Journal of International Money and Finance', Vol. 16, No. 4. pp.

561-579, 1997
~ ) Pergamon © 1997 Elsevier Science Ltd. All rights reservcd
Printed in Great Britain
PIh S0261-5606(97)00020-X 0261-5606/97 $17.00 + t).l)0

Stock returns and volatility in emerging

financial markets

G I O R G I O DE SANTIS*
Marshall School of Business, Universityof Southern California,
Los Angeles, CA 90089-1421, USA
AND
SELAHATTIN iMROHOROGLU
Marshall School of Business, Universityof Southern California,
Los Angeles, CA 90089-1421, USA

This paper studies the dynamics of expected stock returns and volatility in
emerging financial markets. We find clustering, predictability and persis-
tence in conditional volatility, as others have documented for mature
markets. However, emerging markets exhibit higher conditional volatility
and conditional probability of large price changes than mature markets.
Exposure to high country-specific risk does not appear to be rewarded
with higher expected returns. We detect a risk-reward relation in Latin
America but not in Asia when we assume some level of international
integration. We do not find support for the claim that market liberaliza-
tion increases price volatility. (JEL G15). © 1997 Elsevier Science Ltd.

The flow of portfolio investments to emerging financial markets has increased

from $6.2 billion in 1987 to $37.2 billion in 1992 (Gooptu, 1994). Although debt
instruments--bonds, certificates of deposit and commercial paper--are still
the main component of such flows, foreign investors have shown an increasing
interest in equities from developing countries. For example, Claessens and
Gooptu (1994) estimate that the flow of foreign capital to equity almost
doubled from $7.6 billion in 1991 to $13.1 billion in 1992.
The revival of emerging financial markets, after the debt crisis of the early
1980s, represents a new challenge for researchers. Probably, the most com-

*We thank Richard Baillie, Geert Bekaert, Ananth Madhavan, John Matsusaka, Hans
Mikkelsen, Mark Weinstein, two anonymous referees and the participants at the 1994
Meetings of the Society for Economic Dynamics and Control for helpful comments and
suggestions.

561
Stock returns and volatility in emerging financial markets: G D Santis and S ]mrohoro~lu
monly known characteristic of these markets is their high volatility compared
to more developed markets. However, statements about volatility are often
based on estimates of the variance of asset returns over relatively long periods
of time and, therefore, are of little use to investors who have to make periodic
decisions about wealth allocation. The purpose of this study is to characterize
the dynamics of stock returns and conditional volatility in a number of
emerging markets.
Conditional second moments play a key role in various financial activities.
Many models of asset pricing predict that the expected return on any asset is
directly related to its covariance with one or more pricing factors. Most
portfolio diversification and risk hedging strategies are based on the ability to
predict variances and covariances. Volatility is also an important element in
the pricing of derivative securities. Although most emerging markets still lack a
number of sophisticated financial instruments, characterizing the distribution
and the dynamics of stock prices is a necessary first step towards their
development.
We focus our attention on the following questions. First, does stock return
volatility change over time? If so, are volatility changes predictable? Second,
how frequent are large price changes in emerging stock markets? Third, what is
the relation between market risk and expected returns? Fourth, has the
liberalization of emerging financial markets affected return volatility?
We proceed in steps. First, we estimate a model that assumes full market
segmentation while allowing for time-varying volatility. In this scenario, we test
whether investors can successfully predict future changes in volatility and, most
important, if they are rewarded with higher expected returns for being exposed
to a higher level of anticipated risk. Second, we relax the assumption of full
segmentation and analyze a number of models that assume different degrees of
market integration. Also in this case we focus our attention on the relation
between expected returns and market risk. Finally, we evaluate the claim that
liberalization is not necessarily beneficial for many developing countries, be-
cause it may increase the volatility of their financial markets.
The main results in the paper can be summarized as follows. We find strong
evidence of time-varying volatility. From a qualitative point of view, our results
resemble those of many studies on developed markets: periods of h i g h / l o w
volatility tend to cluster, volatility shows high persistence and is predictable.
However, from a quantitative point of view, we find that volatility is consider-
ably higher in emerging markets, both at the conditional and unconditional
level. This implies that any prediction interval for future expected returns has
very little information content. We also find support for a fat-tailed conditional
distribution of returns, which implies that large changes in speculative prices
are expected relatively often. This evidence is much stronger for emerging
markets than for developed markets.
We do not find any relation between expected returns and country-specific
risk. This is somewhat surprising, since many of the markets that we analyze
were legally segmented, at least for part of the sampling period. When we relax
the assumption of segmentation, we find that systematic risk is priced in the
Latin American markets, but not in the Asian markets.

