Time-varying financial integration and contagion

Abstract

This thesis examines the evolution of the financial integration and contagion of international stock and bond markets. We focus on integration at the portfolio level, which is constructed by the stock market value, BE/ME ratio, and the bond maturity respectively, in addition to those at the aggregate national market level. The aim is to examine whether these asset characteristics (size effect, BE/ME, and bond maturities) are conductive to the systematic discrepancies in integration between these portfolios with the world market respectively. For financial contagion, this study attempts to investigate whether there exists any financial variables that are competent for identifying the crisis period, whether the contagion coefficient can be expressed as a function of these variables, and whether the contagion level is constant over time. To examine these issues, we model the time variation of integration within the Kalman filter framework extended to allow for GARCH effects in the innovations. The likelihood ratio test shows that our GARCH-filter model, which combines the Kalman filter and GARCH effect, is indeed more efficient than the traditional Kalman filter system. The main results show that large (/growth) stock portfolios are more integrated with the world than small (/value) portfolios. They also show bond portfolios with longer maturities are always more integrated with the world than short-term bonds. For testing contagion, focusing on the transmission of price shocks at times of financial crisis, we find that the conditional variance of assets returns and the increased level of integration are excellent variables for identifying the crisis period. Furthermore, the contagion levels based on these two variables vary dramatically all the time, but are significantly different from zero over time for most cases in our sample. Thus, this study offers more opportunities for investors and portfolio managers, who can benefit from new insight into the co-movements among different asset portfolios in different international markets. The study also provides a consistent platform for measuring financial contagion.