Stock market integration and risk premium: Empirical evidence for emerging economies of South Asia

- We identify the financial integration determinants when investigating the time-varying integration degrees of South Asian markets.
- We apply a conditional version of the ICAPM, and use a GDC-GARCH methodology.
- The considered emerging markets still remain substantially segmented from the Asian market.
- The local risk factor, explains, on average, more than 70% of the total risk premium.
- The US term premium and the market openness level are the most significant integration determinants.

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 five major South Asian markets (Malaysia, Thailand, Singapore, Indonesia, and Sri Lanka), our results support the validity of an 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 the U.S. term premium, and the level of market openness, whatever the measure of currency risk. Finally, and as expected, the degree of stock market integration varies considerably over time and from one market to another. As intense market integration induces both benefits and risks, our findings should have significant implications for economic policies and market regulations in emerging, frontier-emerging and transition countries, particularly for countries from the same region.