On the rationality of Korea's stock market: was the recent Korean financial crisis due to fundamental factors?

Abstract

This paper examines whether the recent financial crisis in Korea was due to fundamental factors. To address this issue, we identify various components of Korea's stock market prices (KOSPI) and examine their responses to different types of shocks. Given the stationary behavior of KOSPI dividends, we relate stock price directly to earnings by deriving and using a log-linear model of the spread between price and earnings with a time-varying discount factor. Therefore, stock-price movements are explained by earnings (numerator component), time-varying discount factors (denominator component), and non-fundamental factors. Although we find evidence of substantial non-fundamental components in Korea's stock market prices, the sudden decline in Korea's stock market prices during the 1997 financial crisis was primarily due to fundamental components, in particular, the numerator component (e.g. earnings) combined with the denominator component (i.e. time-varying discount factor) rather than non-fundamental factors.