Financial Integration of Large- and Small-cap Stocks in Emerging Markets

Transcription

1 Financial Inegraion of Large- and Small-cap Socks in Emerging Markes Ming-Chieh Wang * Associae Professor, Deparmen of Inernaional Business Sudies, Naional Chi-Nan Universiy Absrac This sudy examines he financial inegraion of large- and small-cap socks in 3 emerging markes o deermine heir degree of marke inegraion wih he world and emerging markes. The inernaional asse pricing model canno be rejeced for mos large-cap sock porfolios, bu is rejeced for small-cap porfolios. The ess of asse pricing show ha large-cap socks should be priced globally, whereas small-cap socks have a higher degree of emerging marke inegraion. Our findings also demonsrae ha super large-cap socks have he lowes pricing errors and heir global financial inegraion have increased in recen years. In sum, he empirical resuls indicae ha world marke inegraion is primarily associaed wih he super large-cap socks of large markes. JFL classificaion: G1; G15 Key Words: Financial Inegraion; Asse Pricing; Emerging Mareks * Corresponding auhor. Deparmen of Inernaional Business Sudies, Naional Chi Nan Universiy, Puli, Nanon, Taiwan (R.O.C.) Tel.: (886) #4646; fax: (886) , address: mcwang@ncnu.edu.w

2 1. Inroducion Globalizaion and liberalizaion of financial markes have increased he developmen of emerging markes in recen years. From earlier emerging counries, such as he Four Asian Tigers (Taiwan, Hong Kong, Korea, Singapore), o he recen so-called BRIC naions (Brazil, Russia, India, China), heir equiy markes have shown superior performances han developed markes. As emerging markes grow and develop, hey arac even more inernaional capial flows. For example, he weigh of emerging markes in he world marke capializaion increased from 7% in 004 o 16% in 009, wih he weigh of China in he world marke growing an asounding 874% during his period. 1 Furhermore, foreign invesors hold a subsanial proporion of ousanding shares in hese markes, where hey hold over 30% of Taiwan and Souh Korea equiy markes. However, he regulaions and openness of emerging markes need o improve and heir marke capializaions have an apparen gap versus developed markes. Many sudies have invesigaed he financial inegraion of emerging markes, generally supporing ha hese markes are segmened wih he world marke. Even hough emerging markes are no inegraed globally, he financial inegraion of heir large-cap socks is imporan for furher invesigaion. In emerging markes, many large companies are in he op indusries globally and heir producs are mainly sold o developed counries. For insance, Forune Global 500 in 009 conained 68 companies locaed in emerging markes; Samsung and LG (in Souh Korea) held he firs and second in he marke share for LCD TVs; Acer (in Taiwan) was op hree in he PC indusry; Foxconn (in China) was he larges manufacurer parner for Apple. The revenues of such large companies are more closely linked wih he sales in developed marke. Furhermore, inernaional insiuion invesors prefer holding he equiies of large companies due o heir high qualiy of marke liquidiy and disclosure. The economic recession in developed counries will reduce hese companies revenues and heir sock prices will also decline from redempion by foreign invesors. Conversely, resricions on producion and markeplace induce he core business of small companies o remain locaed in heir home marke. The purpose of his paper is herefore o invesigae he financial inegraion of size-based socks in emerging markes and o examine wheher large-cap socks are priced globally and mid- and small-cap socks are srongly influenced by domesic risk facor. The findings are imporan for undersanding he degree of emerging 1 Source: Daasream. See Chang e al. (1994), Gérard e al. (003), Hardouvelis e al. (006), and Yu e al. (010). 1

3 marke inegraion and for providing invesors wih more direcion o diversify heir invesmens. Because i is solely influenced by local informaion, a compleely segmened marke provides counry-specific reurns o inernaional invesors. However, if large socks of emerging markes are inegraed wih he world marke, hen he benefis of diversificaion are limied when inernaional invesors hold hese socks. The sudy of financial marke inegraion is a he hear of finance and has recenly received much ineres in he relaed lieraure. 3 Harvey (1991) indicaes ha if capial markes are fully inegraed, hen asse reurns can be explained by he world covariance risk. He uses he inernaional asse pricing model (IAPM) o measure he condiional risk of 17 counries and shows ha he excess reurns of counry-specific sock porfolios can be capured parly by he ime-varying covariances and ha he world price of covariance risk is no he same across counries. Bekaer and Harvey (1995) examine he relaionship beween 1 emerging markes and he world marke. They use he condiional pricing model and wo sae ransiion variables o invesigae wheher he degree of inegraion changes over ime. The resuls show ha only Columbia, Jordan, Souh Korea and Malaysia have changed and canno suppor he evidence ha emerging markes are fully inegraed. Dunis (005) ess he inegraion beween emerging markes and Japan, he Unied Saes, and Unied Kingdom, finding ha emerging markes are closely inegraed wih Japan, and 7 markes have a sable relaionship wih he Unied Saes and Unied Kingdom, bu he degree of marke inegraion has decreased over ime. Huang (007) invesigaes he financial inegraion of large- and small-cap socks for nine developed counries and noes ha large-cap socks realize significan comovemens across counries; on he conrary, small-cap socks realize smaller average correlaions. He concludes ha large-cap socks are priced globally, bu global pricing is rejeced for mos mid- and small-cap socks. Wang and Shih (01) measure ime variaion in financial inegraion and in he mean and volailiy spillover effecs from he world and he developed European region for 10 emerging European equiy markes. Their findings suppor he argumens of ime-varying inegraion and volailiy spillover effecs in mos emerging European markes and in developed Europe. The previous empirical sudies indicae ha emerging markes have no inegraed a a world level, 4 bu here is no lieraure discussing he financial inegraion of 3 In general, capial markes are inegraed if foreign and domesic securiies wih he same risk also have he same expeced reurns [Sulz (1981)]. 4 Harvey (1995) and Erb e al. (1998) find evidence o rejec he hypohesis ha emerging sock markes are priced by global risks.

