Cointegration of Asian Developed and Frontier Stock Markets: An investigation of Diversification Opportunities

Abstract

This study examines the cointegration relationship of the Colombo Stock Exchange (CSE) with developed Asian markets (Hong Kong, Japan, Singapore). The main objective of the study is to identify potential diversification benefits that exist in Sri Lankan stock market. The stock market indices are Hang Seng Index (HSI), Nikkei 225(N225), Straits Times Index (STI) and All Share Price Index (ASPI). Daily closing prices of stock market indices were selected for the period of 2013- 2019. The main theoretical base forthe stock market integration was the Law of One Price. The Autoregressive-Distributed Lag (ARDL) bound test used toanalyze data, revealed an insignificant cointegration relationship between CSE and developed stock markets. The ASPI has statistically significant short-run relationships with the STI. HSI and N225 did not provide any evidence of a long-run relationship with the ASPI. A negative insignificant correlation between ASPI and HSI indicates a good combination to have a well-balancedportfolio gain both long and short-run diversification benefits. In conclusion, the non-existence of cointegration among the above stock markets provides opportunities for international diversification of portfolios and possibilities for risk hedging.
 Keywords: Cointegration, Frontier and Developed, Stock Markets, Portfolio Diversification