial. The results are available upon
request. The 95% and 90% critical values are obtained from Osterwald-Lenum (1992). An * indicates
rejection of the null of no cointegration at the 10% level, while an ** indicates rejection at the 5%
significance level.
The tests seem to indicate the presence of two to three cointegrating vectors depending on
which lag length is believed. To determine whether Japan or the US is responsible for driving
cointegration in the PB, the tests were re-computed with Japan excluded, then the US
excluded. As can be seen from table 5.3.2 panel A, the trace statistic from when Japan is
excluded is considerably higher than when the US is excluded.
Table 5.3.2 Cointegration Test Results for the presence of Long-Run Equity Market
Linkage in the Pacific-Basin on the full period (January 5, 1998 - September 7, 2004)
Panel A. The effect of Japan and the US on market linkage
Null
r=0
r1
r2
r3
r4
r5
r6
r7
r8
r9
Trace
statistic for
all markets
392.90**
304.66**
245.77**
197.47*
155.37
113.56
81.87
56.89
39.40
24.80
Trace statistic for

when Japan is
excluded
NA
310.6807**
230.937
176.3436
137.2844
102.1726
72.35816
52.9183
35.3941
21.32065
Trace statistic for when

the US is excluded
NA
278.2973
218.098
167.0039
129.8755
95.92551
69.53845
49.07055
33.44207
20.73436
Critical Values
95%
340.39
291.40
244.15
202.92
165.58
131.70
102.14
76.07
53.12
34.91
90%
333.26
281.63
237.35
196.66
159.74
126.71
97.17
71.66
49.91
31.88
74

r 10
13.82
10.2989
9.658377
19.96
17.79
r 11
6.29
4.455487
3.871029
9.24
7.50
Notes: This table reports the Johansen-Juselius (1992) trace statistics for the
multivariate cointegration tests conducted on the log of stock market indexes of all
twelve markets included in the system. Weekly data is used. The full period covers
5/01/1988 to 7/09/2004. Intercepts are included in the estimated cointegration vectors.
The small sample correction factor suggested by Cheung and Lai (1993) is applied to
all the trace statistics. A lag length of ten was used for all tests. Other lag lengths were
tested. The differences between the results were immaterial. The results are available
upon request. The 95% and 90% critical values are obtained from Osterwald-Lenum
(1992). An * indicates rejection of the null of no cointegration at the 10% level, while an
** indicates rejection at the 5% significance level.
It must be noted that this does not provide concrete evidence to support the proposition that
the US influences the cointegrating relation more than Japan; however, it does provide
persuasive proof to suggest it does. The effect of the EA crisis and September 11 are also
considered in the context of the multivariate setting. The effect of the EA crisis is found to
have a far greater impact upon the level of cointegration than did September 11. It can be seen
that the inclusion of the Asian dummy leads to the identification of two extra cointegrating
vectors compared to the result from the September 11 dummy. This evidence provides
enough proof is from a conservative standpoint to conclude that the EA crisis affected the
long run market linkage between the countries of the PB. Such compelling findings are not
seen when only the September 11 dummy is included.
Panel B. The impact of the East Asian crisis and September 11 on market linkage
Null
Trace statistic
for no dummy
variables
Trace statistic for

when the EA crisis
dummy is included
Trace statistic for

when the
September 11
dummy is included
Trace statistic for

when both dummy
variables are
included
Critical Values
95%
90%
r=0
392.90**
386.23**
371.42**
387.54**
340.39 333.26
r1
304.66**
307.92**
289.44*
308.20**
291.4 281.63
r2
245.77**
253.04**
233.67
253.14**
244.15 237.35
r3
197.47*
199.28*
183.62
199.44*
202.92 196.66
r4
155.37
153.86
139.82
154.01
165.58 159.74
r5
113.56
116.00
106.82
116.04
131.7 126.71
r6
81.87
83.77
76.81
84.88
102.14 97.17
r7
56.89
57.51
54.95
57.79
76.07
71.66
r8
39.4
39.68
36.99
39.82
53.12
49.91
r9
24.8
22.41
22.65
22.54
34.91
31.88
r 10
13.82
12.08
11.77
12.18
19.96
17.79
r 11
6.29
5.69
5.43
5.88
9.24
7.5
Notes: This table reports the Johansen-Juselius (1992) trace statistics for the multivariate cointegration tests
conducted on the log of stock market indexes of all twelve markets included in the system. Weekly data is
used. The full period covers 5/01/1988 to 7/09/2004. Intercepts are included in the estimated cointegration
vectors. The small sample correction factor suggested by Cheung and Lai (1993) is applied to all the trace
75

statistics .A lag length of ten was used for all tests. Other lag lengths were tested. The differences between the
results were immaterial. The results are available upon request. The 95% and 90% critical values are obtained
from Osterwald-Lenum (1992). An * indicates rejection of the null of no cointegration at the 10% level, while an
** indicates rejection at the 5% significance level.
5.2.2 Bivariate Recursive Cointegration Analysis
The methodology for the recursive tests is outlined in section 3.3.1. Because there are 416
observations available per series, to ensure the credibility of the results, lags of 10, 30 and 52
were tested. Even when p = 52, there are still some 260 observations on which the test can be
completed, thus the test still maintains significant discriminatory power. The results from the
30 lag tests will be focused upon in the following discussion and all sixty-six graphs can be
seen in Figure 5.2.2 of the Appendix. Some quick explanatory notes about the graphs
presented, allow for easier interpretation. The first observation corresponds to the 2/01/1996
and finishes on the 7/09/2004, the EA crisis occurs around the 90 observation, while
September 11 is observation 298. The trace statistics have been adjusted for small sample bias
and have been standardized by the 95% critical value provided by Osterwald-Lenum (1992),
such that a valued in excess of 1 indicates significance at the 5% level. The abbreviations
used for the different markets are as follows: AU ! Australia, HK ! Hong Kong, ID !
Indonesia, JP ! Japan, KO ! Korea, MY ! Malaysia, NZ ! New Zealand, PP ! The
Philippines, SG ! Singapore, TA ! Taiwan, TH ! Thailand and US ! The United States.
Therefore, the graph TATH is the weekly recursive cointegration test between Taiwan and
Thailand.
Due to the intricate explanation required to properly describe the findings, only those
containing Australia will be discussed in detail, while other important results also deserve
attention. The overall result that can be taken away from all sixty-six graphs is that, the level
of market linkage is extremely volatile over time and can intensify or decline quickly.
Furthermore, without any doubt it can be concluded that the EA crisis and September 11 to a
lesser extent led to an increase in the level of market linkage. Additionally for some markets,
the fear concerning the Y2K bug caused an increase in market segmentation leading up to the
year 2000; however, the evidence seems to suggest that post 2000 markets quickly reverted to
displaying higher levels of market linkage. Lastly, some evidence emerges supporting the
notion that in the build up to the EA crisis, September 11 and the Y2K bug that the level of
76
linkage was frequently below its average levels. These conclusions opens up a completely
new question to be addressed by the literature and that is, are the effects of market
disturbances more long lived and heightened due to the transmission channels between
markets not operating at full efficiency. This question is far to complex and broad to be
covered in this study, but provides and interesting platform for further study to be completed
upon.
The results pertaining to the tests including Australia and the other eleven markets illustrate
some interesting findings. Australias relationship with Hong Kong is only significant at very
few times over the eight-year period. In the build up to the EA crisis, the level of linkage
increased substantially to its highest before rapidly declining prior to the EA crisis. Following
the crisis, the relationship increased dramatically and attained significance several times in the
following months. In the lead up to the year 2000, the markets displayed a visible lack of
linkage. However, almost immediately into the new year the relationship experienced a
considerable upsurge. This evidence tends to suggest that the fear surrounding the Y2K bug
had a noticeable impact upon markets behaviour. The events of September 11 had an almost
identical effect upon the level of market linkage as the EA crisis did. Pre- September 11,
linkage was relatively low; however almost immediately following the attacks the strength of
the relationship nearly doubled and was significant for an extended period of time (2-3
months). Post- September 11 the intensity declined dramatically, but in the last year has once
again experienced a sizeable increase and a return to significance.
The results for Australia and Indonesia and Australia and Japan, both demonstrate an upward
trend. Prior to the year 2000, Indonesia displayed no significant long run market linkage with
Australia. In the post 2000 period, there has been considerably strong linkage between the
two markets, with a significant relationship being evident constantly for almost the last two
and a half years. For Japan, a similar relationship is found, instead though it appears that
September 11 acted as a catalyst behind increasing the level of association. This result is
mirrored by the GVD results that finds the amount of variance explained by Japan
considerable increase post- September 11. Significant linkage can be seen to have been
present for around the last 130 weeks between Australia and Japan.
77
The importance of the Korean market in regard to Australia can be seen to have increased
gradually over the last eight years. The three events (EA crisis, y2k and September 11) all
seem to result in considerable spikes in the cointegrating relationship. The relationship
displays brief significance post y2k, but quickly deteriorated, before the events of September
11 sparked a marked increase in the level of linkage. The connection continued to be
significant to the end of the sample period, with only small periods of insignificance. The
GVD results exhibit a comparable pattern, showing an increase of 7.5% from the pre- EA
period to the post- September 11 sample.
Malaysia and Australia do not demonstrate any long periods of significant linkage over the
past eight years besides the last couple of months. Again, the three events discussed above all
produce noticeable spikes in the cointegrating relationship, at times to such an extent to cause
brief significance. The connection between Australia and New Zealand exhibits an
unexpected amount of volatility. For the first 250 observations, there is an obvious upward
trend in the relationship and shows sporadic significance over a 60-week period. However,
the decline was swift and by week 300, the intensity had more than halved. Since the decline,
September 11 caused a sharp rise but no significance, while in the last year there has been a
considerable reduction in the strength of the relationship. The GVD produces a result that
describes this relationship almost exactly. In the post- EA/pre September 11 period
Australia accounts for 13.19% of the forecast error variance in New Zealand, while New
Zealand explains 12.71% of the Australian variance. In the post September period Australia
accounts for only 7% in new Zealand and New Zealand a considerably smaller 4.43%.
Immediately preceding the EA crisis the level of association between Australia and the
Philippines is almost negligible. Like other results, the EA crisis caused the relationship to
undergo a considerable change. Even though the spike was only temporary, the underlying
level of linkage remained quite high. Almost simultaneously, following the new year in 2000,
the level of linkage tripled and fir the first time displayed significance. From the time since,
the relationship has continued to expand and a considerably high concentration of linkage is
apparent. On the back of extensive and robust growth, it is not surprising that Australia and
Singapore have become linked to one another. The relationship can best be described as
spasmodic expansion followed by an immediate decline then a period of static followed by
another jump in the intensity and such the cycle continues. The driving forces behind the
78
spasmodic increases are the three major events as described above. However, only in the past
year has a significant relationship been realized. The GVD results provide further
corroborating evidence to support the gradual increase in linkage between the two markets.
Australia and Taiwan have been significantly linked to one another briefly at several times
over the sample examined. The first period followed the EA crisis, while the other two
periods of significance can be directly attributed to the passing of the y2k bug and September
11. Thailand and Australia displays an almost identical relationship as to Australia and
Taiwan, that is, the three periods over significance are driven by the three events already
mentioned. In the last year, the relationship for both markets and Australia has remained
robust, but still insignificant.
Lastly, the result between Australia and the US as per expectations has been remarkably
strong during the sample period. The strong association with the US began in early 2000 as
the fears surrounding the Y2K bug subsided. Almost immediately, the relationship
experienced a dramatic appreciation. For the next three and a half years the US and Australia
were significantly linked to one another. It has only been since September 2003 that
significance has been lost. An interesting observation is the relatively small affect of
September 11 compared to the EA crisis and Y2K bug.
5.3 Persistent Profile Analysis
Section 5.4 outlines the methodology required to estimate persistent profiles. The first
condition is to ensure the variables are integrated of the same order. The result of ADF and
PP tests for stationarity can be seen in Table 4.1. For all twelve markets, the null hypothesis
of non-stationarity for stock prices could not be rejected for the full sample period as well as
the three sub periods. The null hypothesis of non-stationarity is rejected in all cases for all
periods for the differenced data. Thus, the condition of being integrated of the same order is
satisfied.
As outlined in section 3.3.1, the JJ test for cointegration is performed. Table 5.3 displays the
results from the multivariate JJ cointegration tests conducted on the full sample. The presence
79