4 large- and small-cap socks in hese markes. This paper aemps o provide some insighs on he global pricing of size-based porfolios. If he model is rue for large-cap socks, hen here are significan implicaions for asse managemen and rewards of inernaional diversificaion. In addiion, because i is possible ha only he larges companies are highly correlaed wih he world marke, his sudy consrucs super large-cap sock porfolios ino our ess. We also compare he explanaory power of world and emerging marke indices on he predicion of size-based sock reurns and measure he change of financial inegraion under he wo subperiods beween he Asian financial crisis and he U.S. subprime financial crisis. Therefore, his sudy is able o undersand he world covariance risk of size-based sock porfolios in emerging markes more clearly and o compare he financial inegraion wih developed markes. Our findings can be summarized as follows: Firs, consisen wih previous sudies, we find ha large-cap socks realize sizable comovemens across counries and heir reurns should be priced by global variables. The mid- and small-cap socks show lower correlaions across counries and are influenced by domesic variables raher han global variables, and local risks are priced. Second, he es of condiional IAPM shows ha super large-cap socks have he smalles mean absolue pricing errors and he evidence becomes sronger when hese porfolios are consruced by soring heir marke values from all counries, no from each counry; and heir pricing errors are lower in large markes han in small markes. Third, he emerging marke index offers more predicabiliy for he excess reurns of mid- and small-cap socks han he world marke index, bu he explanaory power of his index does no increase for large-cap socks. Finally, he financial inegraion of super large-cap socks has increased in recen years from he subperiod ess. Overall, large-cap socks are more inegraed globally han mid- and small-cap socks in emerging markes and heir reurns can be deermined by he world covariance risk. In paricular, he global pricing perains mosly o he super large-cap socks of large markes. The remainder of his paper is organized as follows. Secion describes he mehodology and daa, and Secion 3 presens he empirical resuls. Secion 4 provides a brief summary.. Mehodology and Daa.1. Mehodology To invesigae he financial inegraion of size-based sock porfolios in emerging markes, we apply he condiional IAPM proposed by Harvey (1991), o measure he 3

5 relaionship beween he sock reurns and he world covariance risk, and hen es he model resricions by using he mehod of generalized mehod of momens (GMM). If he inernaional financial markes are fully inegraed, Harvey shows ha he condiional expeced reurn on a financial asse is proporional o is covariance wih he world marke porfolio. The condiional pricing model can be expressed as: r E m, I 1 E rj, I 1 Covrj,, rm, I 1, (1) Var r I m, 1 where r, is he excess reurns of porfolio j from ime 1 o, r m, is he j excess reurn of world marke porfolio m from ime 1 o, and I 1 is he informaion se a ime 1. The world price of covariance risk can be obained from he raio of he condiionally expeced world marke reurn o he condiional marke variance; ha is, E rm, I 1 Varr I m, 1 under he resricions of his model., and he price should be he same across all counries To es he pricing model, we assume invesors use he following linear filer o form he condiional expeced reurns on porfolio j and world marke porfolio m : rj, (), 1 j j, r, (3) m, 1 m m, where is he se of k 1 informaion variables ha are available o invesors 1 under I ; 1 j and m are he ime-invarian weighs ha invesors use o derive he condiionally expeced reurns on porfolios j and m, respecively; and j, are he forecas errors from he respecive porfolio reurns j and m. m, Combining equaions () and (3), equaion (1) can be rewrien as follows: where Z j, m, 1 m, 1 Z 1 j 1 j j, m, 1 E m, Z 1 Z E Z, (4) E is he condiional variance of world marke reurns, and E Z is he condiional covariance of he world marke and porfolio j. The 4

6 above equaion can be rewrien as: Z Z E Z Z E. (5) m, 1 j 1 j, m, 1 m 1 Therefore, he pricing error under he seing of equaion (1) is described as: j, m, 1 j j, m, 1. (6) m To es he finess of his model, we calculae he mean absolue pricing errors (MAE) from dividing he average absolue value of pricing errors by he condiional variance of world marke reurns: MAE 1 T 1 j, T. (7) m If he MAE value is greaer han zero, hen our model canno fully explain he excess reurns of size-based sock porfolios. In order o examine wheher he excess reurn can be explained by he world covariance risk, he resricions of he pricing model in equaion (1) need o be esed nex. Combining equaions (), (3), and (6), we have he following equaions: r 1, m,, r m (8), 1 m m, 1 m, 1 m where is a 1 n (number of counries ) vecor of innovaions in he condiional means of he counry reurns. If E Z 1 0, hen he condiional IAPM fis he asses pricing, because he errors are unrelaed o he informaion. This sudy applies Hansen s (198) GMM mehod o esimae he parameers in equaion (8). The mehod firs forms a vecor of orhogonaliy condiions g vec Z, where is he marix of error erms from T observaions. Nex, he parameer vecor is chosen o make g close o zero by minimizing he quadraic form g wg, where w is a symmeric weighing marix. Finally, o examine he finess of he model, he saisic is used o es he over-idenifying resricions, where he degrees of freedom equal he number of orhogonaliy condiions minus he number of parameers. If high saisics are obained, hen he pricing model is a misspecificaion by he reason ha he disurbances are correlaed wih he insrumen variables. 5

7 We finally invesigae wheher he expeced reurns of size-based porfolios are proporional o he expeced reurns of a world marke porfolio. In oher words, he world price of covariance risk is he same across counries. We assume his price equal o a consan, where Erm, I 1 Varr I m, 1. Equaion (1) can hen be rewrien as:, (9) r m, where denoes he pricing error under our assumpion. Combining equaions () and (3), he sysem of equaions is described as: where r 1 (10), m,, rm, 1 m r m, is he marix of pricing errors from he above sysem. Similarly, we use he GMM es and MAE values o measure he finess of his model and o examine wheher he world price of covariance risk is consan... Daa This sudy selecs 3 counries defined by Morgan Sanley Capial Inernaional (MSCI) as emerging markes. These include China, India, Indonesia, Israel, Souh Korea, Malaysia, Pakisan, he Philippines, Thailand, and Taiwan in Asia; he Czech Republic, Hungary, Poland, Russia, and Turkey in Europe; Argenina, Brazil, Chile, Colombia, Mexico, and Peru in Lain America; and Egyp and Souh Africa in Africa. The monhly oal reurns and marke values for he companies include in he counry indices are drawn from he DaaSream daabase. The sample period is from January 1997 o December 009. All marke values and sock reurns are denominaed in U.S. dollars. Table 1 provides a descripion of he number of companies lised in each counry s sock exchange and he marke capializaion of hese companies a he end of 009. The weigh ha each counry commands in he MSCI Emerging Markes Index is also shown. The eigh larges markes, including China, Brazil, Souh Korea, Taiwan, Russia, India, Souh Africa, and Mexico, comprise 81.09% of he MSCI index. Their marke capializaions are greaer han oher markes. Because a larger weigh marke would arac more capial inflows from passive inernaional invesors, his paper also discusses he global pricing of size-based porfolios in he eigh markes and expecs he large socks o be beer fied for he pricing model. 6