562
 Stock returns and volatility in emerging financial markets: G D Santis and S [mrohoro~,lu
Finally, the prediction that liberalization would increase market volatility is
not supported by the data in our sample.
The paper is organized as follows. Section I specifies the models and the
econometric methods. Section II describes the data. Section III provides a
discussion of the empirical evidence. Section IV concludes.

I. Models and empirical methods

In the following subsections, we discuss several models that we use to describe
the dynamics of market-index returns and we specify the hypotheses to be
tested. Since a characteristic of speculative prices is volatility clustering, we
model the conditional second moments using variations of the G A R C H process
originally proposed by Bollerslev (1986).

I.A. Time-varying market volatility

Let Ri, t denote the return on the market index of country i, between time
t - 1 and time t. The first model assumes that the index return is linearly
related to an autoregressive component and its own conditional volatility
(1) Ri,t~-ai+biRi,t_l +cihii,t+ui,t, ui,tllt_l ~GED(O,hii,t,~,i) ,
and
9
(2) hii,t = °.)i + ° l i a i , t - 1 "~ ~ihii,t - 1,
where I,_ ~ is the set of information available at the beginning of time t and
the conditional density function is modelled as a Generalized Error Distribu-
tion (GED). ~
The biRi, t_ 1 component is included in the mean equation to account for the
autocorrelation potentially induced by non-synchronous trading in the assets
that make up a market index. This problem can be particularly severe in
emerging markets, given their low level of liquidity. The parameterization that
we use follows Lo and MacKinley (1988). 2
The choice of a G E D density is dictated by the inability of gaussian G A R C H
processes to account for the leptokurtosis of most return series, an issue that is
likely to be even more relevant when using emerging market data. 3
Omitting the subscript i to simplify the notation, the GED distribution is
written as follows
v e x p [ - (1/2)[uth 7 ~/2/al~] 2(_ 2/~)F(1/v) 1/2
f ( u t) = h2[(~+ 1)/~lF(1/v ) h;- t/2, with h = F(3/v) '

where F(.) is the gamma function and u is a measure of tail-thickness which is

equal to two for the normal density and smaller than two for leptokurtic
distributions.

LB. Expected returns and market risk

One of the primary reasons to study the dynamics of market volatility is that
investment performance is potentially affected by the degree of exposure to

