Interdependence, Contagion and Price Discovery: A Study of International Stock Markets

Abstract

The contagion across capital markets is an important phenomenon in an increasingly integrated financial world. To investigate the contagion from the U.S., Japan, and Hong Kong to Asian emerging economies, we design a research strategy which captures fundamental interdependence among these stock markets as well as departures from this interdependence. Based on these departures, we propose a new contagion measure and link this measure to the price discovery measure, which reveals how one market responses over time to a shock in another market. We also propose a new forecast error variance decomposition in analyzing contagion from the portfolio manager's perspective. Using this research strategy, we find that during the U.S. subprime crisis, the U.S. stock market was cointegrated with the Asian stock markets. Beyond this fundamental interdependence, the shocks from both Japan and Hong Kong, but not that from the U.S., have significant contagion effects on the Asian emerging stock markets. We note a significant overreaction of the Asian emerging stock markets to the shocks from the Japan and Hong Kong stock markets but a marked underreaction to the shock from the U.S. stock market. The variance decomposition analysis also confirms this conclusion.

Keywords: stock markets, contagion, price discovery, stock markets, cointegration, structural vector autoregression, time series, causality

JEL Classification: C32, E44, F36, G15