Equity Price Dynamics in Thin Emerging Markets of Central and Eastern Europe

This paper investigates the apparent co-movement of equity prices in the Czech Republic, Hungary and Poland. The main underlying force moving stock prices in these countries is argued to be the inflow and outflow of foreign capital. Since the inflow of foreign investment to these markets is an unobservable variable, it is modelled as a two- state Markov chain. This latent variable is driving the stock returns process and makes it switch from a high growth regime to a depression regime, or vice versa. In such a framework, the stock return process comes from a mixture of two normal distributions with different means. This is modelled using the vector Markov switching method of Hamilton (1989, 1990). The estimated process shows significant correlation with a number of data series on global capital flows. The paper applies the Hamilton technique to the new dataset and, most importantly, it builds an empirical model for the stock returns of the `thin' emerging markets of Central and Eastern Europe.