Contributions to Management Science For further volumes: http://www.springer.com/series/1505
Mohamed El Hedi Arouri l Duc Khuong Nguyen Fredj Jawadi l The Dynamics of Emerging Stock Markets Empirical Assessments and Implications
Prof. Mohamed El Hedi Arouri University of Orleans Faculty of Law, Economics, and Management rue de Blois 45067 Orléans CX 02 France mohamed.arouri@univ-orleans.fr Prof. Fredj Jawadi Amiens School of Management 18 place Saint Michel 80000 Amiens CX France fredj.awadi@supco-amiens.fr Prof. Duc Khuong Nguyen ISC Paris School of Management 22 Boulevard du Fort de Vaux 75848 Paris CX 17 France dnguyen@groupeisc.com ISSN: 1431-1941 ISBN: 978-3-7908-2388-2 e-isbn: 978-3-7908-2389-9 DOI 10.1007/978-3-7908-2389-9 Springer Heidelberg Dordrecht London New York Library of Congress Control Number: 2009936784 # Springer-Verlag Berlin Heidelberg 2010 This work is subject to copyright. All rights are reserved, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilm or in any other way, and storage in data banks. Duplication of this publication or parts thereof is permitted only under the provisions of the German Copyright Law of September 9, 1965, in its current version, and permission for use must always be obtained from Springer. Violations are liable to prosecution under the German Copyright Law. The use of general descriptive names, registered names, trademarks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. Cover design: SPi Publishing Services Printed on acid-free paper Physica Verlag is a brand of Springer Verlag Berlin Heidelberg Springer Verlag is a part of Springer Science+Business Media (www.springer.com)
Preface By the end of 2008, thirty-four developing countries were considered as emerging markets by the world s leading index provider Standard and Poor s according to a wide range of economic and financial criteria. Yet, the more we learn about the financial markets in developed countries, the more challenging and mysterious emerging markets look. Thirty years ago, they, the 32 emerging markets surveyed by the International Finance Corporation in 1982, started to attract attention from investors of developed countries. The simple reason is that exposure to emerging markets allows to take advantage of their enormous growth potential which generates distinctively equity returns superior to those on developed markets. Moreover, as far as diversification issues are concerned, adding emerging market assets into an existing portfolio would lead to improving its risk-adjusted return performance as they have a low correlation with developed markets. The increased investor interest for investing in emerging markets is also linked to the wave of market reform policies aiming to stimulate economic growth, weakened by severe recession and oil crisis of the early 1970. As foreign investors benefit from a greater access to local markets following their openings, private capital flows (net foreign direct investment, portfolio investment, and bank loans and deposits) to emerging markets have steadily increased over time, from only $39.8 billion in 1990 to $1974.9 billion in 2007. Emerging markets, however, encounter several periods of reversals of foreign capital flows. The 1980s was particularly marked by the debt crisis in Latin America while the 1990s witnessed many episodes of extreme instability including, among others, the Mexican peso devaluation in 1994 1995 and Asian and Russian crises in 1997 and 1998. Some would attribute these consequences to increased mobility of cross-border capitals resulting from financial liberalization. These observations raise some intriguing questions relating to both market participants (foreign and domestic) and policymakers of emerging markets, and the most important are: v
vi Preface What are the diversification benefits from investing in emerging markets? And to the extent that emerging markets have become more integrated into the world financial system in recent years, how strong will be these benefits in the long run? Is the long-term performance of emerging markets sustainable, given their relative vulnerability to external shocks? What are, for policymakers wishing to know the effectiveness of their reform programs, the effects of increased foreign participation in domestic financial markets and real economy? Answering such questions requires not only a good understanding of emerging markets and the underlying factors of their dynamics, but also an appropriate analysis tools because standard models proposed in financial theory often fail to deal with specific characteristics inherent to these markets. By blending both theoretical and empirical approaches, this book attempts to bridge the gap between theories and practices of emerging markets, using modern financial econometric techniques. The text is structured in three parts. Part I, composed of two chapters, provides a comprehensive overview of emerging markets in terms of their accessibility, performance characteristics, and dynamics related to ongoing market reforms. Part II, composed of four chapters, explores the dynamics of asset prices and valuations in emerging markets with a particular focus on asset pricing, evolving efficiency and return volatility. Part III, composed of three chapters, develops specific models to apprehend the dynamics of emerging market integration with the world markets as well as contagion effects around the current global financial crisis 2007 2008. We hope that readers will find material in The Dynamics of Emerging Stock Markets, relevant and useful for understanding the evolving behavior of emerging markets in the contemporary international financial architecture. M.E.H. Arouri, F. Jawadi, and D.K. Nguyen
