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Improvements in technology have reduced informational barriers that formerly restrained investment in international markets (Bekaert 1995). An overall movement towards fewer capital controls and reducing other market inefficiencies (e.g. poor credit ratings, high and variable inflation, exchange rate controls, etc ) due to globalization implies that equity markets are converging towards financial and economic integration over time (Bekaert, Harvey, Lundblad, Siegal 2011). Integration of emerging market economies into the world financial markets is generally followed by: a significantly larger and more liquid equity market, returns which are more volatile and more correlated with world market returns, a lower cost of capital (and thus lower risk premiums and increased investment), improved credit ratings, real exchange rate appreciation, and increased economic growth (Bekaert, Harvey, Lumsdaine).
Introduction and Literature Review
Theoretical Model
Data
Cointegration of Equity Returns in Brazil, Russia, India, China and South Africa (BRICS) By Dominic Anene, Florentine Eloundou, Timothy Larach, Melanie Lugo
Graphical Results
Numerical Results
Acknowledgements/References
Methodology
Models
(1)Testing for stationarityβ’ Unit root, Dickey-Fuller Test(2) Testing for Cointegrationβ’ Extracting long run component variable from level modelβ’ Testing the significance of long-run component in the Error Correction Model.(3) Granger/Causality Test β’ Testing the joint significance test of lagged variables.(4) Graphical Viewing of Impulse Response Functions (IRF)
Over the next decade, the importance of the BRICS, andespecially China, in world GDP will grow vastly. The IMFpredicts that they will account for as much as 61% of globalgrowth by 2016. This invites pertinent questions about theeconomic impact of fiscal and monetary policies in thesecountries, not only on the global economy, but also on the othermembers of the BRICS. We examine the co-integration of thesecountriesβ market returns over time, their response toeconomic shocks, and their intertwined Granger Causalities.
Research Question
Discussion
MSCI Emerging Markets Index (1993-2013, monthly)Morgan Stanley Capital International Index.
Cointegration between Brazil, India, & South Africa
(1)
VARIABLES D. ln_brazil
Uhat_B,I,SA -0.110***
(0.0252)
R-squared 0.438
Adjusted R-Square 0.431
Cointegration between China & Russia
(1)
VARIABLES D.ln_russia
Uhat_C,R -0.0296***
(0.0109)
R-squared 0.289
Adjusted R-Square 0.269
Cointegration between Brazil, China, & Russia
(1)
VARIABLES BCR
Uhat_B,C,R -0.0542***
(0.0191)
R-squared 0.474
Adjusted R-Square 0.462
Cointegration between India, China, & Russia
(1)
VARIABLES D.ln_india
Uhat_I,C,R -0.0430**
(0.0201)
R-squared 0.257
Adjusted R-Square 0.247
Cointegration between South Africa, China, & Russia
(1)
VARIABLES D.ln_southafrica
Uhat_SA,C,R 0.0114
(0.00943)
R-squared 0.459
Adjusted R-Square 0.452
Standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.1
Granger Causality Matrix
ReferencesBekaert, Geert, Campbell R. Harvey, and Robin L. Lumsdaine. "Dating the Integration of World Equity Markets." Journal of Finance Economics 00 (2002) 000-000. (August 2001): 1-43. Duke University Faculty. Duke University. Web.
Bekaert, Geert, Campbell R. Harvey, Christian T. Lundblad, and Stephan Siegel. "What Segments Equity Markets?" Netspar Discussion Paper (February 2011): 1-38. Web.
Henry, Peter Blair. "Do Stock Market Liberalizations Cause Investment Booms?" (April 2000): 1-43. Graduate School of Business, Stanford University, Stanford, CA 94305-5015, USA. Web.
Korajczyk, Robert A. "A Measure of Stock Market Integration for Developed and Emerging Markets." World Bank Policy Research Working Paper No. 1482 (1995): 1-29. Print.
AcknowledgementsWe wish to thank the immensely helpful Dr. Bohara, the AEA Summer Training Program 2013 and RWJ Foundation Center for Health Policy.
Supervised by Dr. Alok Bohara as partial fulfillment of the research requirement for ECON409: Intermediate Applied Econometrics (Department of Economics, UNM)
HypothesisThe lessening of capital controls in the 1980s and 1990s, alongwith increased availability of information, has caused the price ofrisk to be equalized across assets. We therefore expect to seediminishing differentials in BRICS equity returns over time asdifferent markets now demand the same compensation (i.e.returns should be converging).