Table 5.3 Cointegration Test Results for the presence of LongRun Equity Market Linakge in the Pacific-Basin
Null
Adjusted Trace Statistic
Critical Value
full
period
pre EA
post EA
95%
90%
r=0
392.90** 360.71**
388.22**
340.39 333.26
r1
304.66** 292.6**
304.63**
291.4 281.63
r2
245.77**
229.7932
236.956 244.15 237.35
r3
197.47*
182.4899 184.5456 202.92 196.66
r4
155.37
144.3046 133.9664 165.58 159.74
r5
113.56
108.9757 100.4413 131.7 126.71
r6
81.87
79.86194 69.35261 102.14 97.17
r7
56.89
56.06952 43.93166 76.07
71.66
r8
39.4
35.89299 29.65278 53.12
49.91
r9
24.8
20.8248 18.73039 34.91
31.88
r 10
13.82
12.37812 19.50358 19.96
17.79
r 11
6.29
4.494546 3.973298
9.24
7.5
of three cointegrating vectors48 can be identified. Similar results are found for the pre and post
EA crisis period. Unlike the short run measures, the multivariate tests for cointegration
consume a considerable number of degrees of freedom. As a result, it makes the sample too
small to accurately conduct the tests on the three sub samples.
The results from the PP for the full period are contained in the Appendix in Figure 5.3a, 5.3d
and 5.3e. The cointegration tests identify three cointegrating vectors. An alternative
interpretation is that there are nine different stochastic processes in the Pacific-Basin. The
results show that near convergence is achieved after thirty weeks for vectors 1, 2 and 3. The
rate of convergence is very stable, implying a low level of volatility between markets.
Looking at Figure 5.3b, 5.3d and 5.3e the PP for the pre-East Asian crisis period can be seen.
The results show that cointegrating vectors obtains near convergence after 20 weeks.
Cointegrating vector two is faster to revert to equilibrium with over 95% of convergence
completed after thirty fifteen weeks. Like the results for the full period, convergence for the
pre-EA crisis period occurs steadily, thus indicating low volatility is the system.
Figures 5.3c, 5.3d and 5.3e show the PP for the post-EA period. The notable difference is the
in the speed of the convergence. Both vector 1 and 2 achieve over 95% of convergence within
48
Assuming a lag length of 10 is being employed
80
ten weeks. The increased speed in convergence indicates that the markets of the PB became
more efficient and linked to one another following the EA crisis.
5.4 Generalized Impulse Response Functions
Figures 5.4a 5.4g display the results from the GIR functions. As mentioned in earlier
sections generalized impulse functions show how quickly a market reacts and reverts to
equilibrium following a one standard deviation shock in another market. Fast convergence is
an indicator of strong market linkage. A two standard error bound can be observed on all
graphs of the GIR functions. This bound should be interpreted in the following manner. When
the both the bounds are in the positive or negative section of the graph, then it can be
concluded that the response by market A to a shock in market B is significant. The situation
when both bounds are not in the same region indicates an insignificant response. This can
indicate two vastly different situations. The first is that market A is not linked to market B
and therefore does not respond to the disturbance. The alternate interpretation is that the
response is so fast that it cannot be discerned using weekly returns. For the full period and
the three sub-samples, Japan and the US were shocked and the responses observed.
Figures 5.4a and 5.4b show the GIR functions for the full sample period. Looking at the effect
of a shock in the US, most markets exhibit significant reversion after the two-week mark.
Australia, Hong Kong, Japan, Korea, Malaysia, New Zealand and Taiwan display strong
linkage with the US. The conclusion arises from the speed at which the markets converge to
equilibrium. The markets are highly efficient with most of the convergence completed by the
second week and only an immaterial level of noise remaining. These results provide
supporting evidence for the bivariate cointegration tests. From table 5.2, significant
cointegration with the US is evident between Australia, Japan, Korea, Malaysia and Taiwan at
shorter lag lengths.
Singapore and Thailand seem to respond slower with significant adjustments still present after
two weeks. However, this result still reinforces the existence of a noticeable relationship. As
postulated in this thesis, both the Philippines and Indonesia take the longest to return to
equilibrium. The Philippines takes over three weeks, while Indonesia displays significant
responses in the fourth week following the initial shock.
81
Markets in the PB appear to react differently to a shock originating from the Japanese market.
For all markets, the response to a shock originating form Japan is more quickly incorporated
than a shock from the US. The US displays the fastest convergence and the lowest volatility
with full convergence achieved in less than two weeks. . The results pertaining to Australia,
Hong Kong, Korea, Malaysia and New Zealand are not materially different from the
responses to a shock in the US. This finding provides evidence to support the proposition that
more developed markets are linked with one another. It might can argued that the Malaysian
economy is not as advanced as the other four markets discussed above, therefore how can this
finding be explained. The linkage between Malaysia and the US arises from the enormous
amount of capital investment US companies have contributed over the last thirty years. The
relationship with Japan extends from the dominance of the Japanese market in the PacificBasin.
Singapore and Thailand exhibit faster reversion to a Japanese shock, considering all
significant adjustment occurs in less than two weeks. Both the Philippines and Indonesia,
display substantially faster convergence considering no significant corrections take place after
two weeks have passed. This evidence reveals that the markets of the Pacific-Basin
demonstrate a greater level of linkage with Japan than with the US.
The results for the pre-EA crisis period displayed in Figures 5.4c and 5.4d, uncovers some
intriguing results. Figure 5.4d shows the effect of a one standard deviation shock to the US
market. The major conclusions that can be reached from the impulse response functions are
that Hong Kong and Japan completely adjust in less than a week. Australia, Malaysia, New
Zealand, Singapore and Thailand also rank highly considering no significant reaction takes
place after week two. This result is an improvement over the full period result for Singapore
and Thailand. The Philippines displays markedly faster reversion, with only residual noise
present after week 3. No significant convergence takes place by Indonesia, Korea or Taiwan.
This finding is somewhat unexpected considering the strong cointegration results obtained for
Korea and Taiwan, but not for Indonesia that appears to be segmented from the US.
The impulse response functions generated by a shock to the Japanese market are presented in
Figure 5.4c. The results further provide evidence toward the suggestion that the Pacific-Basin
82
has a different relationship with Japan than it does with the US. Hong Kong, Malaysia, New
Zealand, Singapore, Thailand and the US all demonstrate an extremely high level of market
linkage with Japan considering no significant adjustment occurs past week one. Australia,
Korea and Taiwan follow suit and complete any necessary reversion by the end of week two.
In almost all cases, this marks a considerable improvement in the level of linkage compared to
the full period result. Indonesia and the Philippines do not display any significant adjustment
over all time horizons.
In the post-ea/pre-September 11 period the level of the speed of convergence for all markets
improves dramatically. The impulse response functions in relation to a shock in the US are
exhibited in Figure 5.4f. All markets besides Indonesia achieve full convergence in or less
than two weeks. Korea, Malaysia and Taiwan require special mention considering they show
no significant adjustments past week one. This is a noticeable improvement for Korea and
Taiwan whom in the pre- EA period did not display any significant response. Thus, it can be
argued that following the EA crisis, either US investors shifted their attention toward Korea
and Taiwan or vice versa. This result provides convincing evidence towards hypothesis 3A
and 3B, showing that in the period following the EA crisis the level and nature of market
linkage underwent an appreciable change. In opposition to this Indonesia does not
significantly respond to the shock in the US. That is, it appears that following the EA crisis
that Indonesia became even further segmented from the US.
The result of a shock to the Japanese market during this time is similar to that of the US
except for two differences. The first is that the speed of convergence to the shock in Japan is
slightly faster than that originating from the US. Secondly, unlike in the US case, Indonesia
responds quickly and significantly to a deviation in the Japanese market. Phylaktis and
Ravazzolo (2002), who found that the EA crisis reduced the level of global integration but
increased regional (i.e. the Pacific-Basin) integration, support this result.
Finally, the post-September 11 findings are outlined in Figures 5.4g and 5.4h. The obvious
result is the distinct increase in the level of market linkage concerning both markets. When
the US is shocked most markets experience significant reversion in week 1 and only some
noise after. The only other result worthy of mention is the lack of meaningful response by
Indonesia following a disturbance in the US. Hon et al (2004) find that post September 11
83
Indonesia has one of the lowest level of correlation (below 0.13) with the US, while on
average correlation increased between the US and all other Pacific-Basin markets.
The GIR functions for a shock to the Japanese market in the post-ea/pre-September 11period
can be viewed in Figure 5.4g. New Zealand and Taiwan demonstrate the highest level of
market linkage with Japan. The continuing speed at which New Zealand reverts to
equilibrium following a disturbance provides considerable evident to support the proposition
that New Zealand takes its lead from Japan and not necessarily Australia. Australia, Hong
Kong, Korea, Malaysia, Singapore and the US also quickly converge back to equilibrium
following the shock to the Japanese market. The interesting fact to note is that both Indonesia
and the Philippines display significant adjustment for up to two weeks. This finding is in stark
contrast from the result obtained from when the US is shocked and indicates that Indonesia
shifted away from being linked with world markets and became more reliant upon nations in
the Pacific-Basin. Therefore, it can be concluded that following September 11 the level of
market linkage experienced a substantial improvement.
These results provide overwhelming evidence to support hypothesis 2 that is the markets of
the Pacific-Basin are linked to one another in a short run fashion. In addition, the results
obtained form the generalized impulse response functions help to validate the findings of the
bivariate cointegration tests, often finding a significant relationship in both the short and longrun. Furthermore, it provides evidence as to the structure of market linkage both pre and post
market disturbances. The evidence clearly supports hypothesis 3A and 3B. That is, not only
has the relationship between markets in the PB altered over time, but also following market
turmoil the level and structure of market linkage undergoes an evolution. Building on the
point further it is possible that the increase in market linkage in the post-ea/pre-September 11
period led to the events of September 11 not having such a significant impact because markets
had become more efficient and therefore the shock passed through faster. Possibly a more
credible argument is that, as suggested by the evidence and past empirical work that the PB is
not as strongly linked with the US as it is with itself.
84