563
Stock returns and volatility in emerging financial markets: G D Santis and S [mrohoro~lu
market risk. Typically, most asset pricing models postulate a relation between
expected retums and some measure of risk. For example, in the static version
of the Capital Asset Pricing Model (CAPM) the expected return on any asset is
a linear function of the covariance between the return on that asset and the
return on the market portfolio.
In order to determine whether investors are rewarded for their exposure to
market risk we use the following variation of the CAPM
(3) E t_ l( R i , t ) = a i d- biRi, t_ 1 -b chim,t V i ,
where him,t indicates the conditional covariance between the return on index i
and the return on the market portfolio.
Equation (3) differs from the traditional CAPM in two respects. First, it
includes an autoregressive component to take into account the effect of
non-synchronous trading. Second, it is inspired by Black's (1972) version of the
CAPM, which does not include a risk-free rate. 4 In order to test the model, we
complete the specification by assuming that the conditional second moments
follow a G A R C H process.
The choice of the proxy for the market portfolio is dictated by the level of
international integration. The objective of this part of the analysis is to
determine which source of risk - - domestic or international - - is priced and,
therefore, infer the level of financial integration in the markets that we study.
First, we consider a scenario in which assets are priced as if markets were
fully segmented. In this case, the domestic version of the CAPM can be applied
separately to each country and the market portfolio can be approximated with
the country's market index. In general, the system of equations in (3) can be
applied to any set of assets within a country. However, since we only study one
index for each market, under the segmentation hypothesis the system is
reduced to a single equation. In practice, we estimate the following model
(4) Ri,t=ai-l-biRi,t_l -{-cihii,t-l-ui,t, ui,t[It_ 1 " - ~ G E D ( O , h i , t , u i ) ,
where hii,t is the conditional variance of the market portfolio in country i and
the univariate G A R C H process for the conditional variance is described in (2).
If international financial markets are fully segmented and expected returns
increase with market risk, the coefficient c i in equation (4) should be positive
and statistically significant.
The second family of asset pricing models that we test assumes market
integration, either at a regional or at a global level. In particular, we use a
simple version of the international C A P M in which investors do not cover their
exposure to currency risk or, equivalently, the price of currency risk is equal to
zero. 5 In this case, the system of equations in (3) is estimated by choosing one
reference currency to measure all returns and one proxy for the market
portfolio. In the implementation of the test, the only difference between global
and regional integration is in the choice of the market portfolio. The testable
implication is that the price of covariance risk c has to be positive and equal
across markets.
Compared to the case of full segmentation, this hypothesis can only be
tested by using a multivariate system. In fact, the restriction that covariance

564
 Stock returns and volatility in emergingfinancial markets: G D Santis and S [mrohoro.~lu
risk (him,t) is priced must hold not only for the market portfolio itself, but also
for any country which is assumed to be financially integrated. This implies that
we need to estimate and test a system of asset pricing restrictions in which the
first k equations represent any set of k countries and the last equation is used
to price the market portfolio.
Formally, let R t be the (k + 1)-dimensional vector of returns (which includes
the market portfolio as its last element), then the asset pricing restrictions can
be tested by using
(5) R t = a + b * R t_ 1 + chm.t + Ut, u, llt-1 ~ N ( O , H t ) ,
where a and b are(k + 1)-dimensional vectors of unknown parameters, c is the
unknown price of market risk, which is common across countries, hm. t is the
last column of the conditional covariance matrix H t and * denotes the
Hadamard (element by element) matrix product. The normality assumption is
used to simplify the estimation in the multivariate case. Although it is inconsis-
tent with our assumptions for the univariate processes, our only goal in this
case is to test the significance of the price of risk. This can be done using
quasi-maximum likelihood (QML) standard errors, which are robust to mis-
specifications of the conditional density. 6
Obviously, we also need to generalize the process for the conditional second
moments to a multivariate framework. A typical multivariate G A R C H parame-
terization for the conditional covariance process is the diagonal GARCH(1,1)
model
<6> H,=C'C +aa' *ut-lu',-i + /3/3' * Ht l,
where C is a symmetric matrix and o~ and /3 are vectors of unknown
parameters. According to this specification, the variances in H t depend only on
past square residuals and an autoregressive component, while the covariances
depend upon the cross-product of past residuals and an autoregressive compo-
nent. 7
Unfortunately, this parameterization is still hard to estimate when applied to
a relatively large number of assets. For this reason, most applications test the
pricing restrictions using only few assets at a time. For example, Bekaert and
Harvey (1995) use a model similar to the one used here, but test the restric-
tions separately for each country. This is unsatisfactory because the tests are
not independent. We attempt to solve the problem by using a more parsi-
monious parameterization originally proposed by Ding and Engle (1994) and
recently generalized by (De Santis and Gerard, 1997a,b). Under the assumption
that the process is covariance stationary, the unconditional covariance matrix
of the residuals implied by (6) is equal to H 0 = C ' C * ( L ~ . ' - c ~ o < ' - / 3 / 3 , ) - i
where ~ is a vector of ones. Therefore equation (6> can be rewritten as
H, = H I ) * ( ~ ' - cece' -/3/3') + c~c~'* u , _ l u ' t _ 1 + / 3 / 3 ' * H , _ l .
Although HI) is unknown, it can be evaluated recursively during maximum
likelihood estimation/
The third scenario that we consider assumes full market segmentation until
the official liberalization date, and full integration thereafter. We refer to it as

