Essays on Financial Market Interdependence

University dissertation from Department of Economics, Lund Universtiy

Abstract: This thesis aims at investigating the risk spillover and correlations among national stock markets, and the structure of dependence between stocks and commodity futures. It consists of four chapters. Chapter 1 briefly reviews the literature background of financial market interdependence and summarizes the contribution of the thesis.

Chapter 2 proposes a binary response model approach to measure and forecast extreme downside risks in Asian-Pacific markets given information on extreme downside risks in the U.S. and Japanese markets. The extreme downside risk of a market is measured as the occurrence of extreme downside movement market returns falling below left-tail Value at Risk in a Markov switching framework. The empirical findings are consistent with the following notions. First, extreme downside movements of the S&P 500 and Nikkei 225 are significantly predictive for the likelihood of extreme downside movements in all the investigated Asian-Pacific markets. Second, the majority of Asian-Pacific markets become more sensitive to Japan's extreme downside risk when the Japanese market switches into high volatility periods, whereas the U.S. spillover effect is intensified only on Taiwan during high volatility periods in the U.S. Third, mainland China is the least sensitive to extreme downside risk in the U.S. and Japan, Australia is the most sensitive to the U.S., and Singapore is the most sensitive to Japan.

Chapter 3 finds substantial risk diversification potential between seven groups of commodity futures and stocks by exploring the dependence between their patterns of regime switching. None of the commodity futures groups share a common volatility regime with stocks, nor are the regime switching patterns of grains, industrials, metals, or softs, dependent on that of stocks. Simultaneous volatile regimes of commodity futures and stocks tend to be infrequent and short-lived. Correlations between the commodity futures and stocks are low, despite of increase in simultaneous volatile regimes. In addition, animals, grains, and softs demonstrate very low correlations with stocks even in simultaneous volatile regimes.

Chapter 4 uses a dynamic panel gravity model to explain the correlations between 41 markets from 1996 to 2010 using four types of market linkages: information capacity, financial integration, economic integration, and similarity in industrial structure. While all the linkages have a significant impact on the overall stock market correlations, the mechanism of interdependence of developed markets is different from that of developing markets and varies over sub-periods. Information capacity has a stronger impact on the interdependence of developed markets than on that of developing markets. There is a negative relation between industrial dissimilarity and stock market interdependence in the second half of the sample period, 2003--2010, which is more evident for developed markets. A significant effect of joint EMU participation is found on stock market integration from 1996 to 2002. However, this effect becomes insignificant in the post monetary transition period of EMU (2003--2010) when one controls for heterogeneous mechanisms across markets at different levels of development.