A Markov switching model of market integration

Abstract

In this paper we estimate a bivariate two-state Markov switching model of excess returns on both domestic equities and a world index of equities for Thailand, Taiwan, and Korea. Our reason for doing so is to determine if changes in the behavior of equity returns can be linked to changes in policies governing the integration of these economies and their capital markets with world markets. We find clear evidence of two regimes: one characterized by a low variance of domestic equity returns and a low β of domestic equities relative to the world index, the other by a high variance of equity return and a high β, in all three countries. The differences across states in the covariance of the local market returns with the world index is consistent with greater integration of goods and capital markets in the high-covariance, high-β state. We find, however that the even in the ‘integrated’ state, equity returns are not consistent with a simple, single-β model of an integrated world capital market. For all three countries our estimates suggest that stock returns are higher than would be predicted by a simple CAPM. Only for Thailand is the temporal behavior of the probability that the high-covariance state is generating the data consistent with a change in government policies leading to greater goods and capital market integration. The estimated probabilities indicate quite clearly that a regime change occurred in the mid-1980s. The early 1980s are characterized by the low covariance state, ‘segmented’ state and thereafter, the data are generated by the high covariance, ‘integrated’ state.KeywordsCapital MarketStock ReturnExcess ReturnEquity ReturnMarket IntegrationThese keywords were added by machine and not by the authors. This process is experimental and the keywords may be updated as the learning algorithm improves.