565
Stock returns and volatility in emerging financial markets: G D Santis and S ]mrohoro~lu
dynamic integration. Formally, the estimated pricing equation for country i is

(7} Ri, t = a i + b i R i , t _ 1 + c i h i i , t D C i , t + d h i m , t ( l - O C i , t) "[-ui,t,

where DC i is a dummy variable which is equal to one before the opening date
for market i and zero otherwise. We impose the restriction that the price of
risk is country-specific before liberalization and equal across countries when
markets become integrated.
This specification is based on the model proposed by Bekaert and Harvey
(1995). The main difference is that we identify the date when each country
switches from being fully segmented to being fully integrated and we assume
that the process of integration is irreversible. 9
The simplification of the regime structure and the parsimonious parameteri-
zation for the multivariate G A R C H process discussed above allow us to test
the pricing restrictions of the model simultaneously over several markets. The
ability to evaluate the cross-section restrictions of the model, as well as its time
series properties, can add significant power to our test relative to Bekaert and
Harvey. However, there is also a potential cost in using our approach. If the
official date of market liberalization that we use for each country is a poor
indicator of when that market actually became accessible to foreign investors
and allowed residents to invest abroad, then our method is less likely to detect
the presence of the two regimes in the data.

L C. Liberalization and return volatility

The liberalization of international financial markets is a relatively recent
phenomenon. For example, many barriers to international investment were
lifted in Japan and the U K only at the beginning of the 1980s. The process of
liberalization started even later in many emerging markets. 1° This fact may
appear surprising in light of the need for foreign capital in most developing
countries. However, one of the arguments often used against liberalization is
that investment flows towards emerging markets would be extremely volatile in
response to changing economic conditions. One of the consequences of volatile
investment flows would be high volatility in stock prices. The empirical implica-
tion of this view is that market volatility should increase after the liberalization
date.
We use a deterministic two-regime model in which both the conditional
mean and the conditional variance processes are allowed to change with
market liberalization. Formally

(8} Et- l(Rit) = [ Id'i't( 01 ) before liberalization

/zi,t(02) after liberalization
and

O)i,l -'}- OLi,l U~,t- 1 -'}- ~i,l h ii,t - 1 before liberalization

(9) hii,t =
t°i,2 + ai,2u2i,t - 1 q- ~i,2hii,t-1 after liberalization.

566
 Stock returns and volatility in emerging financial markets: G D Santis and S [mrohoro,~lu
The explicit parameterization of the mean process will depend on the results of
the other tests discussed earlier in this section.

