What Drives Equity Returns in Central and Eastern Europe

Abstract

This paper investigates apparent comovement of equity prices in Czech Republic, Hungary and Poland. It argues that main underlying forces moving stock prices in small open emerging markets are of exogenous nature. It models main factor driving prices in region as an unobservable variable labeled the international investor sentiment. This latent variable is represented as a two-state Markov chain and makes stock returns switch from a high growth regime to a depression regime, or in opposite direction. In such a framework, stock return process comes from a mixture of two normal distributions with different means. This model is estimated using vector Markov switching method of Hamilton (1989, 1990). The estimated process shows a significant correlation with a number of data series on capital flows as well as with emerging markets' benchmark indices, corroborating main argument of paper.