Brazil China Russia India South Africa
Brazil - Yes*** Yes*** Yes*** Yes***
China Yes** - Yes* Yes* Yes***
Russia Yes** No - Yes* Yes**
India Yes*** No No - Yes***
South Africa Yes*** Yes*** Yes** Yes*** -
P-Values: ***=1%, **=5%, *=10%
Conclusion and Further Research
The test for stationarity confirmed that MSCI returns in theBRICS are following a trend, and we needed to adjust for thisnon-stationarity (by differencing) in our model. The ErrorCorrection Model suggest that the returns to equity in theBRICS follow a long-term trend. This result implies that if ashock drives any of these returns away from the current trend,in equilibrium, these returns will revert back to the trend.
Our Granger Causality tests suggest that beyond cointegration,some of these markets Granger-cause each other. For example,equity market returns in South Africa, Granger-causes returnsin all the other BRICS at the 1% significance level. In otherwords, one can use the results from the returns of one countryto predict the returns from another.
Because we orthogonalized the errors in the impulse responsefunction, we can guarantee the consistency of the impulseresponse functions (IRF). With these functions, we can predictthe impact that a shock on one countryβs returns will have onanotherβs.
American Economic Association
Our analysis of equity returns in the BRICS showed evidence ofco-integration between returns in the BRICS, and that some ofthe returns Granger-cause each other. Further, we note thatshocks in some marketsβ returns will affect othersβ. Therefore,our study leaves room for forecasting the future extent ofcorrelation, and investigating the underlying force of the co-integration.We suspect that the driving force behind the cointegration isglobalization. Further research will employ structural VARmodeling techniques to tease out multi-directional influences.
Take a one good closed economy, featuring a competitive market.
ππ π’π‘ππππ§π π‘βπ β²ππππππ‘ πππ₯ππππ§ππ‘πππ ππ πππππ β² ππ’πππ‘πππ πππ₯ πΎπΌπΏ1βπΌ β π€πΏ β (π + πΏ)πΎ = 0
Where (π + πΏ) is the real cost of capital with r being the interest rate and πΏ being the depreciation rate.
GDP=Y=πΎπΌ πΏ 1βπΌ
By taking the first order condition with respect to capital (K) we obtain
π + πΏ = πΌπΎββ1πΏ1ββ = πΌπΎ πΌβ1
In a balanced growth path πΎ = πΎβ , is constant over time. Therefore, in the balanced growth path, r is constant over time meaning π β πΏ(the real interest rate) is constant over time
With increased liquidity to additional capital flows and liberalization, the equity premium decreases, which reduces the cost of capital. The marginal product of capital of the firms will decrease to reflect the new cost of capital, which means, private investment and stock market returns increase. With newly lowered financial walls, investors will be able to take advantage of cross market arbitrage, and thus cross market returns will converge.
Error correction model (ECM)
1. Level model
y3π‘ = π½0 + π½1y1π‘ + π½2y2π‘ + π½4y4π‘ + π½5y5π‘ + ππ
2. Error Correction Model
D.π¦3π‘ = π D. y3,π‘βπ ,π·. y1,π‘βπ ,
π·. y2,π‘βπ ,π·. y4,π‘βπ ,π·. y5,π‘βπ + πΏπ π‘β1 + νπ ,π‘βπ
Vector Auto-regression Model (VAR) (Optimal Lag=1)
π¦1
π¦2π¦3
π¦4
π¦5
=
π£1
π£2π£3
π£4
π£5
+
π11,1 π12,1 π13,1 π14,1 π15,1
π21,1 π22,1 π23,1 π24,1 π25,1
π31,1
π41,1
π51,1
π32,1
π42,1
π52,1
π33,1 π34,1 π35,1
π43,1 π44,1 π45,1
π53,1 π54,1 π55,1
π¦1,π‘β1
π¦2,π‘β1π¦3,π‘β1
π¦4,π‘β1
π¦5,π‘β1
+
ν1π‘
ν2π‘ν3π‘
ν4π‘
ν5π‘
π¦1 = Log ππ πππ’π‘β π΄πππππ π ππ‘π’πππ π¦2 = Log ππ π΅πππ§ππ π ππ‘π’πππ π¦3 = Logππ πΌππππ π ππ‘π’πππ
π¦4 = Logππ π π’π π ππ π ππ‘π’πππ π¦5 = Logππ πΆβπππ π ππ‘π’πππ
Orthogonal Impulse Response Function
π¦π‘= π + ππ60π=0 π€π‘βπ
π: πΆπππ π‘πππ‘ π€:πππ‘βππππππππ§ππ πππππ
π: 5π₯5 π π‘ππππππππ§ππ πππππππππππ‘ πππ‘πππ₯ ππ’ππ‘πππππππ ππ πππππ£ππ‘πππ ππ‘ πππππππππ‘ πππ πππππππ
Cointegration between the BRICS
Standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.1
(1)
VARIABLES D.ln_india
Uhat_I,B,C,R,SA -0.132***
(0.0351)
R-squared 0.392
Adjusted R-Square 0.367