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Equity Market Integration and Currency Risk: Empirical Evidence for Indonesia

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  • Khaled Guesmi
  • Frédéric Teulon

Abstract

This paper tests the time-varying degree of Indonesian market integration using conditional version of the International Capital Asset Pricing Model (ICAPM) with applying a GDC-GARCH. The use of the GDC-GARCH technique allows us to first, describe the time-varying stochastic conditional covariance matrix and second, take into account the dynamic changes in the degree of market integration and risk premium. Our empirical results show clear evidence of market integration varying degree, explained by the U.S term premium and the level of market openness. Even though it reaches high values during turmoil periods, and exhibits an upward trend towards the end of the estimation period, Indonesian stock market still remain substantially segmented from the regional market. These results thus suggest that diversification into emerging market assets continues to produce substantial profits, and that the asset pricing rules should reflect a state of partial integration. Our investigation addresses the evolution and formation of total risk premiums and confirms this empirically. In fact, the total risk premium decomposition shows that the variance risk related to the local market index (the local risk factor), explains more than 50% of the total risk premium on average.

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Bibliographic Info

Paper provided by Department of Research, Ipag Business School in its series Working Papers with number 2014-096.

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Length: 12 pages
Date of creation: 12 Feb 2014
Date of revision:
Handle: RePEc:ipg:wpaper:2014-096

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Keywords: Time-varying integration; risk premium; ICAPM; GCC-GARCH;

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  1. Guesmi, Khaled & Nguyen, Duc Khuong, 2011. "How strong is the global integration of emerging market regions? An empirical assessment," Economic Modelling, Elsevier, vol. 28(6), pages 2517-2527.
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  11. Berger, Tino & Pozzi, Lorenzo, 2013. "Measuring time-varying financial market integration: An unobserved components approach," Journal of Banking & Finance, Elsevier, vol. 37(2), pages 463-473.
  12. Chambet, Anthony & Gibson, Rajna, 2008. "Financial integration, economic instability and trade structure in emerging markets," Journal of International Money and Finance, Elsevier, vol. 27(4), pages 654-675, June.
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