II. Data
The main source of data for this study is the Emerging Markets Data Base
(EMDB) constructed by the International Finance Corporation (IFC). The
data base contains monthly and weekly stock market indices for a large number
of developing countries. The indices are consistently computed across different
countries and, therefore, directly comparable. The stocks included in the
indices are selected on the basis of market size, trading activity and sector
representation. All indices are weighted by market capitalization.
We analyze the weekly series II from the last week of December 1988 to the
second week of May 1996, for a total of 384 observations. The countries
covered in this study can be grouped into three geographical regions:
Europe/Mid-east (Greece, Turkey), Asia (India, Korea, Malaysia, Philippines,
Taiwan/China, Thailand), and Latin America (Argentina, Brazil, Chile,
Colombia, Mexico, Venezuela). All of the countries use a Monday-Friday
trading week, except Korea and Taiwan/China.
To have a benchmark for our results, we extend the analysis to weekly return
series from four developed markets: Germany, Japan, the UK and the US. We
compute the returns for these markets from the daily Financial Times Actuar-
ies (VIA) World Indices. The FTA indices are constructed following two
criteria: investibility and market representation.
All returns include dividend yields as well as capital gains and are continu-
ously compounded.
Table 1 contains summary statistics for the returns, measured in local
currencies.
As expected, emerging markets are characterized by a higher unconditional
volatility, compared to developed markets. In most cases, higher average
returns appear to be associated with a higher level of volatility. Another
interesting characteristic of the weekly data is the high measure of kurtosis.
This appears to be true for all the series in our sample, including the developed
markets. However, it is evident from the table that, in general, the index of
kurtosis is considerably higher in the emerging markets. This suggests that, for
these markets, big surprises of either sign are more likely to be observed, at
least unconditionally.

III. Empirical evidence

III~4. Time-variation and predictability in volatility

The first issue that we investigate is whether volatility in emerging markets
changes over time in a predictable fashion. We estimate two versions of the
model described in equations (1) and (2) and refer to them as Model A and
Model B. In Model A we assume a constant conditional variance, whereas in

567
Stock returns and volatility in emerging financial markets: G D Santis and S [mrohoro~lu
TABLE 1. Summary statistics for weekly returns

Country Mean Median S.D. Skewness Kurtosis Min. Max.

Greece 0.420 - 0.056 4.280 0.783 3.659 - 15.78 20.55

Jordan 0.255 0,040 2.332 - 1,033 13.684 - 17.89 11.15
Turkey 0,113 0.003 2.153 0.678 6.551 - 10.24 13.87

India 1.343 0.580 7,761 - 0.004 1.515 - 29.33 29.64

Korea 0.387 0.022 4.126 0.155 2.347 - 15,78 16.50
Malaysia 0.032 - 0.266 3.296 0.628 1,308 - 7.23 13.39
Philippines 0.376 0,284 3,781 - 0,787 4.882 - 24,05 12.56
Taiwan 0.080 0.170 5.316 - 0.110 3.593 - 23,83 23.31
Thailand 0.422 0.267 4.018 - 0.587 7.654 - 26.75 20.78

Argentina 2.288 1.041 10.557 2.083 10.823 - 40,32 76.06

Brazil 4.305 4,002 8.421 - 0.337 2,995 - 45.75 30.07
Chile 0.718 0.661 2.935 0.248 0.392 - 7.40 10.71
Colombia 0.870 0,454 3.633 1.490 7.700 - 13.77 24.35
Mexico 0.692 0.655 3.179 - 0.331 1.001 - 13.87 10.42
Venezuela 0.919 0.378 5.159 0.703 2.915 - 17.93 26.28

Germany 0.165 0.221 2.257 - 0.428 1.204 - 8.89 6.57

Japan - 0.081 - 0.020 2.753 0.048 2.323 - 11.57 11.20
UK 0.272 0.271 1.868 0.387 1.386 -5.19 8.29
U n i t e d States 0.280 0.431 1.573 -0.386 1.432 -7.11 5.26

Notes: All returns are continuously c o m p o u n d e d . The equity indices o f all emerging markets
are from the International Finance Corporation. T h e returns for the d e v e l o p e d markets are
from the Financial Times Actuaries data base. All returns are m e a s u r e d in local currencies
and expressed in p e r c e n t a g e form. T h e sample covers the period from June 1989 through
May 1996 (384 observations). The indices o f skewness and kurtosis for the normal distribution
are equal to zero.

