Measuring market integration during crisis periods

Pukthuanthong and Roll (2009) measure the degree of market integration by the percentage of a market’s returns explained by global risk factors. However, during periods of crisis characterised by high volatility, their measure may be biased. This paper investigates the determinants of the explanatory power in a multi-factor model during global crises. We show that the explanatory power is influenced by factor heteroscedasticity, changes in factor loadings and residual heteroscedasticity. Using a counterfactual analysis, we establish an empirical framework to examine the effects of each element on integration for 53 financial markets during six recent crisis periods. We find the unconditional market integration is much lower for most markets during a period of crisis than implied. Both factor heteroscedasticity and the existence of contagion during crises account for this difference.