The nature and determinants of comovement between developed, emerging and frontier equity markets: Europe versus Asia‐Pacific

• Published date: 01 March 2019
• Author: Smita Kashiramka,Surendra Singh Yadav,Nisha Mary Thomas
• Date: 01 March 2019
• DOI: http://doi.org/10.1002/tie.22015

AREA PERSPECTIVES: EUROPE

The nature and determinants of comovement between

developed, emerging and frontier equity markets: Europe

versus Asia-Pacific

Nisha Mary Thomas | Smita Kashiramka | Surendra Singh Yadav

Department of Management Studies, Indian

Institute of Technology Delhi, New Delhi, India

Correspondence

Nisha Mary Thomas, Doctoral Scholar,

Department of Management Studies, Indian

Institute of Technology Delhi, Room

No. 601, 6th Floor, Vishwakarma Bhawan,

Saheed Jeet Singh Marg, Hauz Khas, New

Delhi 110016, India.

Email: nishamthomas11@gmail.com

International investors are increasingly attracted towards emerging and frontier markets

because of their potential to enhance diversification benefits of a global portfolio. This calls for

a rigorous analysis of the nature and determinants of stock market comovement between devel-

oped, emerging, and frontier markets in Europe and Asia-Pacific regions. The findings suggest

that unlike their Asia-Pacific counterparts, European developed, emerging, and frontier stock

markets display a higher degree of comovement. Although Asia-Pacific frontier markets provide

good diversification opportunities, investors must be cautioned against their weak financial sys-

tem. The volatility of returns, gross domestic product growth rate, and the 2008 global financial

crisis (GFC) are the key determinants of stock market comovement in Europe. The mechanisms

by which comovement in the Asia-Pacific region is strengthened differ across markets. Compar-

ative analysis of comovement and its determinants across different classes of equity markets

and geographies is expected to provide valuable perspectives to global investors, portfolio man-

agers, and policymakers.

KEYWORDS

Asia-Pacific, DCC-GARCH, emerging markets, Europe, frontier markets, stock market

comovement

1|INTRODUCTION

“In my 45-year career as an investment counselor,

humility did show me the need for worldwide diversifi-

cation to reduce risk.”Sir John Templeton

The world has always been on a lookout for fast-growing invest-

ment avenues. However, the 2008 global financial crisis (GFC)

adversely affected their risk appetite that resulted in a flight to safe

options like gold. However, investors have been starved of high yields

for too long and are now rediscovering their risk appetite. The spot-

light has now shifted to emerging and frontier markets to satiate this

appetite. Frontier markets are relatively small equity markets existing

in countries that are in the early stages of economic development.

Recent data indicate heavy investment in emerging markets and

increasing interest in frontier markets. Institute of International

Finance projects nonresident inflows to emerging markets to cross

USD 1 trillion in 2018 (Reuters, 2017). The annual performance of

MSCI Frontier Market Index jumped from 3.16% in 2016 to 32% in

2017 (MSCI, 2017). This reflects renewed interest in frontier markets

owing to their good economic growth and expanding domestic mar-

ket. The growing importance of emerging markets and frontier mar-

kets in the investment community makes it imperative to analyze

stock market comovement between themselves and in relation to

developed markets.

Stock market comovement has implications for international

investors, portfolio managers, and policymakers. A strong comove-

ment implies limited international diversification benefits for investors

and portfolio managers. For policymakers, it implies easy access to

foreign capital as well as increased vulnerability to financial contagion.

However, mere existential knowledge of stock market comovement is

inadequate for both these groups. They also need to know the factors

that drive stock market comovement. An understanding of the deter-

minants will enable investors and portfolio managers to design an

optimal portfolio and will facilitate policy makers in formulating suit-

able resource mobilization and economic stabilization policies.

DOI: 10.1002/tie.22015

Thunderbird Int. Bus. Rev. 2019;61:291–307. wileyonlinelibrary.com/journal/tie © 2018 Wiley Periodicals, Inc. 291

Having underscored the importance of emerging and frontier

equity markets in the global portfolio and the implications of stock

market comovement, this study is motivated to address the following

important questions: (a) How has the stock market comovement

between developed, emerging, and frontier equity markets changed

over the last couple of decades? (b) What are the factors that drive

comovement between these three sets of equity markets? (c) How is

the behavior of stock market comovement and its determinant in

Europe distinct from its counterparts in the Asia-Pacific region? These

questions are highly pertinent as their investigation allows compara-

tive analysis not only across different classes of equity markets but

also across different geographies. Such analysis will provide valuable

global and regional perspectives to investors and policymakers.

This study performs a two-step procedure to address the above

questions. First, the study examines how stock market integration

between three market pairs viz. (a) developed and emerging markets

(DM-EM), (b) developed and frontier markets (DM-FM), (c) emerging

and frontier markets (EM-FM)has evolved over time. For this purpose,

the Dynamic Conditional Correlation (DCC) framework is employed.