5.5 Generalized Variance Decomposition
the generalized variance decomposition was completed using TSP. As discussed in section
3.3.3 the computations were completed for the full period and three sub-samples. The results
of the analysis can be observed in Panel A D of Table 5.5.
The results from all four periods provide some interesting findings. The results from the full
period show that Hong Kong, New Zealand, Singapore and the US strongly influence
Australia. Furthermore, at the 20-week horizon foreign markets explain 63% of the variance
in Australia. This evidence clearly displays the high level of market linkage between Australia
and the Pacific-Basin in the short run. Hong Kong is found to be even more exogenous than
Australia, with over 68% of its variance explained by other Pacific-Basin economies. As per
expectations, Australia is found to account for about 9% of the variance in Hong Kong, while
Singapore contributes around 12.75%. Malaysia, the Philippines and Thailand are also worthy
of mention, explaining 7.52%, 6.84% and 7.23% (at the 20-week horizon) respectively.
Indonesia is found to be highly endogenous accounting for 58% of its own variance. This
result complements the findings from the impulse response functions. Additional evidence to
support this conclusion comes from the fact that the Philippines contribute 40.5% to its own
variance.
On the other hand, Japan and the US are not as endogenous as would have been thought. At
the 20-week horizon, all other markets explain 54% of the variance for Japan and 55% for the
US. Several markets make material contributions to the variance of Japan; they include
Australia (6.63%), Hong Kong (6.89%), Korea (5.89%), Singapore (8.16%) and the US
(6.89%). For the US, Australia (10.84%), Hong Kong (7.47%), Japan (6.6%) and Singapore
(6.7%) are all important markets.
Malaysia and Singapore, like Australia and Hong Kong are highly exogenous, only
accounting for 37.75% and 31.19% of their own variances. Furthermore, the well-documented
relationship between Singapore and Malaysia is highlighted by the results. Singapore explains
10.94% of the variance in Malaysia, while Malaysia accounts for 8.67% of variance in
85
Singapore. In both markets, Hong Kong plays a critical role, while the contribution from
Thailand should not be underestimated49.
Korea and Taiwan display considerable endogeneity over the full period. Korea is responsible
for 45.59% of its variance, while the contribution of Taiwan to itself is an incredible 61.25%
after week 1 and 55.84% at week 20. Again, Hong Kong and Singapore are vital to both
markets, explaining some 9.34% and 8.43% in Korea and 5.89% and 6.04% in Taiwan
respectively.
The market of New Zealand is somewhat endogenous, while Thailand for a developing
market is quite exogenous. The only note worthy result pertaining to New Zealand is that
Australia is responsible for over 14% of the forecasted error variance. Hong Kong (9.21%),
Malaysia (8.92%), Singapore (8.13%) and Taiwan (11.19%) all considerably influence
Thailand.
The pre- EA results are similar to the generalized impulse response functions, that is, markets
are far more endogenous and not linked during this time. In terms of the GVD, it essentially
means that markets explain more of their own variance and less of each others. Australia
explains material levels of variance in Hong Kong (6.61%), Japan (5%), New Zealand
(13.14%) and the US (9.41%), while Hong Kong, Malaysia, new Zealand, Singapore and the
us are discussion all these levels are down compared to the full period results. Not
surprisingly, Australia accounts for more than 13% of the error variance for New Zealand.
Besides Australia, the only other country to explain any other material amount in New
Zealand is the US. The conclusion that can be drawn from these results is the effect of close
economic relationships on the level of market linkage. The four countries mentioned above
represent the major trading partners of one another in the pre-ea period.
The endogeneity of Indonesia is even further exacerbated in the pre EA sample. Even after
20 weeks, Indonesia still accounts for 69.26% of its own variance, while no other market
accounts for more than 5% and it explains no more than 3% in any other market. Similar to
Indonesia, Japan also demonstrates considerable independence. However, it is essential to
49
For Malaysia, Hong Kong explains 9.49%, while Thailand accounts for 9.22%. In the case of Singapore, Hong
Kong contributes a staggering 12.93% and Thailand a considerable 8.86%.
86
note that during the period being examined that Japan at times was the largest equity market
in the world and therefore is expected to display a certain level of segmentation. This same
argument is also applicable to the US. However, unlike Japan significant contributions are
made by individual countries including Australia (9.41%), New Zealand (5.61%) and
Singapore (6.25%).
Both Korea and Taiwan display a distinct lack of integration, with each market contributing
over 59% of their own variance. The only country worthy of mention is Singapore, which has
the greatest level of explanatory power in both markets. The level of fragmentation restricts
the contributions made by Korea and Taiwan to other markets in the Pacific-Basin to below
5%.
Hong Kong is found to exert considerable influence over Malaysia, the Philippines, Singapore
and Thailand, while all four markets explain more than 5% of the forecasted error variance in
Hong Kong. In addition, it must be noted that the other four other markets are the largest
contributors to the variance decomposition of one another beside that explained by the
domestic market. The evidence supports the notion that these five markets form a bloc within
the PB.
As has been noted in the previous sections, the EA crisis caused a significant transformation
of relationships in the PB. This conclusion is further supported by the results outlined in table
5.5 panel C. The overriding finding is that markets explain considerably less of their own
variance and are explained noticeably more by foreign markets.
Some of the most compelling results from the post ea crisis include, the incredible change in
the Korean and Taiwan markets from being endogenous to being more exogenous than
several other markets. Korea established strong links with Australia, Hong Kong, Japan, the
Philippines, Singapore and most importantly the US. This result almost exactly mirrors the
relationship found to exist between Korea and the US from the impulse response functions
presented in section 5.4. Taiwan on the other hand demonstrates considerable influence over
Korea and Japan, while Hong Kong, Japan, Korea, the Philippines and Singapore all make
sizeable contributions towards the forecasted error variance of Taiwan.
87
The proposed bloc between Hong Kong, Malaysia, the Philippines, Singapore and Thailand
seems to be weakened in the post EA period. The main change seems to be related to
Malaysia whose orientation moves away from the four markets towards Australia, Korea, new
Zealand and the US. However, the other four markets still display above average levels of
market linkage.
The level of independence shown by Japan and the US continued to decline, to such an extent
that they became more exogenous than other smaller markets in the PB. It is also interesting
to see that in the case of Japan that the US is the most important market, while for the US,
Japan ranks second behind Australia. Meanwhile, the strong relationship between Australia
and New Zealand continued to be evident.
The level of segmentation of Indonesia and the Philippines between the markets in the PB
decreased substantially. The level of integration of the Philippines increased to such an extent
that it is responsible for explaining more than 7% of the variation in 10 out of 11 other
markets. Indonesia does not display the same increase in market integration, but still
demonstrates significant improvement.
The other standout discovery is the reaction of Malaysia to the EA crisis. The amount of
variance explained by itself for the 1, 5 and 10-week horizon after a shock on average is
greater than that in the pre EA sample. Furthermore, as discussed above the Malaysian
market appeared to shift away from the group of markets including Hong Kong, the
Philippines, Singapore and Thailand and toward Korea and New Zealand. This could have
been the result of Malaysia introducing capital restrictions in the wake of the EA crisis, or a
structural shift in the economy or trading partners.
The post September 11 period highlights how the markets of the PB have become
increasingly dependent upon each other. For all 12 markets at the 20-week horizon the level
of forecast error variance in the domestic market, explained by the domestic market does not
exceed 24%. The credibility and significance of this result should not be underestimated. It
shows that the level of market linkage in the PB is not the result of a spurious correlation.
Instead, the increase in intensity can be traced back to a systematic reduction in barriers that
has led to immeasurable changes in the region. The results from this sample are extremely
88
interesting considering that this thesis uses data for up to September 7, 2004, and therefore is
likely to highly relevant to the current market environment. All the figures referred to in the
analysis can be observed in table 5.5 Panel D.
The composition of markets affecting Australia post September 11 is markedly different
from that from previous periods. The importance of Hong Kong, New Zealand, and the US
have declined,50 while Japan, Korea, Singapore and Taiwan have assumed greater meaning51.
Hong Kong experienced a comparable shift in composition. Japan, Korea, Singapore and
Taiwan consolidated their positions as being markets of considerable importance to Hong
Kong, while Australia and the Philippines suffered a reduction in their level of influence52.
Following the events of September 11, a valid argument supposing that Indonesia is one of
the most exogenous markets in the PB. This conclusion appears to be in direct opposition
with the results from the GIR. However, a more careful inspection finds that both of the
results actually complement one another. The critical point to remember is that in the impulse
response functions only the Japanese and US markets were shocked. After examining the
figures from table 5.5 panel D, it is clear to see that the involvement of the US in Indonesia is
considerably lesser than that of Japan. This result supports the findings from the GIR