8 [Inser Table 1 here] This sudy consrucs size-based sock porfolios for each counry by grouping he individual socks ino deciles according o heir marke values a he end of each previous year. By adaping Huang s (007) mehod, socks ha belong o he larges and smalles wo deciles form he large-cap and small-cap sock porfolios in each counry. The mid-cap porfolios are from socks ha fall ino he middle 0% of socks. The sudy also consrucs wo super large-cap porfolios by selecing socks ha have marke values in he op 5% and 10%. The five size-based sock porfolios are consruced for each year, and he porfolio reurns are obained by he monhly value-weighed sock reurns. The U.S. T-bill rae is denoed as he benchmark of he risk-free rae, and he excess reurn of sock porfolios is calculaed based on he excess of he holding reurn of 1-monh U.S. T-bills. Table presens he summary saisics for monhly excess reurns of he five sock porfolios. Because he U.S. subprime morgage crisis occurred in 008, he mean excess reurns over he sample period for he U.S. and he world markes are only 0.001% and -0.08%. However, emerging markes show srong performance and heir sock porfolios wih negaive reurns are finie. The mean monhly excess reurns for he op 5% and op 10%, large-, mid-, and small-cap porfolios are 0.89%, 0.97%, 0.94%, 1.37%, and.56%, respecively. In he BRIC group, he mean excess reurns are as high as 1% (excep China), and Russia has he highes average reurns. Small socks provide he greaes reurn in mos counries and indicae ha he size effec is consisen wih earlier sudies for developed markes. Average reurns for he op 5%, op 10%, and large-cap porfolios do no differ. For example, he op 5% porfolio has he greaes excess reurns in he hree porfolios for Brazil and Taiwan (1.48% and 0.1%), bu he large sock porfolio has he highes reurn for China and India (0.11% and 1.18%). [Inser Table here] All porfolios in emerging markes have a higher invesmen risk han he world and U.S. marke porfolios, and Russia represens he larges risk in mos size-based porfolios. The average volailiies of he op 5%, op 10%, large-, mid-, and small-cap porfolios are 10.56%, 10.8%, 9.57%, 10.80% and 14.49%, respecively. The volailiy of small-cap socks is he larges, bu he differences beween he small- and large-cap socks are no obvious. Huang (007) indicaes ha he average volailiies of large-, mid-, and small-cap sock porfolios are 4%, 5% and 8%, respecively. We find he volailiy of emerging markes is much larger han ha of developed markes. 7

9 Furhermore, heir large-cap socks are more risky (wice) han hose in developed markes. In sum, he higher volailiy of emerging markes is clear, bu hey also had a significanly larger reward over he long run. Table 3 shows he correlaion marix for he MSCI index reurns of emerging markes, U.S. and world marke (Panel A) and he average correlaion coefficiens beween size-based porfolio reurns and he world (U.S.) marke reurns (Panel B). Panel A shows ha he average coefficiens beween he counry-specific MSCI index reurns and he world (U.S.) index reurn is only 0.5 (0.47); he highes coefficien is 0.73 (0.7) in Mexico and he lowes is 0.15 (0.13) in Pakisan. The correlaion coefficiens beween emerging markes are mosly below 0.5, wih an average of 0.41, which is lower han he correlaions beween emerging markes and he world (U.S.) marke. Panel B shows ha he average coefficiens beween he porfolio reurns and world (U.S.) marke reurns is 0.76 (0.70) for large-cap socks and 0.48 (0.43) for small-cap socks. This shows ha larger companies are highly correlaed wih he world and he U.S. marke, bu smaller companies are no. [Inser Table 3 here] For comparison, Table 3 also conains he Huang s (007) resuls for he average correlaions in developed markes. Relaive o developed markes, emerging markes realize smaller comovemens wih global and U.S. markes, and smaller average correlaions across counries. However, he correlaions wih he global (U.S.) marke vary among size-based porfolios. The large-cap socks have a higher correlaion wih he global (U.S.) marke han mid- and small-cap socks, and his value is close o he socks in developed markes. Therefore, he findings do no suppor ha a common facor is driving equiy reurns across emerging markes, bu large-cap socks may be driven mainly by a common source of risk, which is he same as developed markes. This furher suggess ha an invesigaion of financial inegraion for large and small socks is imporan. 3. Empirical Resuls 3.1 Insrumenal variables Following he mehodology of Harvey (1991), his sudy uses a series of global and local informaion variables o measure explanaory power on he condiional excess reurns of size-based sock porfolios for each counry. The daa are drawn from he daabases of DaaSream. Global insrumenal variables include world index excess reurns (RWD), dummy variable for January (JAN), dividend yield raes (DIVWD), 8

10 defaul risk premiums (USDEF), and shor-erm rae differenial (USTB), described as follows: (1) RWD 1 is he monhly U.S. dollar denominaed reurn on he MSCI world index in excess of he holding period reurn on he 1-monh U.S. T-bill rae. () JAN is a dummy variable for he monh of January equals one and zero in oher monh. (3) DIVWD 1 is he dividend yield on he MSCI world index reurn, expressed as he excess of he 1-monh U.S. T-bill rae. (4) USDEF 1 is he defaul premium, expressed as he difference beween he yield on Moody s Baa-raed bonds and he yield on Moody s Aaa-raed bonds. (5) USTB 1 is he erm premium ha presens he difference beween he 3-monh U.S. T-bill and 1-monh U.S. T-bill raes. Several local insrumenal variables are considered: excess reurns of counry -specific sock indices (EXR), dividend yields (DIV), long-erm o shor-erm ineres rae spreads (TERM), shor-erm ineres raes (INT), and foreign exchange rae changes (FX) for each marke. These variables are described as follows: (1) EXR j, 1 is he monhly U.S. dollar reurn on he MSCI sock index j which is expressed in excess of 1-monh U.S. T-bill rae. () DIV j,-1 is he monhly dividend yield on he MSCI sock index for counry j, expressed as he excess of he 1-monh U.S. T-bill rae. (3) TERM j, 1 is he erm premium for counry j, which presens he difference beween long-erm governmen bond yields and shor-erm ineres raes. (4) INTj, 1 is he shor-erm ineres rae for counry j. (5) FX j, 1 is he foreign exchange rae movemen in U.S. dollars for counry j. Table 4 provides he regression resuls on he predicabiliy of large-, mid-, and small-cap sock porfolio reurns using he common (Panel A) and local (Panel B) insrumenal variables. These variables are lagged one period o esimae he expeced porfolio reurns, excep for he January dummy variable. For breviy, we only presen he eigh larges markes from he MSCI index weigh described in Secion.. Panel A of Table 4 repors ha he MSCI global excess reurn has significanly posiive coefficiens ( 1 ) for large socks in Russia, Souh Africa, and India; for mid socks in Brazil, Russia, and Souh Africa; and for small socks in Russia, Souh Africa, India and, Mexico, bu he coefficiens are no significan for porfolio reurns in China, 9

