Is being a super-power more important than being your close neighbour? A study of what moves the Australian stock market

Abstract

This article employs a Fractionally Integrated Vector Error Correction Model (FIVECM) to examine the return transmission between the Australian and New Zealand stock markets and the Australian and the United States stock markets. We augment the FIVECM with a multivariate GARCH model. In so doing, the first and second moments spill over between stock market indices are simultaneously revealed. Our empirical results suggest that the Australian stock market has stronger ties with the United States stock market than with the New Zealand stock market. We conclude that stock market movements in the United States, as the world's economic superpower, are more important to the Australian stock market than stock market movements in New Zealand, Australia's closest neighbour.

Notes

¹ Long memory time series models augmented by GARCH have been adopted in the literature to model a variety of economic and financial topics. For example, Baillie et al. (1996) analyzed the inflation series of ten countries using a fractionally integrated ARFIMA-GARCH model and Lien and Tse (1999) applied a FIVECM-GARCH(1,1) model to evaluate the performance of futures hedge ratios. Few studies, however, have examined stock market co-movements using a FIVECM-BEKK model.

² Besides equity markets, the cointegration and vector error correction model (VECM) has also been extensively applied to other financial markets, typical of which is the foreign exchange market (Clarida and Taylor, 1997; Manzur et al., 1999).

³ For conditions for the general BEKK model, see Proposition 2.7 in Engle and Kroner (1995).

⁴ Details are not reported here but are available upon request.

⁵ This is another interpretation of coefficients in the VAR model due to Granger. That one variable Granger-causes another variable implies that the former variable has forecasting ability for the later variable. The FIVECM model in this article can be viewed as a restricted version of the general VAR model due to the presence of the error correction term. In our bivariate VAR (FIVECM) model, this implies that the lagged US market return can contribute to the prediction of Australian market return.