function, which found Indonesia to be linked with Japan, but not the US. Nearly identical
proof is found for the Philippines, that is, the variance decomposition shows a stronger
relationship with the US than with Japan, as per the GIR functions.
In the post-September 11 world, the effect of the US over markets in the PB is not as
influential as it once was. For all 11 cases, the level of forecast error variance explained by
the US does not surpass 10%, and only averages 5.94%. By contrast, the Japanese market
becomes highly influential, it describes over 10% of the forecast error variance in Australia,
Hong Kong, Korea, Malaysia, Singapore and Taiwan and averages over 7.5% for all markets.
50
The decrease in the amount of forecasted error variance explained by New Zealand in the post September 11
sample is around 10%, while for the US and Hong Kong around 1% depreciation is recorded.
51
The increase in the contribution attributable to Japan is around 4.5%, Korea 1.5%, Singapore 5.2% and
Taiwan a substantial 6%.
52
The Philippines declined by more than 7%, while the decrease in Australias explanatory power was only
marginal
89
The markets of Korea and Taiwan continued to expand their influence over the PB region.
They both contain substantial explanatory for several markets and display a high level of
linkage between themselves. It is also interesting to note the connections concerning Taiwan
and Australia and the US. In the post-EA period, neither market exerted material influence
over Taiwan. However, post- September 11 and the relationship dramatically changed with
Australia accounting for 11.31% and the US 8.16% respectively. The combination of Korea
and Taiwan represents one of if not the most influential pairing in the PB following
September 11. this is extremely intriguing considering their beginnings as closed endogenous
markets. The findings that have been discovered for Taiwan supports the decision by the
Taiwan government to focus its attention toward the PB53.
Malaysias position in the PB following September 11, is one of a market that is considerably
influenced by the markets of Australia, Hong Kong, Japan, Singapore and Taiwan, while
displaying noteworthy explanatory power in the forecast error variance of Japan, Singapore,
Taiwan and the US. For New Zealand, September 11 greatly affected its relationships with
markets in the PB. The major role filled by Australia in the past was replaced by a
combination of Hong Kong, the Philippines, Singapore, Taiwan and the US.
Since the events of September 11, Singapore has continued to mature in its role as a market
leader in the PB. Singapore is found to be the second most exogenous market (only
marginally trailing Hong Kong) and one that accounts for substantial proportions of the
forecast error variance in nearly all markets, averaging of 9.5% of the variance for all 11 other
markets. Unexpectedly, the lowest level variance provided by Singapore is for Malaysia.
However, this result should not be that surprising for the following reason. Prior to the EA
crisis, the linkage between the markets was the strongest between any of the other 66 pairs.
Through the early-mid 1990s, a number of factors changed that drove a wedge between the
two. As the Malaysian economy became more sophisticated, it depended less upon Singapore,
subsequently their linking relationship diminished. The EA crisis then swept into Malaysia
and forced numerous reforms. The reforms attempted to restrict the level of integration of
Malaysia with the world. In addition, the level of market linkage has never reached the levels
prior to the EA crisis.
53
This is actually discussed in section 3.2
90
When the results from the GVD are examined in an overall context, a credible and convincing
set of conclusions can be drawn. The first refers to H2, which postulates the existence of
market linkage in the short run. After conducting the four sets of tests, it can clearly be
observed that the degree of market linkage in the PB over the short-run is exceedingly high
(especially in the post September 11 period). Further evidence from the findings allow the
conclusion that the linking relationship has altered through time and once more, has
experienced an appreciable increase following a period of market turmoil.
5.6 Block Exogeneity Tests
Four sets of block exogeneity tests were completed, the results of which can be seen in Panel
A D of table 5.6. As discussed in previous sections, block exogeneity tests are just the
extension of bivariate Granger causality tests to a multivariate system. The presence of
Granger causality can be interpreted two different ways. The first is that if market A causes
market B it can be said that market A leads market B. The alternative explanation is that if
market A causes market B, then it can be concluded that market B is efficient as it reacts to all
available market information, including that of market A. The first option is likely to apply
when if the US is found to cause Thailand, while the second explanation is more likely if
Thailand is found to cause the US.
The main results that come from the exogeneity tests are that:
1. In the full period the smaller less developed markets of Indonesia, Malaysia, New
Zealand, the Philippines and Thailand all have returns caused by several different
markets. Also for all the countries mentioned above when all markets are excluded
from the equation the evidence suggests that the Pacific-Basin as a whole holds
information for these markets. It is also interesting to note that Japan, Korea and
Taiwan are caused by some markets. However, considering the size of the Japanese
market it is likely that these countries arent causing returns in Japan, rather than
Japan responding to the news from those markets.
2. In the pre EA period the very few cases of causality does not warrant discussion,
except for one surprising result that finds the US is significantly affected by the
91
Pacific-Basin as a whole. This is likely to mean that in this period the US was
sensitive to information originating from the Pacific-Basin
3. Japan again is affected by several markets in the post EA similar to how it was in
the full period. Except this time Australia and the US are found to cause returns in
Japan. Even though Australia is a large developed market it would still is thought
that it does not cause returns in Japan. However, it would be argued that the US
does lead Japan in the post EA period. The other interesting point to make is that
seems that Indonesia is significantly influenced by Australia, Korea, Malaysia and
New Zealand.
4. The most interesting results from the block exogeneity results come from the post
September 11 period. Australia, Hong Kong, Japan and the US are all caused by
much smaller markets that just arent big enough to have a material effect over these
four markets. However, what it dies indicate is that Australia, Hong Kong, Japan
and the US have become more efficient post September 11 such that they react to
sources from information even from the smaller markets.
5.7 Regression Analysis
The cross sectional analysis from the OLS model is contained in panel A D of table 5.7.
Four different dependent variables are tested in the OLS model. Trace1 is the average trace
statistic from the weekly recursive tests with 10 lags, while Trace2 is from the test with 30
lags. Eigen1 and Eigen2 are the eigen values from the respective tests. For the probit model,
the values are restricted to take a value of either 1 or 0. From the tests for when p = 10,
Australia and Hong Kong was found to be cointegrated 0 times. The average number of
cointegrating vectors discovered over the 66 pairs was 58.3. Therefore, in this situation the
pair between Australia and Hong Kong would get a value of 0. That is, a value of 1 is given
when the number of cointegrating vectors for a pair exceeds the average number of
cointegrating vectors over the 66 pairs. This method is used to compute Pr1 and Pr2 (is based
on tests when there are 30 lags).
In three out of four cases, the ASEAN dummy is positive and significant, while in two cases
the interest rate trace is found to be negative and significant. A negative coefficient for the
interest rate trace statistic is unexpected. Location is found to be highly significant in all four
92
tests, and displays positive correlation with market linkage instead of the predicted negative
relation. This result can be explained quite easily, after examining the data the longest
distances between markets always is the distance between themselves and the US. Since the
US is the largest market in the world, and as discovered in the previous section is open to
other markets, then it would be expected that there is high market linkage between the
countries of the PB and the US, thus biasing this variable upward.
The variable sdiff is found to be strongly negative in all the regressions. The discussion
regarding the construction of this variable in chapter 4, predicted that a negative relationship
should be discovered. The turnover ratio is also found to be significant and negative as
predicted in an earlier section. The size dummies, display mixed results. From a theoretical
perspective the dummies both are as expected. That is, the large dummy has a positive
(although not significant) coefficient while the small group is negative. The results from these
variables demonstrate the importance of market development regarding market linkage. The
OECD dummy was found not to be significant in any model and appears to not be fitting with
the other variables. Therefore, in the multivariate tests it was not included.
Unexpectedly the industrial production trace is found to be negative and only significant in
one regression. This result is likely for the inability of the proxy to properly capture the
information it was supposed to. Keeping in mind that this section is highly experimental then
any results serve as an interesting platform for further work to launch from. In contrast to the
contagion hypothesis the volatility between markets is likely to cause a decline in the level of
market linkage volatility gets higher. This indicates that investors will try to stay away from
markets that are characterized by high volatility. Only the probit results for the multivariate
model is discussed, because of the immaterial difference with the OLS results54. Six
regressions were conducted for pr1 and pr2, an example of the output is provided below:
pr1
coefficient
t-stat
std err
std dev
%
R
54
intercept
-3.010
-2.124
1.417
aseand
1.956
2.763**
0.708
0.361
0.707
exvol
-4.423
-0.009
516.633
0.001
-0.002
Extract of table 5.7