11 Souh Korea, and Taiwan. The variables of he January dummy ( ) have significan explanaory power only for small socks in Taiwan and India. The dividend yields offer predicive power on he porfolio reurns for Taiwan hrough a significanly negaive 3 coefficien, bu he coefficiens of defaul risk premium ( 4 ) are no significan for all counries. The difference in shor-erm ineres raes ( 5 ) provides significanly negaive power for predicing of mid- and small-cap sock reurns in China and Souh Korea. Huang (007) indicaes ha, for developed counries, he January effec is more obvious in small-cap socks han in large-cap socks, and he adjused R values are higher for small-cap socks, bu he same resuls are no found in emerging markes. [Inser Table 4 here] Panel B of Table 4 presens he predicabiliy of counry index reurns wih local insrumenal variables. The coefficiens of MSCI counry-specific lagged excess reurns ( 1 ) on he size-based porfolio reurns are significan and posiive for largeand mid-cap porfolios in Taiwan, Brazil, Souh Africa and for five small-cap porfolios. The dividend yield ( ) offers significan predicive power for small-cap socks in Taiwan and India (0.05 and -0.08). The coefficiens of erm premium ( 3) and he shor-erm ineres rae difference ( 4 ) are saisically significan for some porfolios in Brazil and Mexico. The influence of exchange rae movemens ( 5 ) is negaive for mid and small socks in Souh Korea, bu is posiive for large socks in Souh Africa, small socks in Brazil, and all sock porfolios in India. 5 This able shows ha esimaes wih significan coefficiens are limied and he adjused R values are small; hese condiions also occurred in previous sudies. 6 In addiion, consisen wih Avramov (00) and Huang (007), he MSCI world and counry index reurns have more posiive predicabiliy on small-cap porfolio reurns han large-cap reurns. We sugges ha he predicive power of he wo lagged index reurns decreases, because large companies are more correlaed wih he world marke and are he main componens of MSCI counry indices. 3. Asse pricing ess on size-based sock porfolios 3..1 GMM ess wih he condiional IAPM This sudy nex invesigaes wheher he resricions of he condiional IAPM can 5 This sudy also uses insrumenal variables o regress he excess reurn of he op 5% and op 10% porfolios and finds ha heir regression resuls are similar o large-cap sock porfolios. 6 See Harvey (1991), Campbell and Hamao (199), and Huang (007). 10

12 be rejeced for size-based sock porfolios. If he model fis well, he expeced excess sock reurns should be priced globally. To compare wih earlier sudies, he MSCI counry index reurns are added o he sample. This invesigaion uses he GMM mehod o esimae he model parameers in equaion (8), and hen ess he goodness of fi for his model using he saisics and he MAE values defined in equaion (7). If he saisics for he overidenifying resricion are no rejeced and he pricing error is small, his indicaes ha he pricing model can predic he porfolio reurns and a co-movemen exiss beween he sock porfolios and he world marke. The condiions also impose a consan world price of covariance risk across counries. By conras, rejecion of his model shows ha porfolio reurns canno be priced globally and sock reurns should be deermined by heir local risk facors. Table 5 presens he resuls of saisics (Panel A) and he MAE values (Panel B) for he five size-based sock porfolios. Panel A shows ha he model resricions of he condiional IAPM canno be rejeced in 17 large-cap porfolios from he values (a he 10% level). Furhermore, he saisics for super large-cap porfolios show ha he model canno be rejeced for 17 counries in he op 5% porfolios and 1 counries in he op 10% porfolios. For he eigh larges markes, he model only rejecs Russia for he op 5% porfolio and rejecs hree counries for he op 10% porfolios. Therefore, large-cap socks are inegraed wih he world marke and heir excess reurns should be priced by global variables, and he financial inegraion perains o super large-cap socks in large emerging markes. 7 For MSCI indices, he values are equivalen o hose of he large-cap porfolios and only six counries rejec he IAPM resricions. The resuls indicae ha he global pricing model for sock indices likely reflecs he pricing of large-cap socks. This finding is generally consisen wih hose of Harvey (1991) and Huang (007). [Inser Table 5 here] For small-cap sock porfolios, he values show ha 19 markes are rejeced a he 5% level, and reveal ha heir sock reurns are no priced globally under he model resricions. However, he model canno be rejeced for Taiwan and he Czech Republic. This is because he elecronic indusry plays an imporan role in he wo counries and many small companies conduc manufacuring for large elecronic 7 The model is rejeced for super large-cap socks in Russia. This may be caused by he larges socks in Russia being mosly naion-owned enerprises and hese companies including oil, naural gas, and minerals. The influence of he world marke movemen is limied for hese super large socks. 11

