Essays on market integration and contagion in South East Asian markets

While there is considerable evidence of the diversification benefits of investing in emerging markets, most investors still prefer to invest in their home countries. The reluctance to invest in emerging market countries is often attributed to the fact that, in addition to market risk, investment in emerging markets are exposed to the risk associated with exchange rate fluctuations and capital market restrictions.; This dissertation includes four studies on the issues of currency risk and capital market segmentation in emerging countries. In the first study, I investigate the covariance structure of equity returns in emerging and developed countries. I find that the covariance structure between emerging and developed market equity returns differ from the covariance structure in emerging or developed markets. This suggests that special attention must be focused on the specification of the covariance process of equity returns across developed and emerging markets.; The second study investigates the degree of market integration between emerging equity markets, developed markets and the World index in the framework of an international asset pricing model where prices of market risk and domestic risk are allowed to vary over time. I find no evidence that domestic risk is priced. This finding implies that capital markets in the study are integrated. However, I find that there is some predictability left unexplained in the residuals using variables proxying for currency risk. This suggests that failure to include currency risk as a pricing factor in an asset-pricing model may lead to an inadequate power of the model to test the asset returns.; In the third chapter. I estimate an international asset-pricing model where, in addition to world market risk, currency risk is priced varying over time. I find that the exchange risk premiums significantly affect emerging market returns. Surprisingly, when currency risk is allowed to enter as a pricing factor in the mean equation, I find that the evidence supports the hypothesis of capital market segmentation in South East Asia emerging markets. This result indicates that international capital asset pricing models that do not include currency risk may be misspecified and may lead to incorrect inference about market segmentation.; In the fourth chapter, I examine the nature and extent of contagion during the Asian financial turmoil based on the herding behavior hypothesis. Tests based on conditional correlation coefficients suggest contagion effects only from Thailand to Korea.