Second, the study analyses the factors that drivestock market integra-

tion (if any) between these three market pairs. For this step, System

Generalized Methodof Moments (System GMM) as developed by Are-

llano and Bover (1995) and Blundell and Bond (1998) is used wherein

the average conditional correlation acts as the dependent variable.

Both these analyses are performed in Europe and Asia-Pacific regions.

These two regions provide an ideal sample set as they are endowed

with all the three types of equity markets. Also, the Asia-Pacific region

is far more heterogeneous in terms of the financial system, politicalsta-

bility, and policy formulation. Hence, it is of interest to empirically

examine if there is any similarity in the nature of the interaction

between equity markets and in the determinants of stock market inte-

gration in both the regions.

This article contributes to the literature on stock market integra-

tion in three ways. First, it adds to the scant body of research on the

integration of frontier equity markets. Growing importance of frontier

markets in investment community calls for rigorous empirical analysis

on investing in these markets. Second, unlike previous studies, this

study compares Europe and Asia-Pacific regions in terms of the

degree of stock market comovement and assesses how distinct are

determinants of stock market integration across these two geogra-

phies. Such a comparative assessment provides valuable perspectives

to both investors and policymakers. Third, this study advances the

knowledge of factors that drive stock market comovement.

Rest of the article is as follows. The following section presents lit-

erature review on stock market integration and its determinants. Next,

the empirical framework and data are described. Afterward, the

results are presented. This article concludes by discussing the central

findings of the study and the managerial implications of the same.

2|RELATED LITERATURE

Literatureis rich in studies on understanding stockmarket comovement

between developed markets and between developed and emerging

markets. For instance, Chen, Firth, and Rui (2002) found that Latin

American equity markets are well integrated, and hence a portfolio of

these markets will yield limited diversification benefits. Diamandis

(2009) and Fernández-Serrano and Sosvilla-Rivero (2003) show that

emerging equity markets of Latin America and United States are inter-

dependentand hence a combination of these marketsmay not enhance

diversification benefits of the portfolio. Rua and Nunes (2009) employ

wavelet analysis to examine comovement between Germany, Japan,

United Kingdom,and United States and foundthat Japan is weakly cor-

related with the othermarkets under study. Demian (2011) and Voron-

kova (2004) focus on European markets and found that Central and

Eastern Europe are cointegrated within themselves and also with the

United States.By using the DCC framework and waveletanalysis, Dajc-

man, Festic, and Kavkler (2012) conclude that stock market comove-

ment between UK, Germany, France, and Austria is time varying in

nature. Guesmi,Kaabia, and Abid (2017) provideevidence of increasing

regional integration among equity markets of ASEAN and equity mar-

kets of China, Japan, and South Korea. Huyghebaert and Wang (2010)

show that the stock market integration between East Asian markets

strengthenedafter the 1997 Asian Financial Crisis.Recent studies have

examined the impact of 2008 GFC on stock market comovement

(Boubaker, Jouini, & Lahiani, 2016; Hemche, Jawadi, Maliki, & Cheffou,

2016; Syllignakis& Kouretas, 2011; Wang, 2014). Overallthese studies

found that stockmarket comovement strengthenedduring GFC.

Frontier equity markets have just started receiving attention from

the academic world. Speidell and Krohne (2007) and Quisenberry and

Griffith (2010) are some of the early studies on frontier equity mar-

kets. Both these studies show frontier markets display the same risk–

return characteristics that emerging markets displayed twenty years

ago. Kiviaho, Nikkinen, and Piljak (2012) and Miles (2005) demon-

strate that U.S. investors can earn better risk-adjusted returns by cre-

ating a portfolio of frontier and developed equity markets. Thomas,

Kashiramka, and Yadav (2017) and Mensi, Shahzad, Hammoudeh, Zei-

tun, and Rehman (2017) show that the frontier markets of the Asia-

Pacific region provide good diversification opportunities to interna-

tional investors. Dania and Maysami (2017) found frontier equity mar-

kets of Africa and the Middle East regions to be fairly segmented from

the major stock markets of the world. Speidell (2017) asserted that

frontier markets will register the highest growth in the coming years

and hence investors cannot ignore them for long.

Emphasis on identifying the determinants of stock market

comovement has gained momentum in the last couple of decades.

The positive association between trade relationship and stock market

integration is established by Paramati, Roca, and Gupta (2016).

Guesmi and Nguyen (2014) found that stock market integration can

be explained by stock market development and trade openness. Lucey

and Zhang (2010) show that countries with a smaller cultural distance

will have a higher degree of stock market comovement. Alotaibi and

Mishra (2017) found that trade openness, market size, and liquidity

have a positive influence on stock market integration among Gulf

Cooperation Council (GCC) countries. Lee and Cho (2017) indicate

that greater differences in inflation rates, interest rates, and gross

domestic product (GDP) growth rates have a negative impact on stock

market integration in the Asia-Pacific region. In the context of GCC

countries, Neaime (2006) found markets in close geographic proximity

tend to transmit volatilities faster. According to Beine and Candelon

292 THOMAS ET AL.