13 indusries, which would increase he financial inegraion of hese companies. Panel B repors ha he mean absolue pricing errors in he super large- and large-cap socks are ypically lower han in mid- and small-cap socks, bu he differences among he op 5% and op 10% and large porfolios are finie. Average pricing errors for he op 5%, op 10%, large-, mid-, and small-cap porfolios are 1.54%, 1.50%, 1.51%, 1.87%, and.34%, respecively. The average of pricing errors for MSCI counry indices is 1.5%. Thus, consisen wih Panel A of his able, he resuls furher evidence ha he condiional IAPM represens he bes goodness of fi for super large- and large-cap sock porfolios, and he pricing errors of he hree porfolios are close o ha of MSCI counry indices. Fedorov and Sarkissian (000) find small socks have a greaer pricing error in Russia. Huang (007) indicaes ha he pricing errors of large-cap sock porfolios are similar o MSCI counry indices, wih hose errors smaller han ha of mid- and small-cap socks in developed markes. Our findings are consisen wih earlier sudies and show ha large-cap socks are fied for he condiional IAPM and should be priced globally. 3.. Tess on he consan world price of covariance risk If inernaional capial markes are fully inegraed, he expeced reurns of individual capial asse are proporional o ha of he world marke porfolio; ha is, he world price of covariance risk is he same across counries. This sudy furher invesigaes wheher he expeced reurns of size-based porfolios can be priced by he same covariance risk and measures heir expeced compensaion for world marke volailiy. By applying he GMM mehod proposed by Harvey (1991), his sudy esimaes he reward-o-risk raios for each counry and saves he weighing marix and values. As described in equaion (10), a resriced muliple-counry sysem wih a consan reward-o-risk raio across counries is esimaed using he saved weighing marix. Panel A of Table 6 repors he esimaing resuls. Comparing he esimaors of world covariance risk, he reward-o-risk raios beween hese porfolios are no equivalen, and he raios of large socks are lower han ha of small socks. The resuls sugges low compensaion for he world covariance risk in large socks. [Inser Table 6 here] To es he model finess, his sudy uses he GMM mehod o es overidenifying resricions, and Panel B of Table 6 presens he resuls. The values show ha he model is no rejeced for 18 large porfolios (excep for Israel, Indonesia, Egyp, Colombia, and Peru), wih saisical significance a he 10% level, and he porfolios conain he eigh larges markes. We furher examine he super large-cap porfolios 1

14 and find ha he values of he op 10% porfolios are qualiaively he same as hose of large-cap porfolios. For he op 5% porfolios, only Russia and Colombia rejec he model seings (a he 5% level). The null hypohesis is rejeced for all emerging counries a he 10% level for mid- and small-cap socks. These findings are similar o earlier resuls. Therefore, according o he condiional IAPM or a consan world covariance risk, he pricing models indicae ha he world marke movemen has explanaory power on excess reurns of super large- and large-cap socks and ha heir excess reurns should be priced globally. 3.3 Tess of condiional IAPM for super large-cap porfolios The empirical resuls show ha super large-cap sock porfolios have he greaes degree of world marke inegraion. The sock porfolios are sored by marke values in heir lising counry; however, each counry s marke value varies relaively versus oher counries. For example, he mid-cap sock in China may indeed be a large-cap sock in Pakisan. In addiion, if re-arranging he full sample socks according o heir marke values a he end of 009, he composiion of op 5% and op 10% sock porfolios from he eigh larges markes are 79% and 73%, respecively. To invesigae he financial inegraion of large socks more clearly, requires considering firm size based on all emerging markes. Therefore, his invesigaion reorders he sample socks according o heir marke values a he end of 009 and consrucs he op 5% and op 10% sock porfolios. The finess of he global pricing model is measured using he mehodology in Secion. o explore wheher he wo new porfolios would be more inegraed globally. Table 7 repors he resuls. From he values of he wo porfolios, he model resricion of condiional IAPM canno be rejeced a he 5% level. In addiion, he pricing errors for he op 5% and op 10% sock porfolios are 0.69% and 0.66%, respecively. They are subsanially lower han he errors of he wo porfolios from each counry in Panel B of Table 6 (1.54% and 1.50% for he op 5% and op 10% porfolios). Finally, he null hypohesis of a consan price of world covariance risk canno be rejeced. Therefore, he resuls of he hree ess are sufficienly powerful o suppor he assumpion ha he larges socks in emerging markes have a higher degree of world marke inegraion and srongly indicae ha hese sock reurns should be priced globally. [Inser Table 7 here] 13

15 3.4 Using he Emerging Markes Index o measure marke inegraion This secion uses he MSCI Emerging Marke Index o replace he MSCI World Marke Index and invesigaes wheher his index is more appropriae for measuring he inegraion of emerging markes. We adap he oher global insrumenal variables defined in Secion 3.1 in he pricing model, and hen es he model resricions and calculae he pricing errors. Table 8 presens he resuls of saisics (Panel A) and he MAE values (Panel B). Using he emerging marke index, Panel A shows six, five and, six counries ha rejec he model resricions for he respecive op 5%, op 10% and large-cap porfolios. For mid- and small-cap socks, he model resricions are rejeced for 8 and 19 counries. The resuls are similar o hose using he world index in Panel A of Table 5. Therefore, he emerging marke index does no increase evidence o suppor he model resricions from he values, and his resul does no find an index ha is more fied for emerging markes. [Inser Table 8 here] Panel B of Table 8 presens he MAE values. Consisen wih he resuls of he world marke index in Panel B of Table 5, he larges socks have he lowes pricing errors, and he smalles socks have he greaes errors. The averages of MAE values for he op 5%, op 10%, large-, mid- and small-cap sock porfolios are 1.56%, 1.45%, 1.47%, 1.78% and.1%, respecively. We compare he difference in MAE values beween he wo marke indices and measure which index provides a lower pricing error. A negaive difference indicaes he world marke index has a higher predicabiliy for excess sock reurns. We find ha, for he op 5% and op 10% porfolios, he average of MAE differences is -0.03% and 0.05%, respecively. In conras, he average differences for he large-, mid- and small-cap socks are all posiive, and he greaes is he small-cap socks (0.%). The findings also show ha he average differences of he eigh larges markes are lower han ha of all emerging markes, and he differences for he op 5% and op 10% porfolios are -0.07% and %, respecively. In sum, his resul suggess ha world marke inegraion occurs primarily for he larges socks of large markes, and hese socks have idenical global risks. However, he emerging marke index can provide more explanaory power on he excess reurns of oher size-based porfolios, and hese socks offer greaer benefis of inernaional diversificaion. Therefore, hese findings provide convincing evidence ha he world index reurn is he bes predicor for excess sock reurns of he larges socks, paricularly for socks in large emerging markes. 14

