Crises and the Cross-Market Premium

The impacts of financial crises are more ambiguous. They can temporarily influence the level of financial integration, as the risk associated with swapping the underlying stock for the DR and vice versa increases due to higher volatility of exchange rates and risks of transfer and convertibility. On the other hand, an increase in the variability of the premium could simply reflect the greater price volatility that characterizes episodes of financial turmoil, even if the degree of arbitrage remains unaltered. However, before studying the effects of crises on the cross-market premium, it is necessary to define crises periods, which are less trivial than supposed.

A. Crisis Periods

Times of crises are difficult to pin down. Perhaps what makes this task particularly challenging is the lack of an uncontroversial operational definition of crises. Aside from the problem of not having a uniform criterion to define crises, as there are various methodologies and ad hoc criteria used to identify crises, the literature concentrates on determining the beginning of crises, but not their end. For our purpose, it was essential to accurately determine the duration of crises in order to correctly specify the periods we wished to analyze.

To define crises, we followed the approach adopted by Broner, Lorenzoni, and Schmukler (2004), which determined ex ante certain criteria to identify the beginning and end of crises according to the behavior of certain market indicators. Their methodology allowed us to distinguish country-specific crisis periods (which could be of domestic or foreign origin), without having had to resort to the use of ex post data. We used two different procedures to identify crisis periods: one based on the exchange market pressure (EMP) index and the other based on the local stock market index.²³ As crisis dating is arbitrary, we performed a robustness exercise.

The EMP index is computed as the weighted average of the daily changes in the interest rate and the log difference of the exchange rate, with weights equal to the reciprocal of the standard deviation of the respective variables.²⁴ A crisis initiates when the EMP volatility (its 15-day rolling standard deviation) exceeds a threshold level and remains above that level for at least four weeks, where the threshold is defined as the mean of the EMP volatility plus one standard deviation. A crisis ends the first date after which the EMP volatility drops below the threshold and remains there for three months.

When using stock market prices, crises begin when the stock market index starts a decline of at least five consecutive weeks that reaches a cumulative drop in excess of 25%. A crisis ends on the first date after which the index grows for at least four consecutive weeks.

The exchange and interest rate series came from Bloomberg and Datastream and the local stock market index series came from the Emerging Market Database (EMDB). The interest rates used varied according to data availability, in all cases however, all available marketdetermined interest rates behaved similarly over the sample period.²⁵ Table 3 [ PDF 19.9KB | 1 page ] reports the crisis periods identified by both procedures. The EMP crisis period was identified using an EMP index, the weighted average of the daily changes in the interest rate and exchange rate. The crises considered did not coincide with periods in which capital control modifications took place (e.g., Argentina's stock market crisis in 2001–2002 coincided with the introduction of capital controls, so this case was excluded from the analysis; the same applies to the 1997 crisis in Korea).

B. Effects of Crises

As in the case of capital controls, we examined the impact of crises on financial integration by performing event studies. Table 4 [ PDF 16.9KB | 1 page ] presents the results of the event study tests for crisis events; it also shows the number of cases in which the post-event mean is significantly different from the pre-event mean. The event studies examined whether the post-event mean was significantly different from the pre-event mean. The pre- and post-event periods are equal to each other, with the length varying on a per country basis. The upper panel displays the event study results when the crisis dates were based on the EMP criteria. The lower panel shows the event study results based on the stock market criteria. Mean and variance significance tests were done at a 10% significance level. The upper panel of the table provides the results using the EMP crisis definition; the lower panel shows the results using the SM crisis definition.

In addition, Figure 3 [ PDF 20.5KB | 1 page ] shows the behavior of the average cross-market premium for Brazil, Indonesia, Mexico, and Russia, countries that experienced a crisis (as determined by our EMP definition) during our sample period. Since there was a large change in the variance, Figures 3 and 4 also report the pre- and post-event variance. They also display, on a per country basis, the behavior of the cross-market premium before and during crisis periods. The event date, marked as time zero, is the day the crisis started based on the EMP criteria.

The charts indicate that in all four cases the mean of the cross-market premium becomes negative during the crisis. In Indonesia for example, the pre-event mean equals 0.40, while the post-event mean equals -1.39. Similarly, in Mexico the mean of the average crossmarket premium dropped to -1.20 during the crisis, compared to 0.21 in the pre-crisis period. The results in the upper panel of Table 4 show that most stocks indeed experienced a significant drop in the cross-market premium during the crisis period. The country with the weakest result is Brazil, where only 4 out of 11 stocks showed a significant drop in the mean. This result can be explained by the fact that it was hard to detect a clear crisis period in Brazil, as there was a prolonged period of turbulence, but there was only a limited period of severe exchange in market pressure. There was a decrease in the average mean, and compared with tranquil times, the volatility of the premium significantly increased during crises. In Russia for example, the variance increased from 1.67 before the crisis to 38.82 after the crisis. Also in Indonesia, the premium became much more volatile, with the variance increasing from 1.20 to 13.62 (Table 4). Volatility also increased in Mexico and Brazil, albeit at a more modest level

Thus, the results indicate that during crises, the cross-market premium becomes more volatile and continues to oscillate around zero, while the average premium drops. This implies that markets do not segment during crises. However, the risks associated with swapping the underlying stock for the DR and vice versa increased due to exchange rate, transfer, and convertibility risks. Moreover, the typical decline in liquidity in periods of financial distress tended to reduce traders' inventories and added to price volatility, thus inhibiting immediate arbitrage. This is in line with the findings in Levy Yeyati, Schmukler, and Van Horen (2008b), where we documented, using an event-study approach, an increase in trading costs (e.g., bid-ask spreads widen) in times of crisis. The negative cross-market premium suggests that these risks are more pronounced for the underlying stock and, as a result, investors demand a discounted price for this stock.

As a robustness test, we performed the same event studies using the stock market crisis definition. The results in the bottom panel of Table 4 and in Figure 4.A [ PDF 20.5KB | 1 page ] and Figure 4.B [ PDF 24.4KB | 1 page ], which display, per country, the behavior of the cross-market premium before and during crisis periods, largely confirmed our previous results. During crisis periods, the premium continued to oscillate around zero, indicating that the markets remain integrated. However, volatility substantially increased in all but one case. The results on the drop of the mean of the crossmarket premium during crises were however, less pronounced in this case. Still, in the vast majority of cases, where there existed a significant negative difference between pre- and post-event mean.

In summary, the result showed that contrary to the introduction of capital controls, the occurrence of a crisis did not break down arbitrage. However, investors appear to have demanded a risk premium for the underlying stock to compensate them for the risks associated with selling the stock in the local market.

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