Model B we assume that the conditional variance follows a GARCH(1,1)

process. For each model, we estimate the standardized residuals (2 t = ~tlat 1/2)
and the squared standardized residuals and then, for each series, we compute
the Ljung-Box (LB) statistic to test the null hypothesis of no autocorrelation
up to order twelve. Overall, the results in Table 2 support our specification.
Consider first the LB test statistic for the standardized residuals. The
purpose of this test is to evaluate whether any form of autocorrelation is left in
the residuals after the AR(1) correction for non-synchronous trading. Although
some form of residual autocorrelation is left in four out of the 18 markets for
Model A, Brazil is the only country for which the null hypothesis is rejected
once we allow for conditional heteroskedasticity.
Consider next the LB test for the squared standardized residuals. ~2 For 12
out of the 14 emerging markets that we consider, the squared standardized
residuals obtained from Model A show some form of autocorrelation, at least

568
 Stock returns and volatility in emerging financial markets: G D Santis and S [mrohoro{ht
TABLE 2. Specification tests

Qle(uh-1/2) Ql2(Uh- i/2)2 Wald

Model A Model B Model A Model B

Greece 0.090 0.070 0.000 0.850 0.000

Turkey 0.417 0.328 0.000 0.795 0.000

India 0.323 0.351 0.000 0.749 0.000

Korea 0.810 0.488 0.015 0.403 0.067
Malaysia 0.233 0.703 0.000 0.193 0.000
Philippines 0.208 0.234 0.930 0.997 0.000
Taiwan 0.020 0.118 0.000 0.370 0.000
Thailand 0.019 0.351 0.000 0.012 0.001

Argentina 0.000 0.677 0.000 0.755 0.000

Brazil 0.146 0.009 0.042 0.890 0.000
Chile 0.791 0.583 0.000 0.718 0.000
Colombia 0.000 0.136 0.000 0.786 0.000
Mexico 0.398 0.234 0.074 0.772 0.000
Venezuela 0.398 0.579 0.036 0.960 0.000

Germany 0.896 0.880 0.000 0.572 0.000

Japan 0.225 0.303 0.000 0.295 0.000
United Kingdom 0.318 0.235 0.935 0.864 0.000
United States 0.557 0.690 0.006 0.561 0.000

Note: The first four columns contain Ljung-Box test statistics for the standardized residuals
tth 1/2 and the standardized residuals squared ( u h - 1 / 2 ) 2. The statistics are computed for
two models. Model A assumes a constant conditional variance. Model B assumes a
GARCH(1,1) process for the conditional variance. Both models assume a conditional GED
distribution. The numbers in the table are p-values. The maximum order of auto-correlation
is 12. The column labelled Wald contains p-values for the robust Wald test of the hypothesis
of conditional homoskedasticity.

at the 5% level. With the exception of Thailand, the autocorrelation disappears

when the conditional variance is assumed to follow a GARCH(1,1) process. We
also compute a robust Wald test for the hypothesis that the coefficients a and
/3 in the G A R C H parameterization are jointly different from zero. The
p-values for this test are consistent with the findings of the LB test.
The last four rows in the table contain diagnostic statistics for the four
developed markets. From the point of view of model specification, the evidence
confirms our findings for the emerging markets. Therefore, we choose the
AR(1)-GARCH(1,1) parameterization with a conditional G E D distribution to
perform our next test.
Table 3 contains parameter estimates when returns are computed in local
currencies. At first glance, the results are consistent with those of other

569
Stock returns and volatility in emerging financial markets." G D Santis and S [mrohoro~lu
TABLE 3. Quasi-maximum likelihood estimates

ai bi Ci °)i °ti [~i vi L.F.