Acknowledgements We would like to acknowledge with considerable appreciation those who have directly or indirectly contributed to the publication of this book. Our thanks go particularly to all our colleagues who provided us with constructive and helpful comments during international conferences and seminars. We are also very grateful to our family members for their full support and encouragements throughout the writing of this book. vii
Authors Dr. Mohamed El Hedi Arouri is an associate professor of Finance at the University of Orleans and a Researcher at EDHEC Business School (France). He holds a Master s degree in Economics and a PhD in Finance from the University of Paris X Nanterre. His research focuses on the cost of capital, stock market integration, and international portfolio choice. He published articles in refereed journals such as International Journal of Business and Finance Research, Frontiers of Finance and Economics, Annals of Economics and Statistics, and Finance. Dr. Fredj Jawadi is currently an assistant professor at Amiens School of Management and a Researcher at EconomiX at the University of Paris Ouest Nanterre La Defense (France). He holds a Master in Econometrics and a PhD in financial econometrics from the University of Paris X Nanterre. His research topics cover modelling asset price dynamics, nonlinear econometrics, international finance and financial integration. He has published articles in refereed journals such as Journal of Risk and Insurance, Applied Financial Economics, Finance, and Economics Bulletin. Dr. Duc Khuong Nguyen is an associate professor of Finance and Head of the Department of Economics, Finance and Law at ISC Paris School of Management (France). He holds an MSc and a PhD in Finance from the University of Grenoble II (France). His principal research areas concern emerging markets finance, market efficiency, volatility modeling, and risk management. He has published articles in refereed journals such as Review of Accounting and Finance, Managerial Finance, American Journal of Finance and Accounting, Economics Bulletin, Applied Economics Letters, and Bankers, Markets and Investors. The courses taught by the authors in their respective institutions cover a wide range of topics including, among others, international finance, portfolio management, financial econometrics, and financial markets and valuations. ix
Contents 1 Emerging Markets: Overview and Performance Analysis...1 1.1 Basics of Emerging Markets......1 1.1.1 The Concept of Emerging Markets....2 1.1.2 Dispersions Among Emerging Markets......3 1.1.3 Capital Markets......5 1.2 Risk and Return Characteristics of Emerging Stock Markets..... 11 1.2.1 Risk and Returns..... 12 1.2.2 Correlation.... 14 1.3 The Process of Market Integration and Risk-return Tradeoff..... 16 1.3.1 The Case of Complete Integration.....16 1.3.2 The Case of Partial Market Integration......17 1.4 Specific Risks.... 18 1.4.1 Political Risk...18 1.4.2 Liquidity Risk...19 1.4.3 Currency Risk...19 1.5 Investing in Emerging Markets: Why and How?.....20 1.5.1 Advantages of Emerging Markets..... 20 1.5.2 Accessibility to Foreign Investors..... 22 1.5.3 Market Entry Methods.... 23 1.5.4 The Future of Emerging Market Investments...... 24 1.6 Summary...26 References............................................ 27 2 Dynamic Process of Financial Reforms...29 2.1 Oil Shocks and Economic Recession in the 1970s....29 2.2 Financial Liberalization as a Solution to Economic Development....30 2.3 Liberalization Methods and Indicators.... 31 2.3.1 Official Versus Effective Liberalizations..... 31 2.3.2 Liberalization Indicators...32 2.4 Dynamics of Liberalization Process...... 39 2.4.1 The Gradual Process of Financial Liberalization...39 xi
