Financial instability, integration and volatility of emerging South Asian stock markets

PurposeThe purpose of this paper is to examine the short- and long-run spillover effect of international financial instability on emerging South Asian stock markets. The paper also investigates the financial integration regionally.Design/methodology/approachGranger causality test is used for short-run causal relations. Since results of preliminary test highlight the significant autocorrelations in stock returns, GARCH class models with extreme shocks in international financial market are utilized to test the long-run spillover impact on stock returns.FindingsResults indicate significant short- and long-run spillover impacts of international financial instability on the stock returns. They highlight the significant co-integration of South Asian stock markets with the international market. Significant correlations in stock returns and volatility reveal the degree of regional integration to be high between India, Pakistan and Sri Lanka.Research limitations/implicationsBusiness, political and market conditions of South Asian stock markets are fundamentally different from each other. These economies were liberalized at different time, which in turn may affect the degree of integration with international equity markets and regionally alike.Practical implicationsFinancial liberalization has linked the South Asian stock markets to the rest of the world. Stock prices move in the same line with the emergence of global expected and unexpected economic shocks. The benefits that arise from the diversification of funds will be eradicated in the long run. Investors with long investment horizons will not actually benefit from portfolio diversification in South Asian equity markets. The Bangladesh stock market does not respond to volatility in international market in the short run and may be a good destination for short-term investment.Originality/valuePioneer efforts are made by utilizing a novel approach with the use of net volatility change in world financial instability for measuring the short- and long-run impacts. Given the emergence of South Asian stock markets, new insights into their vulnerability to world financial shocks provide interesting findings for portfolio diversification.