Common Components in Co-integrated System and Its Estimation and Application: Evidence from Five Stock Markets in Asia-Pacific Chinese Region

Abstract

Abstract Previous studies on co-integration focused on whether there is co-integration between variables, and might not explore which variables are caused when co-integration exists. This study is based on a multivariate factor model and apply Quah’s decomposition theorem to derive common factors affecting long-run equilibrium, and use this common factor to explain which variables affect the formation of co-integration. Empirically, five stock markets in the Asian-Pacific Chinese region (Hong Kong, Singapore, Taiwan and China including Shanghai and Shenzhen stock markets) are the objects of analysis. According to the estimated common factor, the existence of the co-integration among the five stock markets is caused by the stock markets in Taiwan and Hong Kong. Therefore, when investing in these five stock markets, investors must incorporate and use the information of the two stock markets as a decisive factor in order to promote correct decision-making. That is, the policy authorities of these countries should promote the effective interaction and operation of the stock market. The decisive influence of stock market information in the two countries cannot be ignored. JEL classification numbers: F30, F65, G10, G15. Keywords: Co-integration, Error Correction Model (ECM), Common Component, Quah’s Decomposition Theorem.