xii Contents 2.4.2 The Intensity of Liberalization...40 2.4.3 Challenges in Measuring Liberalization Effects.... 43 2.5 Financial Impacts of Liberalization...... 44 2.5.1 Cost of Capital......45 2.5.2 Observed Volatility...47 2.5.3 Unconditional Cross-Market Correlation..... 50 2.5.4 Stock Market Development......53 2.6 Summary...53 References............................................ 54 3 Asset Pricing Models....55 3.1 Introduction......55 3.2 The Capital Asset Pricing Model...56 3.2.1 Theoretical Framework of the Model...56 3.2.2 The CAPM.... 58 3.2.3 Extensions of the Original Model.....60 3.2.4 Empirical Test of the CAPM.....62 3.3 Arbitrage Pricing Theory..... 64 3.3.1 Theoretical Framework of the Model...64 3.3.2 Derivation of the Valuation Relationship..... 66 3.3.3 APT and CAPM.....67 3.3.4 Extensions of the APT: Towards the Equilibrium APT... 68 3.3.5 Empirical Test of the APT......68 3.4 Particularities of Asset Pricing in Emerging Markets...69 3.5 Summary...70 References............................................ 71 4 Threshold Stock Price Adjustments...73 4.1 Introduction......73 4.2 Economic Justifications of Nonlinearity in Stock Price Dynamics...74 4.2.1 Market Microstructure Approach...... 74 4.2.2 Behavioral Finance Approach.... 75 4.2.3 Nonlinearity and Emerging Stock Markets...76 4.3 Threshold Econometric Modeling...78 4.3.1 Brief Presentation of Threshold Models..... 78 4.3.2 Mixing Tests....80 4.4 Empirical Results and Discussions...81 4.4.1 Data and Preliminary Tests......81 4.4.2 Mixing Test Results......82 4.4.3 Estimation of ESTECMs...82 4.4.4 Essays in Nonlinear Modeling of Oil and Stock Market Linkages......85 4.5 Summary...88 References............................................ 89
Contents xiii 5 Evolving Stock Market Efficiency...91 5.1 Theory of Stock Market Efficiency......91 5.1.1 The Concept...92 5.1.2 Consequences of the Market Efficiency......93 5.1.3 Three Forms of Informational Efficiency..... 95 5.1.4 Empirical Evidence....96 5.1.5 Anomalies to Market Efficiency......97 5.2 Informational Efficiency in Emerging Stock Markets...98 5.2.1 Challenges to Market Efficiency......99 5.2.2 Usual Tests and Evidence on Market Efficiency...101 5.2.3 Financial Liberalization and Market Efficiency.... 103 5.3 Structural Reforms and Hypothesis of Evolving Efficiency...... 105 5.3.1 Rationale of the Evolving Efficiency...105 5.3.2 Econometric Specification....106 5.3.3 Weak Form Efficiency and Transaction Costs..... 108 5.4 Results and Discussions......109 5.4.1 Summary Statistics...109 5.4.2 The Evidence of Time-Varying Predictability..... 110 5.4.3 The Effect of Financial Liberalization...115 5.5 Implications of the Results.... 119 5.6 Summary...119 References............................................119 6 Stock Market Volatility...123 6.1 Introduction......123 6.2 Financial Risk and Its Assessment...124 6.2.1 Empirical Approach......124 6.2.2 Probabilistic Approach.... 125 6.3 Behavior and Sources of Emerging Market Volatility....126 6.4 Time-Varying Volatility Models...127 6.4.1 Linear ARCH Models.....128 6.4.2 Nonlinear ARCH Models...130 6.4.3 ARCH-M Models.... 131 6.4.4 Volatility Modeling and Tests.... 132 6.4.5 Empirical Evidence on Emerging Market Volatility Using GARCH Modeling Approach...133 6.5 Empirical Applications of GARCH Modeling...134 6.5.1 Data and Preliminary Analysis...134 6.5.2 GARCH-Based Models for Emerging Market Volatility...137 6.6 Summary...142 References............................................143 7 Globalization and Market Integration...145 7.1 Introduction......145
xiv Contents 7.2 The Notion of Financial Integration......147 7.2.1 The Law of One Price.....148 7.2.2 Factors Increasing Financial Integration..... 150 7.3 Advantages and Disadvantages of Financial Integration..... 152 7.3.1 Benefits of Financial Integration...... 152 7.3.2 Disadvantages of Financial Integration...... 154 7.4 Assessment of the Degree of Financial Integration.... 155 7.4.1 Qualitative Aspects of Financial Markets Integration..... 156 7.4.2 Empirical Aspects of Financial Integration...158 7.5 An Empirical Assessment of Financial Integration of Emerging Stock Markets in Latin America...160 7.5.1 Methodology....160 7.5.2 Data and Results.....162 7.6 Summary...165 References............................................166 8 Dynamics of Market Integration and International Asset Pricing...167 8.1 Introduction......167 8.2 Basic Problems of Asset Pricing in an International Environment... 168 8.2.1 The Relationships of the PPP....168 8.2.2 The International Asset Pricing...170 8.3 Equilibrium International Asset Pricing Model (ICAPM).... 171 8.4 International Versus Domestic CAPM.... 173 8.4.1 Assumptions and Notations...... 173 8.4.2 Pricing Error...174 8.5 The ICAPM: A Tool for Analysis of Portfolio Choice and Market Integration....175 8.6 An Empirical Investigation of the Integration of an Emerging Market into the World Market.....177 8.6.1 Methodology....178 8.6.2 Data and Results.....180 8.7 Summary...183 References............................................184 9 International Financial Crisis and Contagion...185 9.1 Introduction......185 9.2 Financial Crises and Emerging Markets...186 9.2.1 Brief Overview of Past Financial Crises..... 186 9.2.2 How Does the Current International Financial Crisis Affect Emerging Market Dynamics?.... 187 9.3 Contagion in Emerging Markets.... 189 9.3.1 Contagion Definitions and Factors..... 189 9.3.2 Contagion Effects Within the Current Financial Crisis.... 190
Contents xv 9.3.3 Contagion Tests and Previous Findings...... 191 9.4 Empirical Investigation...... 192 9.4.1 Data Used and Statistical Properties...193 9.4.2 Contagion Tests..... 194 9.4.3 Contagion Modeling with VAR Model......197 9.5 Summary...200 References............................................201 Index....203