Global and Local Sources of Risk in Eastern European Emerging Stock Markets

Abstract

IntroductionInternational investors and researchers have been drawn to emerging markets because of their rapid economic development, high returns, and potential for diversification as well as because of the series of reforms on these capital markets. The big challenges for researchers, in turn, have been devising ways to price risk and distinguish the roles of global and local sources of risk in these markets. Several empirical studies find market segmentation is typically larger in emerging markets than in developed markets, suggesting that local sources of risk are more critical than international sources (e.g. Korajczyk, 1995;Shackman, 2005). On the other hand, Bekaert and Harvey (1995), who test a two-factor asset-pricing model in which the conditional expected returns of a country are affected by global and local sources of risk, see evidence of a rising role for global sources of risk and a diminishing role for local risk sources.The more recent literature is mixed on the subject of financial integration. Tai (2006) and de Jong and de Roon (2005) claim markets become more integrated after equity market liberalization. Brooks and Del Negro (2002), on the other hand, note that Europe has become more integrated while elsewhere segmentation has lately increased. Some researchers see no evidence of increased integration over time (e.g. King and Segal, 2008).Most papers on currency risk in emerging markets conclude that it is priced on stock markets (e.g. De Santis and Imrohoroglu, 1997; Tai, 2006; Saleem and Vaihe-* The authors are grateful to the anonymous referees for their comments, which greatly improved the paper. They would also like to thank Niklas Ahlgren, Iikka Korhonen and Timo Rothovius and other participants at the GSF Winter Workshop and at the Bank of Finland Research Seminar for their helpful comments and insights.