iptrace irtrace
location
-0.044
0.059
0.000
-1.504
1.509
2.940**
0.029
0.039
0.000
9.023
7.790
4670.089
-0.395
0.459
1.214
vol
885.111
1.135
779.679
0.001
0.474
ldum
0.857
1.716
0.500
0.422
0.362
sdum
-0.198
-0.390
0.507
0.422
-0.084
0.432
The results are available upon request.
93

pr1
intercept aseand
exvol
iptrace
irdiff
Location
vol
ldum
sdum
coefficient
-1.230
2.011 691.121 -0.015 -0.075
0.000
106.723
0.680
0.184
t-stat
-1.199
2.843**
0.897
-0.606 -0.756
2.674**
0.156
1.458
0.400
std err
1.026
0.707 770.853 0.025
0.100
0.000
685.361
0.466
0.460
std dev
0.361
0.001
9.023
7.790
4670.089
0.001
0.422
0.422
%
0.726
0.387
-0.136 -0.586
0.782
0.057
0.287
0.078
R
0.408
Notes: The results above are produced from a probit regression where pr1 is the dependent variable
and the independent variables are the same as those described in section 3.5. The t-stats have 55
degrees of freedom and at the 95% level the critical value is 2.0040 and 1.673 at the 90% level.
The full results are contained in table 5.7. In both the OLS and probit models the ASEAN
dummy was found to be postivie and significant. This result is credible as trade and economic
integration is likely to substantially affect the level of market linkage. Excahnge rate volatility
is found to be significant in eight of the OLS regressions, but not in the probit model. The
sign is almost always found to be positive. This indicates that the level of linkage increases in
the face of higher exchange rate volatility. As argued in chapter 3, greater exchange rate
volatility is likely to result in greater levels of trade and capital flowing between countries.
The trace statistic from the cointegration tests on the industrial production statistics is found
not to be significant in any of the cases. Again, this relationship can be attributed to the proxy
for goods market linkage, that is, the trace statistic appears not to be an appropriate proxy.
From the OLS regression the interest differential was significant in the majority of cases and
negative in all cases. This result provides evidence to support the PVM proposition, that is, a
higher differential will lead to a greater differential in prices and therefore reduce the level of
market linkage between markets. Location like the ASEAN dummy is one of the most
significant variables. Again, the slope is always positive. However, as discussed above this
result can be easily accounted for. The large market dummy was significant and positive in a
number of cases. This result is as per the predictions of this thesis. That is, the larger markets
are linked to one another, but display lower levels of linkage with the smaller markets. The
small market dummy again was found to be significant in the bulk of cases and the coefficient
was negative. This result was also not surprising as it would be thought that the small markets
might be linked with a medium to large country, but not another developing market.
While it appears that the regression results are not persuasive, the adjusted R squared provides
evidence to the contrary. In most regressions (both the OLS and probit) the R squared
94
exceeded 40%, indicating that the factors may not be significant individually, they still have
considerable explanatory power. Lastly, examining the % statistic gives an indication of the
economic significance of the variable. Location is found to be the most economically
significant variable. The ASEAN dummy also was economically significant, while the
interest rate trace and interest rate differential were alos found to be economically significant.
The remainder of the results is too erratic to be able to accurately interpret. However, it must
be noted that the testing procedures and proxies employed in this section were completely
original and experimental. The magnitude of the R squared statistics does still indicate that
the model is capturing a considerable amount of variation in market linkage.
95
CHAPTER 6CONCLUSION
CHAPTER 6: Conclusion
6.1 Contribution
As per the discussion in section 1.3, this thesis aimed to add to the current academic literature
in three aspects:
1. Are the equity markets of the Pacific-Basin region linked to one another in either the
short or long run;
2. If so, has this relationship varied over time; and
3. Which variables have been responsible for markets becoming more integrated with
one another
The actual contribution made regarding the first proposition is the undeniable level of
evidence produced that unequivocally establishes that the equity markets of the Pacific-Basin
demonstrate a certain level of interaction in both the short and long run. The use of recursive
bivariate cointegration provides the most accurate and complete picture of the structure of the
market linkage in the Pacific-Basin constructed to date. Furthermore, the results from this
thesis are made even more compelling due to all test statistics being adjusted by a small
sample bias correction. Therefore, the results generated by this thesis are extremely robust
and allows credible conclusions to be drawn from them. . The use of three methods to
establish the short run market linkage ensures a complete analysis of the subject.
Like the first proposition, this thesis provides overwhelming evidence that the level of market
linkage varies through time. The recursive bivariate tests provides some of the most
persuasive evidence in regard to the current literature. The use of the dummy variable analysis
in regard to the Pacific-Basin markets has not previously been employed. The inclusion of
this methodology was validated by the results produced from it. The persistent profile
analysis showed that the speed at which prices in the Pacific-Basin converge back to
equilibrium is significantly higher in the post- EA crisis period. All three short run measures
for substantial evidence to suggest the relationship has altered over time and in fact grown
stronger.
The evidence presented in relation to the final proposition was not as strong as that provided
for propositions 1 or 2. However, it still did make several contributions that could be used to
96
CHAPTER 6CONCLUSION
guide future research. First off it must be noted that the testing procedure implemented in this
thesis is completely original and experimental. That is, no previous works have used trace
staitistics or eigenvalues to proxy for the level of market linkage. Secondly, the applicaiton of
a probit model has not previously been used or propsed in the context of marklet linkage.
While some of the independent variables in this study were influenced by other pieces fo
literature, ultimately they too are unique to this study. Considering, the level of
experimentation surrounding this final proposition the fact that outstanding results were not
obtained should not come as a surprise.
6.2 Limitations
While the section above outlined the strengths of the results obtained in this thesis, there still
exists ample room for improvement in this study. The first and probably most obvious
limitation of this study was using weekly prices over a sixteen-year period. After completing