16 3.5 Tess of condiional CAPM wih wo subperiods To es wheher he degree of financial inegraion changes over ime, he sample period is divided ino wo subperiods: January 1997 o March 003 and April 003 o December 009, based on he dynamics of he MSCI Emerging Marke Index shown in Fig. 1. In his figure, wo major rends emerge during he sample period. The firs rend rereas because of he burs of he do-com bubble and he reversed course of he bear marke in April 003. This marke index shows a rapid rise because of he moderae inflaionary numbers and low ineres raes. However, since he bear marke resuling firs from high energy prices, and subsequenly from he U.S. subprime morgage crisis, his index dropped sharply in lae 008. The bear marke reversed course in March 009, as he index rebounded more han 50% o he close of he year from is low. Based on he wo major rends, we use he IAPM model defined in equaion (8) o measure he change of MAE values beween he wo subperiods. Values in he second period ha are less han he firs period mean ha he degree of inegraion has increased in he second period. [Inser Fig. 1 here] [Inser Table 9 here] Table 9 repors he resuls. The averages of MAE changes from he firs o he second period are -46%, -3% and -5% for op he 5%, op 10% and large-cap socks, respecively. However, he average changes are 1% and 11% for he respecive midand small-cap socks. The average changes for he MSCI counry index is similar o he op 5% porfolios. The MAE changes of super large-cap socks clearly show ha hese socks are more inegraed globally in he second period. However, he degree of change for mid- and small-cap socks has no increased over ime. For he eigh larges markes, he differences in changes are consisen wih he full markes, bu he degree of financial inegraion for large-cap socks has increased. As expeced, he empirical resuls show ha only he larges socks have increased heir degree of inegraion over ime; even emerging capial markes increase rapidly. The finding is consisen wih he Huang s (007) sudy for large socks in developed markes. 4. Conclusion Previous sudies generally have suggesed ha emerging markes are no inegraed wih he world marke; however, he financial inegraion of heir large-cap socks is 15

17 imporan for furher invesigaion. This sudy examines wheher he excess reurns of size-based sock porfolios can be priced by he world covariance risk in emerging markes. I implemens he ess of he unresriced CAPM and a consan world covariance risk and finds he model s seings canno be rejeced for mos large-cap socks, bu is rejeced for mid- and small-cap socks. Consisen wih earlier sudies, he findings suppor ha large socks are priced globally, bu he influence of global variables on he mid- and small-cap socks is limied. To invesigae he financial inegraion more clearly, his sudy measures he inegraion of super large-cap socks and he influence of he emerging marke index. We find ha super large-cap socks have he lowes model pricing errors and he degrees of financial inegraion have increased when hese socks are obained by soring from he full samples, no from each counry. If we use he emerging marke index o replace he world marke index, hen he pricing errors do no decrease for super large-cap sock, bu do decrease for mid- and small-cap socks. Finally, when he sample is divided ino wo sub-periods, he degree of world marke inegraion has increased for super large-cap socks in recen years. Overall, he empirical resuls provide evidence of financial inegraion for super large-cap socks and indicae ha he inegraion primarily relaes o large markes. These findings are imporan for porfolio managers and inernaional invesors and are also significan for pricing securiies and making asse allocaion decisions in emerging markes. References Avramov, D. 00. Sock Reurn Predicabiliy and Model Uncerainy. Journal of Financial Economics 64, no. 3: Baele, L Volailiy Spillover Effecs in European Equiy Markes. Journal of Financial and Quaniaive Analysis 40, no. : Bekaer, G., and C. R. Harvey Time-Varying World Marke Inegraion. Journal of Finance 50, no. : Bodie, Z.; A. Kane; and A. J. Marcus. Invesmens and Porfolio Managemen, 9nd Ed, NY: McGraw-Hill,

18 Campbell, J. Y., and Y. Hamao Predicable Sock Reurns in he Unied Saes and Japan: A Sudy of Long-erm Capial Marke Inegraion. Journal of Finance 47, no. 1: Chang, E. C.; J. M. Pinegar; and R. Ravichandran Predicabiliy and Regional Inegraion of Pacific Basin Equiy Markes. Journal of Inernaional Financial Managemen and Accouning 5, no. 1: Dunis, C. L., and G. Shannon Emerging Markes of Souh-Eas and Cenral Asia: Do They Sill Offer a Diversificaion Benefi? Journal of Asse Managemen 6, no. 3: Erb, C. B.; C. R. Harvey; and T. E. Viskana. Counry Risk in Global Financial Managemen. Charloesville, VA: The Research Foundaion on he IFCA, Fedorov, P., and S. Sarkissian Cross-secional Variaions in he Degree of Global Inegraion:The Case of Russian Equiies. Journal of Inernaional Financial Markes, Insiuions and Money 10, no. : Gérard, B.; K. Thanyalakpark; and J. A. Baen Are he Eas Asian Markes Inegraed? Evidence from he ICAPM. Journal of Economics and Business 55, no. 5: Hansen, L. P Large Sample Properies of Generalized Mehod of Momens Esimaors. Economerica 50, no. 4: Hardouvelis, J. G.; D. Malliaropulos; and R. Priesley EMU and European Sock Marke Inegraion. Journal of Business 79, no. 1: Harvey, C. R The World Price of Covariance Risk. Journal of Finance 46, no. 1:

19 Harvey, C. R Predicable Risk and Reurn in Emerging Markes. Review of Financial Sudies 8, no. 3: Heson, S. L.; K. G. Rouwenhors; and R. E. Wessels The Srucure of Inernaional Sock Reurns and he Inegraion of Capial Markes. Journal of Empirical Finance, no. 3: Huang, W Financial Inegraion and he Price of World Covariance Risk: Large- vs. Small-cap socks. Journal of Inernaional Money and Finance 6, no. 5: Solnik B., and D. Mcleavey. Global Invesmen, 6nd Ed, Pearson Inernaional Ediion, NJ: Prenice Hall, 009. Sulz, R A Model of Inernaional Asse Pricing. Journal of Financial Economics 9, no. 4: Wang, M. C., and F. M. Shih. 01. Time-Varying World and Regional Inegraion in Emerging European Equiy Markes. European Financial Managemen, forhcoming. Yu, I. W.; K. P. Fung; and C. S. Tam Assessing Financial Marke Inegraion in Asia-Equiy Markes. Journal of Banking and Finance 34, no. 1:

