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5.1.4 Emerging market currencies

Currencies in emerging markets tend to be characterized by large uncertainty and a history of numerous devaluations and defaults. Relevant examples are the Mexican Peso crisis (1994), the Russian Ruble crisis (1998) following the Asian crisis (1997) and the steep decline of the Brazilian Peso (1999). The currency changes have been shown to directly affect stock prices as firm level imports and exports as well as the national level competitiveness is restricted by exchange rates. For international asset valuation the currency corrected capital asset pricing model48 may be applied, however, while such models may be necessary in the evaluation of single assets they have proven less useful for valuating country indices. For most countries including emerging markets, exchange rate exposures temp to be so versatile that the models generally does not exhibit significant explanatory power (Matthias and Thuridur 2002).

Carrieri and Majerbi (2006) support this by concluding that exchange rate exposure is subsumed by local market risk at the aggregate market level. Aggarwal et al (1999) concludes that volatilities are largely equal for emerging market country stock returns whether measured in local currency or US dollar. Currency graphs for all emerging market countries can be found in Appendix A1.6.

interpreted as a measure of integration as countries can be deeply integrated but exhibit low correlations given differing industry mixes. Solnik et al (2000) make use of a cross­sectional dispersion model based on monthly tracking errors from the world market for a range of developed countries. They conclude that the dispersion has decreased between 1971 and 1998 and interpret this as a sign of equity integration.

5.2.1 Correlation as integration

Developments in correlations may be analyzed through controlling for the presence of time­

trends. This can be done through generation of a moving-window correlation series, that for each observation t includes the latest and exclude the oldest observation. Following Engle (2002) it can be expressed mathematically as


ρi j s t n i s


j s

s t n i s t

s t

r r

r r


, ,




= − −


= − −

= −

1 1

2 1 1

n n t

j s




1 2


Here, the test is conducted by continually forming a one­year correlation, including 260 observations ( rt, rt­1 … rt­259 ). Regressions are performed using t as independent variable

(5.2) MAj w, )=α α0+ 1t

where MA(ρj,w) is the 260 days moving window, j is the return from the country analyzed, w is the world return and μ is the residual.

The moving window time-series is serially correlated in its passed terms, and having 259 lagged terms results in severely inflated t-statistics. One way to approach this issue is by correcting the standard errors using the HAC (heteroskedasticity­ and autocorrelation ­ consistent) standard errors also known as the Newey-West standard errors (Newey and West 1987). This method is only valid for large­sample data sets (Gujarati 2003).

Table 5.3 shows the test results where α1 is the coefficient from equation 5.2 and HAC is the adjusted standard deviation measure.

Table 5.3

World­market correlations and time­trends in emerging markets

Country α1 Std. err t­stat p > HAC std. err t­stat p >

Brazil 1.1610E­04 1.7200E­06 67.580 0.000 1.9200E­05 6.050 0.000

China 8.1100E­05 9.1400E­07 88.740 0.000 1.3200E­05 6.140 0.000

Colombia 1.3370E­04 1.5800E­06 84.580 0.000 2.0400E­05 6.570 0.000

Chile 1.3360E­04 1.2900E­06 103.330 0.000 1.4300E­05 9.350 0.000

Czech Republic 1.5630E­04 1.6100E­06 96.900 0.000 1.6200E­05 9.660 0.000

Hungary 1.2880E­04 1.5300E­06 84.000 0.000 1.7300E­05 7.450 0.000

India 1.3730E­04 8.7000E­07 157.740 0.000 1.0900E­05 12.610 0.000

Indonesia 8.7800E­05 1.1400E­06 76.930 0.000 1.3100E­05 6.720 0.000

Israel 1.0430E­04 1.1400E­06 91.280 0.000 1.2000E­05 8.710 0.000

Malaysia 1.2200E­05 1.6000E­06 7.650 0.000 2.6100E­05 0.470 0.640

Mexico 1.1670E­04 1.3300E­06 87.680 0.000 2.0400E­05 5.710 0.000

Peru 7.2300E­05 2.6400E­06 27.350 0.000 3.1400E­05 2.300 0.022

Philippines 4.8500E­05 1.1900E­06 40.750 0.000 1.7200E­05 2.820 0.005

Poland 1.5700E­04 1.3600E­06 115.040 0.000 1.5400E­05 10.160 0.000

Russia 1.7280E­04 2.0000E­06 86.250 0.000 1.8500E­05 9.370 0.000

South Africa 1.0900E­04 1.4600E­06 74.600 0.000 2.0100E­05 5.420 0.000 South Korea 1.1730E­04 9.4500E­07 124.120 0.000 1.6500E­05 7.100 0.000