this thesis, it has been made obvious that when considering cointegration weekly data is
acceptable, but daily data is preferred. The use of daily data would have enabled an even more
robust examination of market linkage in the Pacific-Basin. The effect of having a small
sample severely limited the use of multivariate cointegration tests.
While this thesis presented a number of propositions regarding the direction of the
cointegration between markets it is not formally tested by imposing restrictions upon the
cointegrating vector. A detailed examination on the cointegrating vectors would be quite
interesting.
This thesis did not explicitly consider the impact of other major market disturbances, such as
the Russian default, both Gulf Wars, or effect of the Y2K bug. It is possible that it was one
of these events driving the results rather than those presented in this thesis. Furthermore, the
results pertaining to September 11 could be underestimated because there is only three years
of data available.
There are a number of other variables that could be employed in the final analysis that could
be more important than the variables proposed in this study. Other variables that could be
97
CHAPTER 6CONCLUSION
included are trade and capital flow statistics, sovereign debt ratings, level of unemployment or
inflation. These are also many others could be included.
6.3 Further Research
The area of market linkage has been extensively studied in the current literature; however
there still exist a number of areas that require further examination. The first is the inability of
this thesis and the current literature to explain the level of market linkage between national
equity indices. The question as to what causes market linkage is an important question and
deserves further attention.
Some of the limitations discussed above also open up new avenues for future research. The
identification of the cointegrating vectors would constitute a significant development in the
field. While the use of OLS and probit is adequate, there are other more robust methods such
as GMM that could be employed.
There exists a unique chance at the moment to be able to study the integration of the Chinese
market into the world economy. Considering, the size and importance of China, it would be
interesting to see how it merges into the Pacific-Basin.
98
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30,
4854.
102
Figure 5.2.2 All sixty six graphs of the weekly recursive bivariate cointegration tests
1.2
1.4
1.1
1.4
1.2
1.2
1.0
1.0
0.9
1.0
0.8
0.8
0.8
0.7
0.6
0.6
0.6
0.4
0.5
0.4
0.2
50
100
150
200
250
300
350
400
450
0.4
50
100
150
200
AUHK
250
300
350
400
450
50
100
150
200
AUID
300
350
400
450
300
350
400
450
AUJP
1.4
1.6
1.4
1.2
1.4
1.2
1.2
1.0
250
1.0
1.0
0.8
0.8
0.8
0.6
0.6
0.6
0.4
0.4
0.4
0.2
0.2
50
100
150
200
250
AUKO
300
350
400
450
0.2
50
100
150
200
250
AUMY
300
350
400
450
50
100
150
200
250
AUNZ
103
1.6
1.4
1.8
1.4
1.2
1.6
1.2
1.4
1.0
1.0
1.2
0.8
0.8
1.0
0.6
0.6
0.8
0.4
0.4
0.2
0.6
0.2
100
200
300
400
0.4
100
200
AUPP
300
400
100
200
AUSG
1.4
400
300
400
AUTA
2.4
1.2
300
1.6
1.4
2.0
1.0
1.2
1.6
0.8
1.0
0.6
1.2
0.8
0.4
0.8
0.2
0.0
0.6
0.4
100
200
300
AUTH
400
0.4
100
200
300
AUUS
400
100
200
HKID
104
1.1
1.1
1.1
1.0
1.0
1.0
0.9
0.9
0.8
0.8
0.7
0.7
0.6
0.6
0.6
0.5
0.5
0.5
0.4
0.4
0.9
0.8
50
100
150
200
250
300
350
400
450
0.7
0.4
0.3
50
100
150
200
HKJP
250
300
350
400
450
0.2
50
100
150
200
HKKO
2.4
1.4
2.0
1.2
1.6
1.0
1.2
0.8
0.8
0.6
0.4
0.4
250
300
350
400
450
300
350
400
450
HKMY
1.2
1.1
1.0
0.9
0.8
0.7
0.6
0.0
0.5
0.2
50
100
150
200
250
HKNZ
300
350
400
450
0.4
50
100
150
200
250
HKPP
300
350
400
450
50
100
150
200
250
HKSG
105
2.0
1.6
1.2
1.8
1.1
1.6
1.0
1.4
0.9
1.2
1.2
0.8
1.0
0.7
0.8
0.8
0.6
0.4
0.5
0.6
0.4
0.4
0.3
0.0
50
100
150
200
250
300
350
400
450
0.2
50
100
150
200
HKTA
250
300
350
400
450
0.9
0.6
IDJP
350
400
450
350
400
450
0.4
0.3
0.0
300
300
0.5
0.2
250
450
0.6
0.4
0.2
400
0.7
0.4
0.3
350
0.8
0.6
0.5
300
0.9
0.8
0.7
250
1.0
0.8
200
200
1.1
1.0
150
150
HKUS
1.2
100
100
HKTH
1.0
50
50
0.2
50
100
150
200
250
IDKO
300
350
400
450
50
100
150
200
250
IDMY
106
2.0
1.6
1.8
1.8
1.6
1.6
1.4
1.4
1.2
1.2
1.2
1.0
0.8
1.0
0.8
0.8
0.6
0.4
0.6
0.4
0.2
0.0
50
100
150
200
250
300
350
400
450
0.4
50
100
150
200
IDNZ
250
300
350
400
450
50
100
150
200
IDPP
1.1
1.0
300
350
400
450
300
350
400
450
IDTA
1.4
1.8
1.2
1.6
0.9
1.4
1.0
0.8
250
1.2
0.7
0.8
1.0
0.6
0.6
0.8
0.5
0.4
0.4
0.6
0.2
0.3
50
100
150
200
250
IDSG
300
350
400
450
0.4
50
100
150
200
250
IDTH
300
350
400
450
50
100
150
200
250
IDUS
107
.9
1.2
1.4
.8
1.0
1.2
0.8
1.0
0.6
0.8
0.4
0.6
0.2
0.4
.7
.6
.5
.4
.3
0.0
.2
50
100
150
200
250
300
350
400
450
0.2
50
100
150
200
JPKO
250
300
350
400
450
50
100
150
200
JPMY
1.0
0.9
250
300
350
400
450
300
350
400
450
JPNZ
1.4
1.4
1.2
1.2
1.0
1.0
0.8
0.8
0.6
0.6
0.4
0.4
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.2
50
100
150
200
250
JPPP
300
350
400
450
0.2
50
100
150
200
250
JPSG
300
350
400
450
50
100
150
200
250
JPTA
108
1.2
1.6
2.0
1.4
1.0
1.6
1.2
0.8
1.2
1.0
0.6
0.8
0.8
0.4
0.4
0.6
0.4
0.2
50
100
150
200
250
300
350
400
450
0.0
50
100
150
200
JPTH
250
300
350
400
450
50
100
150
200
JPUS
1.2
250
300
350
400
450
300
350
400
450
KOMY
1.1
.7
1.0
1.0
.6
0.9
0.8
0.8
.5
0.7
0.6
0.6
0.4
.4
0.5
0.4
0.2
.3
0.3
0.2
0.0
50
100
150
200
250
KONZ
300
350
400
450
.2
50
100
150
200
250
KOPP
300
350
400
450
50
100
150
200
250
KOSG
109
.8
.7
.6
1.0
1.3
0.9
1.2
0.8
1.1
1.0
0.7
.5
0.9
0.6
0.8
0.5
.4
.3
0.7
0.4
0.6
0.3
0.5
0.2
.2
50
100
150
200
250
300
350
400
450
0.4
50
100
150
200
KOTA
250
300
350
400
450
50
100
150
200
KOTH
300
350
400
450
300
350
400
450
KOUS
1.4
1.4
1.6
1.2
1.2
1.4
1.0
1.0
250
1.2
0.8
0.8
1.0
0.6
0.6
0.8
0.4
0.4
0.6
0.2
0.0
0.2
50
100
150
200
250
MYNZ
300
350
400
450
0.4
50
100
150
200
250
MYPP
300
350
400
450
50
100
150
200
250
MYSG
110
2.4
1.0
1.6
2.0
0.9
1.4
0.8
1.2
0.7
1.0
0.6
0.8
0.5
0.6
0.4
0.4
1.6
1.2
0.8
0.4
0.3
0.0
50
100
150
200
250
300
350
400
450
0.2
50
100
150
200
MYTA
250
300
350
400
450
50
1.6
0.9
0.9
1.4
0.8
0.8
0.7
0.7
0.6
0.6
0.5
0.5
0.4
0.4
0.3
0.3
200
250
NZPP
300
350
400
450
250
300
350
400
450
300
350
400
450
1.2
1.0
0.8
0.6
0.4
0.2
0.2
150
200
MYUS
1.0
100
150
MYTH
1.0
50
100
0.2
50
100
150
200
250
NZSG
300
350
400
450
50
100
150
200
250
NZTA
111
2.0
1.6
1.6
2.4
1.4
2.0
1.2
1.2
1.6
1.0
1.2
0.8
0.8
0.8
0.6
0.4
0.4
0.4
0.2
0.0
50
100
150
200
250
300
350
400
450
0.0
50
100
150
200
NZTH
250
300
350
400
450
50
100
150
200
NZUS
2.0
1.6
250
300
350
400
450
300
350
400
450
PPSG
1.4
1.8
1.2
1.6
1.4
1.0
1.2
1.2
0.8
1.0
0.8
0.6
0.4
0.8
0.4
0.6
0.2
0.0
50
100
150
200
250
PPTA
300
350
400
450
0.4
50
100
150
200
250
PPTH
300
350
400
450
50
100
150
200
250
PPUS
112
1.6
1.2
1.4
1.4
1.2
1.0
1.2
1.0
0.8
1.0
0.8
0.8
0.6
0.6
0.6
0.4
0.4
0.4
0.2
0.2
50
100
150
200
250
300
350
400
450
0.2
50
100
150
200
SGTA
250
300
350
400
450
50
100
150
200
SGTH
1.2
1.0
300
350
400
450
300
350
400
450
SGUS
1.8
1.4
1.6
1.2
1.4
0.8
250
1.0
1.2
0.8
1.0
0.6
0.6
0.8
0.4
0.4
0.6
0.4
0.2
50
100
150
200
250
TATH
300
350
400
450
0.2
50
100
150
200
250
TAUS
300
350
400
450
50
100
150
200
250
THUS
113
Figure 5.3a Persistence Profile for the Full period