Greece -0.20 0.17 0.01 0.43 0.10 0.87*** 1.18"** - 1024.44

Turkey 1.56"* 0.15"** - 0 . 0 2 10.56" 0.25*** 0.57*** 1.66"* - 1298.82

India 0.01 0.10"* 0.01 0.93** 0.14"** 0.81"** 1.34"** - 1048.75

Korea - 3.00 - 0.02 0.27 13.53 0.08 - 0.36 1.38"** -989.16
Malaysia 0.57** 0.08 -0.03 0,32 0.10"* 0.86*** 1.57"** -925.71
Philippines 1.03"** 0.15"** -0.06*** 0,21"* 0.03*** 0.96*** 1.23"** - 1028.94
Taiwan -0.10 0.03 0.01 1.77" 0.17"* 0.76*** 1.46"** - 1130.84
Thailand 0.73* 0.11" -0.03 1,06" 0.11"* 0.81"** 1.47"** - 1028.48

Argentina 0.02 0.10"** 0.01" 1.78" 0,26*** 0.75*** 1.27"** -1295.33

Brazil 0.51 0.23*** 0.03 0.44 0.08* 0.92*** 1.47"** -1335.61
Chile 0.55 0.25*** -0.01 1.40"* 0.14"** 0.68*** 1.72 -935.23
Colombia 0.44 0.29*** -0.01 0.51" 0,30*** 0.70*** 1.17"** -927.41
Mexico 0.77 0.22*** -0.01 0.73 0.08* 0.85*** 1.57"** -971.40
Venezuela - 0 . 3 6 0.25*** 0.03** 1.96 0.18" 0.76*** 1.14"** - 1129.68

Germany 0.23 0.02 0.03 0.11 0.05** 0.91"** 1.55"** -775.57

Japan -0.25 0.02 0.05 0.58** 0.16"** 0.77*** 1.45"** --897.67
U.K. 0.29 0.01 -0.01 0.29 0.09*** 0.85*** 1.59"** -836.06
USA 0.25 -0.16"** 0.06 0.03 0.05* 0.94*** 1.55"** -695.84

Notes: The estimated model is Ri, t = a i -F biRi, t _ l q- cihii,t -t- lti,t, where lti,t[lt- 1
G E D ( O , h i , t,~,i). The conditional variance process is hii,t = to i -k otitl2t_ 1 -t- ~ihii,t_ 1. The
results are obtained using weekly returns in local currencies from June 1989 through May
1996. L.F. indicates the value of the log-likelihood function. *, ** and *** denote statistical
significance at the 10%, 5% and 1% levels, respectively. The test on the tail-thickness
parameter v i is computed against the alternative hypothesis that ui < 2.

empirical work on time-varying volatility. First, the GARCH parameterization

is statistically significant in most cases. Second, the /3 coefficient in the
conditional variance equation is considerably larger than o~, implying that large
market surprises induce relatively small revisions in future volatility. Third, the
persistence of the conditional variance process, measured by a +/3, is high and
often close to the Integrated GARCH model of Engle and Bollerslev (1986).
This implies that current information is relevant in predicting future volatility,
also at very long horizons.
However, the similarities between emerging and developed markets docu-
mented in Table 3 hide some interesting differences. The estimated conditional
volatility for most of the emerging markets is considerably larger than that of
any developed market, essentially at each point in time. This evidence is
summarized in the first four columns of Table 4. The average values of the
conditional volatility confirm the fact that, unconditionally, emerging markets
are more volatile than developed markets. However, the table also shows that

570
 Stock returns and oolatility in emerging financial markets: G D Santis and S imrohoro,~lu
TABLE 4. Summary statistics for conditional volatility and kurtosis

Country Conditional standard deviation Conditional

kurtosis a
Mean S.D. Min. Max.