20 Table 1 Descripions of MSCI emerging markes on December 31, 009 Counry Number of companies lised Marke capializaion of sock exchange (billions of U.S. dollars) Weigh in MSCI Emerging Marke Index (%) China (CN) Brazil (BR) Souh Korea (KR) Taiwan (TW) Russia (RU) India (IN) Souh Africa (ZA) Mexico (MX) Israel (IL) Malaysia (MY) Poland (PO) Turkey (TU) Indonesia (IN) Chile (CH) Thailand (TH) Czech Republic (CZ) Egyp (EG) Hungary (HN) Colombia (CO) Peru (PE) Philippines (PH) Argenina (AS) Pakisan (PK) The Morgan Sanley Capial Inernaional (MSCI) Emerging Marke Index includes 3 counries on December 31, 009. These counries are: China (CN), Brazil (BR), Souh Korea (KR), Taiwan (TW), Russia (RU), Souh Africa (ZA), India (IN), Mexico (MX), Israel (IL), Malaysia (MY), Poland (PL), Turkey (TR), Indonesia (ID), Chile (CL), Thailand (TH), Czech Republic (CZ), Egyp (EG), Hungary (HU), Colombia (CO), Peru (PE), Philippines (PH), Argenina (AS), and Pakisan (PK). The number of companies lised and he marke capializaion of sock exchanges are drawn from Daasream. The weigh in he MSCI Emerging Marke Index is drawn from Morgan Sanley Capial Inernaional.

21 Table Summary saisics for he size-based porfolios of emerging markes Porfolio Top 5% Top 10% Large Mid Small CN 0.04 (8.4) 0.08 (8.34) 0.11 (8.19) 0.61 (9.80) 1.08 (10.44) BR 1.48 (10.1) 1.6 (9.68) 1.5 (9.17) 1.53 (7.3) 3.91 (11.38) KR 0.67 (0.80) 0.81 (19.57) 0.71 (18.47).73 (18.17) 5.1 (1.8) TW 0.1 (7.91) 0.07 (7.87) 0.05 (7.83) 0.13 (8.98) 0.70 (9.43) RU.30 (18.97) 3.8 (7.98) 3.5 (3.3) 5.55 (3.75) 5.1 (16.17) IN 1.0 (9.09) 1.13 (8.98) 1.18 (8.9) 3.83 (16.85) 3.30 (1.76) ZA (7.90) -0.8 (7.41) -0.8 (7.05) (6.31) (6.45) MX 1.58 (8.10) 1.58 (7.88) 1.4 (7.37) 0.85 (7.71) 1.5 (8.40) IL 0.89 (6.14) 0.84 (6.0) 0.8 (6.34) 1.09 (6.89).1 (7.0) MY 0.16 (8.4) 0.1 (8.43) 0.06 (8.74) (11.78) -0.5 (13.40) PO 0.41 (9.58) 0.39 (3.0) 0.4 (8.66) -1.0 (1.7) 1.5 (9.86) TU 3.83 (16.90) 3.73 (16.54) 3.59 (16.13) 4.17 (16.40) 3.63 (14.43) IN 0.8 (11.53) 0.90 (11.0) 0.83 (10.87) 1.91 (14.33).74 (14.67) CH 0.54 (5.85) 0.69 (5.70) 0.7 (5.34) 1.04 (5.9) 1.8 (4.76) TH 0.01 (11.5) -0.0 (11.7) (10.91) 1.17 (9.96).46 (10.90) CZ 0.91 (10.41) 0.73 (10.37) 0.61 (9.14) 0.95 (8.99) 1.35 (10.75) EG (10.83) 0.13 (10.17) 0.17 (8.9) 0.53 (8.55) 1.79 (10.55) HN 1.08 (11.13) 1.8 (9.68) 1.1 (9.17) 0.71 (8.54).57 (13.40) CO 1.1 (11.0) 1.43 (9.50) 1.44 (9.08) 1.76 (7.09).68 (9.4) PE 0.51 (8.34) 0.4 (7.4) 0.87 (6.65) 1.44 (6.95) 5.19 (16.93) PH 0. (8.37) 0.03 (8.) (8.5) 0.70 (11.68) 9.45 (18.34) AS 1.59 (9.71) 1.5 (9.66) 1.45 (9.51) 0.84 (10.96) 1.34 (10.17) PK 1.6 (11.81) 1.68 (11.36) 1.77 (10.87).7 (8.93).53 (8.85) Average 0.89 (10.56) 0.97 (10.8) 0.94 (9.57) 1.37 (10.80).56 (14.49) MSCI U.S (4.68) MSCI World (4.495) This able repors he means and sandard deviaions (in parenheses) of sock porfolios based on monhly excess reurns from January 1997 o December 009 (156 observaions) for 3 emerging markes. These porfolios are obained by grouping he individual socks ino deciles according o heir marke values a he end of each previous year. The socks in he firs wo (smalles wo) deciles form he large-cap (small-cap) sock porfolio, he middle 0% socks form he mid-cap porfolio, and he op 5% (op 10%) porfolios are hose socks in he larges 5% (larges 10%) of sock marke value for each counry. The sized-based porfolio reurns are value-weighed and are calculaed in U.S. dollars in excess of he holding reurns on he 1-monh U.S. T-bill. The MSCI emerging markes include China (CN), Brazil (BR), Souh Korea (KR), Taiwan (TW), Russia (RU), Souh Africa (ZA), India (IN), Mexico (MX), Israel (IL), Malaysia (MY), Poland (PL), Turkey (TR), Indonesia (ID), Chile (CL), Thailand (TH), Czech Republic (CZ), Egyp (EG), Hungary (HU), Colombia (CO), Peru (PE), Philippines (PH), Argenina (AS), and Pakisan (PK). The means and sandard deviaions on he excess reurns of he MSCI U.S. Index and World Index are also repored. All values are muliplied by 100.

