This article investigates the dynamics of regional financial integration and its determinants in an international setting. We test a conditional version of the international capital asset pricing model (ICAPM) accounting for the deviations from purchasing power parity (PPP) as well as temporal variations in both regional and local sources of risk. Using data from seven major countries of the Middle East North Africa (MENA) region (Turkey, Israel, Egypt, Jordan, Syria, Kuwait and Tunisia), our results support the validity of ICAPM and indicate that the risk is regionally priced. Furthermore, we show that changes in the degree of regional stock market integration are explained principally by inflation, exchange rate volatility, rate spread variations, short-term interest rate and world market dividend yield.
Despite there is a consensus in the literature to say that the degree of emerging market integration varies over time (Bekaert and Harvey, 1995, Carrieri et al., 2007 and Guesmi and Nguyen, 2011), empirical results are relatively divergent regarding the identification procedure of market integration determinants. Studies such as Bekaert and Harvey, 1995 and Bekaert and Harvey, 1997, Adler and Qi (2003), and Hardouvelis et al. (2006) opt for an arbitrary choice of two or three financial and macroeconomic variables to model the dynamics of integration, while Carrieri et al. (2007) determine ex-post financial integration factors. The method proposed by Carrieri et al. (2007) may be subject to criticism because it arbitrarily introduces certain information variables to assess financial integration before they are considered as candidate variables that might explain financial integration.
Our study contributes to the existing literature by examining the dynamic regional integration with its determinants of seven major emerging markets in MENA (Turkey, Israel, Jordan, Egypt, Syria, Kuwait and Tunisia) together in the context of the partially integrated ICAPM whose theoretical foundations have recently developed in Arouri et al. (2012). We believe it makes sense to compare countries that do not belong to a single currency area but which are geographically close to each other, but unlike previous works, we firstly attempt to identify ex ante the driving forces behind the integration process of national stock markets from a set of local, regional and global variables. We also consider, in addition to the systematic risks associated with regional and local markets, changes in exchange rates which are, according to previous studies, a relevant source of risk in pricing emerging market assets ( Adler and Dumas, 1983, Carrieri et al., 2007 and Tai, 2007).
Our empirical results show that the inflation, exchange rate volatility, rate spread variations and world market dividend yield significantly affects changes in regional financial integration. They also point to the validity of the ICAPM and indicate that exchange rate risk is priced regionally. As in previous studies (Hardouvelis et al., 2006, Carrieri et al., 2007 and Tai, 2007), we find that stock market integration involves through time and its changing patterns differ across studied markets.
The paper is organized in five sections. Section 2 presents the model with the estimation methodology used. Section 3 presents the data, while Section 4 presents analyses the empirical findings. Section 5 concludes.
We developed a conditional ICAPM in the presence of exchange rate risk to identify factors that may influence the degree of financial integration for seven major markets in MENA region (Turkey, Israel, Jordan, Egypt, Syria, Kuwait and Tunisia). The findings are then used to study the dynamics of financial integration. Our empirical analysis is conducted on the basis of a nonlinear framework which relies on the multivariate DCC–GARCH model.
By allowing the prices of risk and the level of market integration to vary through time, we show inflation, exchange rate volatility, rate spread variations, Short-term interest rate and world market dividend yield are the most important determinants of regional financial integration. Moreover, the degree of market integration admits frequent changes over the study period and its dynamic patterns differ greatly across the markets under consideration. While the integration of stock market with the regional market tends to rise in recent years but does not record any particular trend upward or downward for Syria.