Taiwan 8.9000E­05 9.4800E­07 93.900 0.000 1.4400E­05 6.190 0.000

Thailand 5.3800E­05 1.2300E­06 43.590 0.000 2.1800E­05 2.470 0.014

Turkey 1.4730E­04 1.5900E­06 92.830 0.000 2.4500E­05 6.020 0.000

The table shows the correlations between the daily world index return and the respective emerging market returns. α1 is the regression coefficient from equation 5.2. HAC SD are the Newey-West corrected standard errors. Source: Thompson-Reuters and own calculations.

The test concludes that for all countries except Malaysia, a positive and significant time- trend exists. This indicates that through the last 20 years, the returns from emerging market indices have become gradually more correlated50 with the returns from the World portfolio.

The strongest time-trend was observed for Russia followed by Poland and Czech Republic51.

5.2.2 Cross-sectional dispersion

The methods of moving window correlation is criticized for diminishing smaller temporary variations thereby only indicating long­term trends. This implies that an unbroken period of seemingly stable correlations may be a spurious result hiding temporary highs and lows.

50 While the result is robust, it may be the case that the increased correlation is due to increasing market share of the emerging markets whereby they constitute an increasing part of the world index.

51 Poland and Czech Republic entered the European Union May 1 2004, which may have been a strong driver for capital market integration at least within the EU.

Using a cross­sectional procedure Solnik and Roulet (2000) derived an instantaneous measure of correlations spanning over a number of countries and their correlation to the world market. It is a measure of correlations for a collected group of countries rather than the individual markets and assumes that the return on national market i at time t is given as

(5.3) Ri t, = Rw t, +ei t,

where Rw,t is the return on the world market at time t and ei,t is the error term also referred to as a tracking error. The tracking error is assumed normally distributed with a zero mean cross-sectionally but for which the standard deviation is allowed to fluctuate over time.

The fluctuations of the united equally weighted tracking errors around the world portfolio in period t, is referred to as the dispersion. The instantaneous measure of correlation between the united group of national markets and the world market is now given as;


ρ σ


i w t

e t w , ( )


= +

1 1

2 2

Solnik et al (2000) find that for a portfolio of 20 developed markets the approach results more volatile than a time­series based approach52.

The portfolio of 20 emerging market countries suffices for construction of cross-sectional data and generation of tracking errors for each period t. To avoid effects from time displacement in the cross­sectional data set, the test is conducted using monthly53 instead of daily observa­


The result unsurprisingly confirms the finding from Section 5.2.1. The time-regression shows an increase in the correlation by 1.23 percent annually on a 1% significance level54 indicating that the emerging markets generally have become more integrated with the world index, that is, fluctuate less around the world deviation as illustrated in Figure 5.2.

Although the data confirms that the emerging markets have become more integrated with the world measured by correlations, a curious observation is that in periods of crisis such as

52 The beta for each country to the world is assumed to be equal so that the dispersion measure can be calculated using equally weights. Also, the world standard deviation is assumed to be the constant unconditional one as it is not observable for each point in time.

53 245 observations in the period 01­01­1990 through 01­06­2010.

54 Even when adjusting for autocorrelation.

in the 1997/98 Asian crisis and the 2008/09 financial crisis the dispersion measure shows falling correlations. This counters the stylized fact presented in Section 2.2.1 that correlations are negatively correlated to returns. Extreme single­country deviations affect the standard deviation of dispersions and thereby contribute to falling cross­sectional correlations. In other words, the falling correlation measure in times of crisis may be a sign that the emerging markets reacts with time-displacement to the shocks. During the Asian crisis, much attention was put on the risk that the emerging market crisis would spread to influence the neighboring economies. These contagion effects have contributed to the interest in the stability of these markets (Ramcharra 2002).


0 50 100 150 200 250


Cross-sectional correlation Trendline

Figure 5.2. Cross­sectional dispersion of the Emerging markets to the World market index. The dispersion figure is a moving average and shows an increasing tendency rising 1,23 percent annually. Monthly observations 01­01­1990 through 01­06­2010.

Calculated according to equation 5.3 and 5.4.

Source: Own calculations.

Appendix A5.4 features an up- down correlation analysis, confirming that the correlations between the world market and each individual emerging market is significantly higher in bear- than in bull markets. For now it suffice to conclude that in union as well as individually, the emerging market indices have grown increasingly correlated with the returns of the world index.