Abstract
In this paper we develop a comprehensive Vector Autoregression Model consisting of five variables; the stock market and price indices of pairs of countries, as well as their bilateral nominal exchange rate. Then, we show that under certain long-run restrictions, our approach encompasses a large number of specifications encountered in the voluminous literature on testing for capital integration with cointegration techniques. This approach minimizes the risk of accepting the null of no cointegration between the equity price indices because of the introduction of additional stochastic trends through the transformation of those indices on a “real or nominal US dollar” basis. Furthermore, other interesting long run specifications emerge either with I(1) only stochastic shocks or with the presence of some I(2) disturbances characterizing the system. We apply the testing methodology on monthly data for the US, UK, Germany, and Japan for the period January 1980–May 2019. The main findings provide partial support in favor of cointegration, and therefore for capital markets integration, among stock market indices when proper attention is given to issues like the identification and temporal stability of the cointegration vectors as well as the choice of units that the stock indices are expressed in.
Highlights
As an outcome of the various stock market crashes that the world has experienced over the last 40 years a voluminous literature has been produced with the intension to examine the possible existence of long-run co-movements among the major stock markets of the world
We analyze the implications for the identification of common stochastic trends among stock price indices by using a model where the transformation of the data to a domestic or U.S dollar—nominal or real—basis is decided statistically and not imposed a priori
By applying a general vector autoregressive (VAR) model where all the relevant variables are included, we show that the expected results from the cointegration analysis differ substantially
Summary
As an outcome of the various stock market crashes that the world has experienced over the last 40 years a voluminous literature has been produced with the intension to examine the possible existence of long-run co-movements among the major stock markets of the world. In stark contrast, Francis and Leachman (1998) study produced a single cointegrating vector among the stock market indices of Germany, Japan, the U.K., and the U.S for the period 1974:1–1990:8 This result is not interpretable since it implies three stochastic trends that are not readily identifiable, given that the data have been converted into their real U.S dollars equivalent. For all three cases under examination we were unable to reject the over-identified restrictions for the scenario that exchange rates are long-run excluded and stock market indices in real terms are cointegrated.
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