Modeling regional linkage of financial markets

With the development of globalization and regional economic integration, regional markets linked with a common currency emerge, in which investors from domestic market are allowed to trade in foreign markets. Empirical studies have evidenced extensively the existence of co-movement of asset prices or cross-correlation in market returns among these markets, especially in global event. However, there is no theoretical model in literature that can provide economically plausible justifications for these stylized facts. This research intends to fill up such a gap with a simplest possible nonlinear dynamic model. Based on the classical market-maker framework of Day and Huang (1990), a two-market HAM model is developed, which does not only prove in theory the existence of price comovement but also replicate in simulation this typical characteristic, along with other well known stylized facts characterizing individual financial market. Moreover, theoretical analysis suggests meaningful implications for market opening policy. In particular, in terms of financial stability, a relatively small market may not benefit from market linkage and market opening is essentially a double-edged sword. © 2013 Elsevier B.V. All rights reserved.