1.2
Persistence Profile
0.8
0.6
0.4
0.2
0
1
13
17
21
25
29
33
37
41
45
49
53
57
61
65
69
73
77
81
85
89
93
97
101
93
97
101
Weekly Horizons
Full Period CV1
Full Period CV2
Full Period CV3
Figure 5.3bPersistence Profile for the Pre-East Asian crisis preiod

1.2
Persistence Profile
0.8
0.6
0.4
0.2
0
1
13
17
21
25
29
33
37
41
45
49
53
57
61
65
69
73
77
81
85
89
Weekly Horizons
Pre-Asian Crisis CV1
114
Figure 5.3c - Persistence Profile for the Post East Asian crisis period
1.2
Persistence Profile
0.8
0.6
0.4
0.2
0
1
13
17
21
25
29
33
37
41
45
49
53
57
61
65
69
73
77
81
85
89
93
97
101
89
93
97
101
Weekly Horizons
Post-Asian Crisis CV1
Figure 5.3d Persistence Profile for Cointegrating Vector 1 for all

periods
1.2
Persistence Profile
0.8
0.6
0.4
0.2
0
1
13
17
21
25
29
33
37
41
45
49
53
57
61
65
69
73
77
81
85
Weekly Horizons
Full Period CV1
115
Figure 5.3e Persistence Profile for Cointegrating Vector 2 for all

periods
1.2
Persistence Profile
0.8
0.6
0.4
0.2
0
1
13
17
21
25
29
33
37
41
45
49
53
57
61
65
69
73
77
81
85
89
93
97
101
Weekly Horizons
Full Period CV2
116
Figure 5.4a :Generalized impulse response functions to a one standard deviation shock in the Japanese market based on the full sample period
Response of Australia
Response of Hong Kong
.010
.020
.008
.016
.006
.012
.004
.008
Response of Indonesia
Response of Japan
.012
.04
.03
.008
.02
.004
.002
.004
.000
.000
-.002
-.004
-.004
.01
.000
-.008
2
10
12
14
16
18
20
.00
-.004
2
Response of Korea
10
12
14
16
18
20
-.01
2
Response of Malaysia
.020
10
12
14
16
18
20
Response of New Zealand
.016
.015
10
12
14
16
18
20
Response of the Philippines
.010
.012
.008
.012
.008
.006
.010
.008
.004
.005
.004
.002
.004
.000
.000
.000
-.005
-.010
-.004
2
10
12
14
16
18
20
.000
-.002
-.004
2
Response of Singapore
10
12
14
16
18
20
-.004
2
Response of Taiwan
.016
.016
.012
.012
.008
.008
10
12
14
16
18
20
Response of Thailand
10
12
14
16
18
20
18
20
Response of the US
.016
.010
.012
.008
.006
.008
.004
.004
.004
.002
.004
.000
.000
.000
-.004
-.004
2
10
12
14
16
18
20
.000
-.004
-.002
-.008
2
10
12
14
16
18
20
-.004
2
10
12
14
16
18
20
10
12
14
16
117
Figure 5.4b : Generalized impulse response functions to a one standard deviation shock in the US market based on the full sample period
.012
.008
Response of Japan
.020
.012
.016
.015
.008
.012
.010
.004
.008
.005
.000
.004
.000
-.004
.000
.004
.000
-.004
-.005
2
10
12
14
16
18
20
-.008
2
Response of Korea
10
12
14
16
18
20
-.004
2
.016
10
12
14
16
18
20
.015
10
12
14
16
18
20
.010
.015
.008
.012
.010
.010
.006
.008
.004
.004
.005
.005
.002
.000
.000
.000
-.004
.000
-.002
-.008
-.005
2
10
12
14
16
18
20
-.004
2
10
12
14
16
18
20
-.005
2
Response of Taiwan
.016
.012
10
12
14
16
18
20
10
12
14
16
18
20
18
20
Response of the US
.016
.016
.025
.012
.012
.020
.008
.008
.004
.004
.000
.000
-.004
-.004
-.008
-.008
.015
.008
.010
.005
.004
.000
-.004
2
10
12
14
16
18
20
10
12
14
16
18
20
.000
-.005
-.010
2
10
12
14
16
18
20
10
12
14
16
118
Figure 5.4c :Generalized impulse response functions to a one standard deviation shock in the Japanese market based on the pre-EA sample period
.008
.006
Response of Japan
.012
.012
.04
.008
.008
.03
.004
.004
.02
.000
.000
.01
-.004
-.004
.00
.004
.002
.000
-.002
-.004
-.008
2
10
12
14
16
18
20
-.008
2
Response of Korea
10
12
14
16
18
20
-.01
2
10
12
14
16
18
20
.012
.012
.012
.008
.008
.008
.008
.004
.004
.004
.004
.000
.000
.000
.000
-.004
-.004
-.004
-.004
-.008
2
10
12
14
16
18
20
-.008
2
10
12
14
16
18
20
.012
.008
.008
10
12
14
16
18
20
10
12
14
16
18
20
10
12
14
16
18
20
18
20
Response of the US
.010
.006
.004
.005
.006
-.008
2
Response of Taiwan
.010
.012
-.008
.004
.002
.004
.000
.000
.002
.000
-.004
.000
-.005
-.002
-.008
-.002
-.004
-.012
2
10
12
14
16
18
20
-.010
2
10
12
14
16
18
20
-.004
2
10
12
14
16
18
20
10
12
14
16
119
Figure 5.4d :Generalized impulse response functions to a one standard deviation shock in the US market based on the pre-EA sample period
.012
Response of Japan
.012
.008
.008
.008
.008
.004
.004
.004
.004
.000
.000
.000
.000
-.004
-.004
-.008
-.004
-.008
2
10
12
14
16
18
20
-.004
-.012
2
Response of Korea
10
12
14
16
18
20
.008
10
12
14
16
18
20
.012
10
12
14
16
18
20
.012
.016
.012
.008
.004
.008
.008
.004
.000
.004
.004
.000
.000
-.004
.000
-.004
-.008
-.004
-.008
2
10
12
14
16
18
20
-.004
2
10
12
14
16
18
20
-.008
2
Response of Taiwan
.008
10
12
14
16
18
20
10
12
14
16
18
20
18
20
Response of the US
.016
.016
.020
.012
.012
.016
.008
.012
.004
.008
.000
.004
-.004
.000
.008
.004
.004
.000
.000
-.004
-.008
-.004
-.012
2
10
12
14
16
18
20
-.008
2
10
12
14
16
18
20
-.004
2
10
12
14
16
18
20
10
12
14
16
120
Figure 5.4e :Generalized impulse response functions to a one standard deviation shock in the Japanese market based on the post-EA sample period
Response of Japan
.016
.04
.03
.04
.012
.03
.02
.03
.008
.02
.01
.02
.004
.01
.00
.01
.000
.00
-.004
-.01
-.008
-.02
-.012
-.03
2
10
12
14
16
18
20
-.01
.00
-.02
-.01
-.03
2
Response of Korea
10
12
14
16
18
20
-.02
2
.04
10
12
14
16
18
20
.03
.03
10
12
14
16
18
20
.03
.008
.02
.012
.02
.02
.004
.01
.01
.01
.000
.00
.00
.00
-.004
-.01
-.01
-.02
-.03
-.02
2
10
12
14
16
18
20
-.01
-.008
-.012
2
10
12
14
16
18
20
-.02
2
Response of Taiwan
10
12
14
16
18
20
-.01
-.02
-.02
14
16
18
20
20
18
20
-.004
-.01
12
18
.000
-.01
10
16
.004
.00
14
.008
.00
12
.012
.01
10
.016
.01
.020
.02
.02
Response of the US
.03
.02
.00
.03
.01
-.008
-.03
2
10
12
14
16
18
20
-.012
2
10
12
14
16
18
20
10
12
14
16
121
Figure 5.4f :Generalized impulse response functions to a one standard deviation shock in the US market based on the post-EA sample period
.020
.04
.03
.015
.03
.02
.02
.010
Response of Japan
.02
.01
.01
.01
.005
.00
.00
.000
-.005
-.02
-.02
-.010
-.03
-.03
10
12
14
16
18
20
.00
-.01
-.01
Response of Korea
10
12
14
16
18
20
-.01
.04
.03
10
12
14
16
18
20
10
12
14
16
18
20
.03
.015
.03
.02
.010
.02
.01
.005
.01
.00
.000
.00
-.01
-.005
-.01
-.02
-.010
-.02
.02
.01
.00
-.01
-.02
-.03
-.04
-.03
2
10
12
14
16
18
20
-.015
2
10
12
14
16
18
20
-.03
2
Response of Taiwan
.03
10
12
14
16
18
20
.02
.02
10
12
14
16
18
20
18
20
Response of the US
.03
.04
.02
.03
.01
.02
.00
.01
-.01
.00
-.02
-.01
.01
.01
.00
.00
-.01
-.01
-.02
-.02
2
10
12
14
16
18
20
-.03
2
10
12
14
16
18
20
-.02
2
10
12
14
16
18
20
10
12
14
16
122
Figure 5.4g :Generalized impulse response functions to a one standard deviation shock in the Japanese market based on the post-September 11 sample period
.016
.03
.012
.02
.008
.01
.004
.000
.00
-.004
-.01
-.008
-.02
-.012
-.016
-.03
2
10
12
14
16
18
20
10
12
14
16
18
.02
.01
.00
.00
-.02
-.01
-.04
-.06
-.02
8
10
12
14
16
18
20
10
12
14
16
18
.02
.04
.01
.02
.00
-.01
-.02
-.02
-.04
-.03
-.06
10
12
14
16
-.02
-.02
-.03
-.03
-.04
2
18
20
10
12
14
16
18
20
10
12
14
16
18
20
.016
.04
.012
.03
.008
.02
.004
.01
.000
.00
-.004
-.01
-.008
-.02
-.012
-.03
-.04
2
10
12
14
16
18
20
10
12
14
16
18
20
18
20
Response of the US
.04
.03
.03
.02
.02
.01
.01
.00
-.01
20
.06
.00
-.01
Response of Taiwan
.03
.01
.00
-.016
.02
.01
.02
.03
.02
.04
.03
20
.03
.04
-.04
Response of Korea
.06
Response of Japan
.04
.00
.00
-.01
-.01
-.02
-.02
-.03
-.03
-.04
-.05
2
10
12
14
16
18
20
-.04
2
10
12
14
16
18
20
10
12
14
16
123
Figure 5.4h :Generalized impulse response functions to a one standard deviation shock in the US market based on the post-September 11 sample period
.015
.03
.010
.02
.005
.01
.000
.00
-.005
-.01
-.010
-.015
-.02
-.020
-.03
2
10
12
14
16
18
20
.04
.03
.03
.02
.02
.01
.01
.00
.00
-.01
-.01
-.02
-.02
-.03
-.03
-.04
2
Response of Korea
10
12
14
16
18
20
-.04
2
.04
.03
Response of Japan
.04
10
12
14
16
18
20
.03
.015
.02
.010
.01
.005
.00
.000
10
12
14
16
18
20

