Bond market and stock market integration in Europe: a smooth transition approach

Abstract

This article investigates whether there has been a structural increase in financial market integration in nine European countries and the US in the period 1980 to 2003. We employ a GARCH model with a smoothly time-varying correlation to estimate the date of change and the speed of the transition between the low and high correlation regimes. Our test produces strong evidence of greater comovement across the board for both stock markets and government bond markets. Dates of change and speeds of adjustment vary widely across country linkages. Stock market integration is a more gradual process than bond market integration. The impact of European monetary union (EMU) is rather limited, as it has mainly affected the timing of bond market correlation gains (but hardly their size) and has had little discernible effect on stock market integration.

Notes

¹ Exceptions are Cappiello et al. (2003), Christiansen (2004) and Kim et al. (2006).

² Karolyi and Stulz (2003) offer a comprehensive survey of the literature on comovement among international equity markets.

³ Note that if γ→∞, the transition between ρ₀ and ρ₁ becomes a step at t = cn.

⁴ Hansen (1996) presents a general treatment of the issue of unidentified nuisance parameters in econometric tests.

⁵ We did not include Japan, because Berben and Jansen (2005) found that the LM test indicated that stock market correlations between Japan and the UK, the US and Germany, respectively did not change in the years 1980 to 2000.

⁶ Burns et al. (1998) show that aggregation to weekly returns largely solves the problems caused by nonsynchronous trading hours.

⁷ Monthly correlations display the same trending behaviour as weekly correlations.

⁸ The one exception is the stock return correlation between Germany and Switzerland (p-value 0.025). The results of the LM test are available from the authors upon request.

⁹ As the parameters of the model are difficult to interpret, we report the estimates of the model in an appendix that is available from the authors upon request.

¹⁰ Recent empirical evidence on increasing business cycle comovement is provided by Lumsdaine and Prasad (2003) and Helbling and Bayoumi (2003), among others.