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Stock market crises and portfolio diversification in Central and Eastern Europe

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Stock market crises and portfolio diversification in Central and Eastern Europe
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  Stock market crises and portfolio diversification in Central and Eastern Europe    Plamen Patev* , PhD D Tsenov Academy of Economics, Department of Finance and Credit 2 Emanuil Chakarov Str. 5250 Svishtov, Bulgaria e-mail: patev@uni-svishtov.bg    Nigokhos Kanaryan D Tsenov Academy of Economics, Department of Finance and Credit 2 Emanuil Chakarov Str. 5250 Svishtov, Bulgaria e-mail: kanaryan@uni-svishtov.bg   * Corresponding author   2 Stock market crises and portfolio diversification in Central and Eastern Europe Abstract We investigate the Central and Eastern European equity market co-movements  before, during and after major emerging market crises. Our study is based on the concept of co-integration. We examine the impact caused by the crisis on the gains of international portfolio diversification in Central and Eastern Europe. The results of the co-integration tests indicate that there is no long-run relationship between the US and the four Central European stock markets. We find a feedback effect and causality in one direction during and after the crisis period. Portfolio benefits decrease in the crisis period  but they increase in the post-crisis period.   3 Stock market crises and portfolio diversification in Central and Eastern Europe 1. Introduction Stock market integration is widely investigated area. It is a consequence of intensive international stock market integration, which has been observed during the last decades. This integration is a result from several powerful economic processes spread over the world. First, stock market integration is a result of economic integration. Second, the market integration is intensified by liberalization and international investment  process. Third, market integration has been influenced by process of market contagion. Two approaches for detecting market integration could be outlined from  published studies. The first approach is focused on investigation of return generating factors. An integrated market implies a high correlation between expected returns in different markets. Karolyi and Stulz (1996) explore the fundamental factors that affect cross-country return. In the same direction are the studies of Camplell and Hamao (1990), Bekaert and Hodrick (1992) etc. Jorion and Schwartz (1986) and Harvey (1991)  suggested single beta model for a world price of covariance risk. In fact, this approach develops International Capital Assets Pricing Model. The second popular approach employs the concept of co-integration. The studies are mostly based on Engle and Granger (1987) methodology. It is based on econometrics tests that quantify market integration. Our study is based on the concept of co-integration. We are not interested in describing factors that affect cross-country returns. Our study aims to quantify co-integration between markets in Central and Eastern Europe (CEE). We assume that the emerging markets in CEE have short history and miss rich experience. These reasons make us rely on econometric approach instead on theoretical model. Thus the econometric view could provide more adequate information about specifics of these new markets. In this paper we investigate four in Central and Eastern Europe - Russia, Poland, Czech republic and Hungary. We regard these markets as a new emerging market region.   4These countries carry out severe market reforms during the 1990-s and have achieved some success. Development of stock markets in these countries is one of the market reforms. Although the short history, Central and Eastern European markets (CEEM) have  passed through several crises – the 1997 Asian, the 1998 Russian and the 1999 Brazilian crisis. These crises happened one after other. It turns out that CEEM has existed in conditions of long crisis period. The objective of this study is to investigate the equity market co-movements of the main Central and Eastern European markets before, during and after the crises period. We examine the impact caused by the crisis on the gains of international portfolio diversification in Central and Eastern Europe. We are interested how market crisis change the benefits for an U.S. investor from portfolio diversification in CEEM. If market integration has increased after the crisis this would lead to less diversification opportunities. If CEEM are not integrated during and after crisis they would attract  portfolio investments. We do not base our conclusions on simple correlation analysis. We employ well-known co-integration techniques for evaluating market co-integration. Firstly we test the market data for stationarity. We use Augmented Dickey-Fuller test and Phillips-Perron test. To identify long run multivariate integration between CEEM we apply Johansen co-integration test. We prove that CEEM are not integrated market. Next we apply Granger causality test and variance decomposition techniques to evaluate short run integration. We define significant increase of the co-integration between CEEM themselves and  between CEEM and U.S. market during the crisis period. However, market co-integration decreases during the post-crisis period. In this way it can be proved that CEEM restore their diversification benefits. The study is structured as follows. Next part presents a review of literature. In part 3 we briefly describe the data and methodology. In part 4 we present the empirical results. The Conclusion is in part 5.   5 2. Literature review  Numerous empirical studies employ co-integration technique to explore international equity market linkages. One group of these studies is concentrated on developed market integration and co-movements between these markets. Arshanapalli and Doukas (1993) find strong evidence of bi-variate co-integration between three European markets (UK, Germany, France) and U.S. Gerrits and Yuce (1999) report significant U.S. impact on three major European markets. Also they find short and long run linkage between European markets, which is an evidence for low diversification  benefits of European portfolios. In contrast, Kanas (1998) find no evidence for double co-integration between U.S. market and six largest markets in Europe. The same conclusion  presents Byers and Peel (1993) after test for multivariate co-integration between European markets and U.S., Japan and Canada. Several studies aimed to define the influence caused by market crises on diversification opportunities. The common conclusion in these studies is that market crises cause an increase in market correlation and integration, and reduction in benefits of  portfolio diversification. The results presented by Meric and Meric (1997) indicate substantial increase in correlations among the twelve largest stock markets in Europe. Employing Box M and principal component analysis, Meric and Meric (1997) prove that co-movements between European markets changed significantly after the 1987 market crash and reducing in this way diversification benefits. Arshanapalli and Doukas (1993), Lee and Kim (1993) and Lau and McInish  (1993) indicate increasing co-integration among major developed markets after October 1987. Malliaris and Urrutia (1992) investigate unidirectional and bi-directional causality relationships between six stock market indexes before, during, and after the market crash of October 19, 1987. They apply Granger causality test assuming 5 lags (5 trading days). The authors find a dramatic increase in bi-directional causality and unidirectional causality is observed in the month of the crash. Tests of contemporaneous causality indicate an increase of contemporaneous causality during and after the month of the crash. Chan, Gup and Pan (1997) analyze stock market indexes of eighteen national stock markets. They find that the number of significant co-integrating vectors increases before

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May 10, 2018
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