.03
.02
.02
.01
.01
.00
.00
-.01
-.01
-.01
-.005
-.02
-.010
-.02
-.02
-.03
-.04
-.03
2
10
12
14
16
18
20
-.015
2
10
12
14
16
18
20
.02
.01
-.03
8
10
12
14
16
18
20
10
12
14
16
18
20
.03
.03
.03
.02
.02
.02
.01
.01
.00
.00
-.01
-.01
-.03
-.02
-.02
-.04
-.03
-.03
-.05
-.04
2
10
12
14
16
18
20
10
12
14
16
18
20
18
20
Response of the US
.04
-.02
-.02
-.01
-.01
.04
.00
.00
.04
.01
-.04
2
Response of Taiwan
.03
-.03
-.04
2
10
12
14
16
18
20
10
12
14
16
124

Honours Thesis - Empirical Finance

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Honours Thesis - Empirical Finance

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The University of Queensland

Faculty of Business, Economics & Law

Market Linkage in the Pacific-Basin: A

Supervisor: Dr. Maosen Zhong

CHAPTER 2LITERATURE REVIEW

CHAPTER 2: Literature Review

CHAPTER 2LITERATURE REVIEW

CHAPTER 2LITERATURE REVIEW

CHAPTER 2LITERATURE REVIEW

CHAPTER 2LITERATURE REVIEW

CHAPTER 2LITERATURE REVIEW

CHAPTER 2LITERATURE REVIEW

2.2 Literature on the use of short run measures

CHAPTER 2LITERATURE REVIEW

CHAPTER 2LITERATURE REVIEW

CHAPTER 2LITERATURE REVIEW

2.3 Literature regarding the time evolution of market linkage

CHAPTER 2LITERATURE REVIEW

CHAPTER 2LITERATURE REVIEW

CHAPTER 2LITERATURE REVIEW

2.4 Literature regarding the determinants of market linkage

CHAPTER 2LITERATURE REVIEW

exports from country i to country j as a percent of is total exports, during year t

CHAPTER 2LITERATURE REVIEW

CHAPTER 2LITERATURE REVIEW

CHAPTER 2LITERATURE REVIEW

CHAPTER 3HYPOTHESIS AND THEROY DEVELOPMENT

Chapter 3: Hypothesis and Theory Development

3.2 Description of the Pacific-Basin Economies

CHAPTER 3HYPOTHESIS AND THEROY DEVELOPMENT

This was excluding financial firms which was capped at 25%

CHAPTER 3HYPOTHESIS AND THEROY DEVELOPMENT

CHAPTER 3HYPOTHESIS AND THEROY DEVELOPMENT

CHAPTER 3HYPOTHESIS AND THEROY DEVELOPMENT

CHAPTER 3HYPOTHESIS AND THEROY DEVELOPMENT

CHAPTER 3HYPOTHESIS AND THEROY DEVELOPMENT

CHAPTER 3HYPOTHESIS AND THEROY DEVELOPMENT

CHAPTER 3HYPOTHESIS AND THEROY DEVELOPMENT

CHAPTER 3HYPOTHESIS AND THEROY DEVELOPMENT

Log Stock Indexes

CHAPTER 3HYPOTHESIS AND THEROY DEVELOPMENT

log of stock index

CHAPTER 3HYPOTHESIS AND THEROY DEVELOPMENT

3.3 Linkage hypothesis

Log Stock Indexes

CHAPTER 3HYPOTHESIS AND THEROY DEVELOPMENT

3.3.1 Cointegration Analysis

CHAPTER 3HYPOTHESIS AND THEROY DEVELOPMENT

where xt is a n 1 vector of nonstationary I (1) dependent variables, A0 is a n 1 vector of

CHAPTER 3HYPOTHESIS AND THEROY DEVELOPMENT

where i is the estimated values of the characteristic roots (referred to as eigenvalues)

CHAPTER 3HYPOTHESIS AND THEROY DEVELOPMENT

3.3.2 Persistent Profile Analysis

where xt is a 12 1 vector of stock price indices, xt is a 12 1 vector of continuously

CHAPTER 3HYPOTHESIS AND THEROY DEVELOPMENT

The price cointegrating relation can be written as:

Following a unit composite shock to the cointegrating vectors in a stationary system,

CHAPTER 3HYPOTHESIS AND THEROY DEVELOPMENT

However, as discussed in Chapter 2 the presence of heteroscedasticity causes correlation

3.3.3 Generalised Variance Decomposition

Generalised forecast error variance decomposition (GVD henceforth) developed by Pesaran

CHAPTER 3HYPOTHESIS AND THEROY DEVELOPMENT

3.3.4 Generalised Impulse Response Functions

CHAPTER 3HYPOTHESIS AND THEROY DEVELOPMENT