22 Table 3 Correlaion marix of he MSCI counry index reurns and he size-based porfolio reurns Panel A: Correlaion marix of he MSCI counry index reurns WD US CN BR KR TW RU IN ZA MX IS MY PO TU ID CL TH CZ EG HU CO PE PK AR US 0.95 CN BR KR TW RU IN ZA MX IS MY PO TR ID CL TH CZ EG HU CO PE PH AR PK Emerging markes Developed markes [Huang (007)] Average correlaion coefficiens beween he MSCI counry index reurns and he MSCI U.S. index reurns Average correlaion coefficiens beween he MSCI counry index reurns and he MSCI world index reurns Average correlaion coefficiens beween MSCI counry index reurns Panel B: Averages correlaion coefficiens of size-based porfolio reurns Emerging markes Developed markes [Huang (007)] Porfolio World U.S. Large-cap Mid-cap World Large-cap Mid-cap Large-cap Mid-cap Small-cap The correlaions are based on monhly daa from January 1997 o December 009 (156 observaions). Panel A presens he correlaion marix of he excess reurns on he MSCI counry indices. Panel B repors he average correlaion coefficiens of size-based porfolio excess reurns. Huang s resuls are based on nine developed counries from January 1980 o December 004.

23 Table 4 Regression resuls for global and local insrumenal variables on he size-based porfolio excess reurns of emerging markes Panel A: Regression resuls for global insrumenal variables Panel B: Regression resuls for local insrumenal variables Porfolio R R CH-L 0.08** (.43) 0.15 (0.89) 0.01 (0.51) -.04 (-0.59) (-0.99) (-0.97) (0.86) 0.04 (0.63) 0.01 (0.55) 0.1 (0.37) (-0.48) (-1.09) BR-L 0.03 (0.87) 0.09 (0.50) (-0.15) (-0.6) (-0.16) -0.4 (-0.6) (-0.49) (-0.78) 0.01 (-0.01) (-1.38) (-0.36) 0.53 (1.05) KR-L 0.10 (1.33) 0.36 (0.94) 0.03 (0.58) (-0.9) 1.09 (0.1) -3. (-0.98) (1.35) 0.10 (0.80) 0.04 (0.68) (-0.1) (-0.61) (-1.41) TW-L 0.01 (0.4) 0.3 (1.44) 0.04 (1.6) -7.3** (-.18) (-1.5) 1.48 (1.09) (0.04) 0.0 (0.31) 0.03 (1.45) 0.37 (0.57) (-0.9) -0.0 (-0.4) RU-L 0.1 (1.37) 0.79* (1.65) (-0.91) (-0.51) 16.0 (1.41) -7.4 (-1.8) (-0.1) 0.7** (.6) (-0.78) 3. (0.87) 3.37 (0.9) 0.0 (0.01) IN-L 0.01 (0.34) 0.53*** (.89) -0.0 (-0.88) -.4 (-0.58) (-0.08) 0.3 (0.14) (-1.05) 0.09 (1.06) -0.0 (-0.66) 0.15 (0.6) -0. (-0.5) 4.71*** (.64) ZA-L 0.01 (0.06) 0.5* (1.70) 0.01 (0.57) -.44 (-0.79) -0. (-0.06) (-0.05) (-0.9) 0.06 (0.95) 0.01 (0.80) 0.81** (.10) (-0.83) 1.8* (1.75) MX-L 0.03 (0.97) 0.05 (0.34) 0.04 (0.0) (-0.01) -.8 (-0.6) 0.13 (0.11) (0.39) (-0.94) 0.05 (0.4) -0.57** (-.94) -0. (-1.33) 0.75 (0.36) CH-M 0.13*** (3.39) (-0.33) 0.04 (1.37) -.50 (-0.61) (-0.81) -.96* (-1.76) (0.99) (-0.4) 0.04 (1.7) 0.58 (0.84) (-0.48) (-1.46) BR-M 0.04 (1.41) 0.61*** (4.1) 0.01 (0.09) (-0.55) 0.91 (0.6) (-0.85) (-0.66) 0.19*** (3.70) 0.03 (0.13) 0.04 (0.17) 0.05 (0.6) 0.63 (1.61) KR-M 0.1*** (.94) 0.18 (0.48) 0.08 (1.43) (-0.69) (-0.01) -5.99* (-1.90) * (1.91) 0.10 (0.83) 0.08 (1.49) (-0.13) -0.1 (-0.5) -7.15** (-.07) TW-M 0.01 (0.37) 0.4 (1.8) 0.04 (1.56) (-.38)** -.93 (-0.67) 0.53 (0.34) (-0.35) 0.18** (.04) 0.03 (1.33) 0.45 (0.6) 0.06 (0.10) 0.5 (0.7) RU-M 0.13 (1.38) 1.15** (.37) -0.0 (-0.31) 5.0 (0.50) 6.6 (0.54) (-1.06) (0.83) 0.37 (3.04) (-0.14) 3.9 (0.89) 3.8 (0.89) 0.03 (0.01) 0.04 IN-M 0.04 (0.76) 0.54 (1.55) (-1.66) (1.43) -.3 (-0.7) 0.31 (0.10) (-0.17) 0.17 (1.06) (-1.61) -0.1 (-0.19) (-1.3) 8.1** (.46) ZA-M (-1.51) 0.37*** (.86) 0.0 (0.86) -4.83* (-1.86) (-0.56) (1.3) (-0.09) 0.18*** (3.03) 0.01 (0.83) -0.0 (-0.07) -0.46** (-.38) 1.36 (1.5) 0.19 MX-M 0.0 (0.06) 0.16 (1.0) 0.01 (0.0) -.00 (-0.59) (-0.47) 0.70 (0.55) (0.89) -0.0 (-0.34) 0.01 (0.04) -0.46** (-.13) -0.31* (-1.71) (-0.17) CH-S 0.16 (3.81)*** -0.0 (-0.96) 0.03 (0.85) (-0.45) -3.6 (-0.8) -3.65** (-.05) (0.91) (-0.71) 0.0 (0.7) 0.80 (1.08) -0. (-0.6) (-1.49) BR-S 0.08* (1.71) -0.0 (-0.09) 0.04 (1.11) -.5 (-0.51) (-0.87) 0.07 (0.04) (0.33) (-0.19) 0.04 (1.13) (-1.5) (-0.97) 1.33*** (.09) 0.01 KR-S 0.9*** (3.34) (-0.31) 0.09 (1.35) 1.15 (0.1) (-0.19) -7.41* (-1.95) ** (.08) -0.0 (-0.17) 0.08 (1.9) 0.37 (0.10) (-0.18) -8.84** (-.17) 0.05