Greece 3.829 1.358 2.335 8.051 1.865

Turkey 7.425 2.249 5.105 21.536 0.451

India 3.940 1.221 2.445 8.875 1.201

Korea 3.248 0.223 2.215 4.916 1.068
Malaysia 2.803 0.779 1.822 6.792 0.610
Philippines 3.694 0.526 2.913 5.204 1.629
Taiwan 4.879 1.901 3.003 15.063 0.850
Thailand 3.709 1.278 2.648 12.852 0.832

Argentina 8.643 6.167 3.135 39.870 1.441

Brazil 8.170 2.150 4.012 16.580 0.844
Chile 2.798 0.518 2.130 5.188 0.348
Colombia 3.231 2.006 1.483 14.291 1.873
Mexico 3.103 0.449 2.370 5.130 0.622
Venezuela 4.977 1.553 2.986 11.484 2.036

Germany 2.193 0.466 1.597 4.495 0.577

Japan 2.634 0.803 1.680 6.685 0.883
United Kingdom 1.849 0.262 1.401 2.689 0.655
United States 1.520 0.331 1.010 2.403 0.650

Notes: The summary statistics are based on the estimated time series for the conditional
volatility obtained from the benchmark GARCH(1,I) model. The conditional kurtosis is
based on the estimated value of the parameter K in the GED distribution. The index of
kurtosis for the normal distribution is equal to zero.

both the minimum and the maximum values of the conditional volatility are, in
most cases, considerably larger in the emerging markets. Finally, the estimated
series for the emerging markets show a higher degree of dispersion, which
implies that large changes in volatility are more frequent than in mature
markets.
These findings have important practical implications. For example, if in-
vestors use their estimates of future volatility to construct prediction intervals
of future expected returns and then make their investment decisions, our
results suggest that the information value of this exercise would be very limited
when applied to emerging markets.
Another characteristic of the estimated model is its ability to capture
leptokurtosis in the data, even at the conditional level. In Table 3 we report the
point estimates of the tail-thickness parameter v and compute a one-sided test
against the alternative hypothesis that the parameter is smaller than two, the
benchmark value for a normal density. In all instances the null hypothesis of
normality is strongly rejected. ~3 As a consequence the point estimates of the

571
Stock returns and volatility in emerging financial markets: G D Santis and S [mrohoro~lu
implied kurtosis, reported in the last column of Table 4, are larger than zero.
More interestingly, in most cases the emerging markets show a higher level of
kurtosis than the developed markets. This implies that beside being more
volatile, emerging markets are also more likely to be affected by big surprises,
conditional on the information available at any point in time.

III.B. Expected returns and volatility

We next study whether investors in emerging markets are rewarded for their
exposure to the high levels of volatility documented above. If developing
markets are fully segmented, investors do not diversify their portfolios intema-
tionally. Therefore, they should be rewarded for their exposure to country-
specific risk. In this scenario, the coefficient that links first and second
moments in equation (1~ can be interpreted as a measure of the price of
domestic market risk. In terms of our benchmark model, we should expect a
positive relation between conditional expected returns and conditional market
volatility. In Table 3 we report point estimates of the price of domestic market
risk (c i) and compute a test of statistical significance using robust standard
errors. The results are quite surprising. The point estimates vary considerably
across markets, both in size and sign, and are statistically significant, at a
conventional level, in only three cases: Philippines, Argentina and Venezuela. 14
Overall, these results strongly reject the hypothesis of full segmentation over
the entire sample. Therefore, we proceed to test alternative specifications of
the model which accommodate different levels of market integration.
U n d e r the hypothesis that markets are fully integrated, the expected return
on any asset is proportional to the conditional covariance between the return
on that asset and the return on an appropriate international market portfolio.
Here we analyze two different levels of integration: regional and global. If
markets are integrated only at a regional level, then a market index for the
region is the appropriate proxy of the market portfolio. For example, the
covariance with a Latin American index should help explain expected returns
in the Latin American markets. On the other hand, if markets are globally
integrated, only a word-wide index should be used to price assets, whereas
regional and country-specific risk should not play any role. In both cases, the
price of market risk is the coefficient that links expected returns to the
conditional covariance with the international benchmark portfolio.
The F F A data base contains one composite index and regional indices for
Asia and Latin America, therefore we compute our tests for the countries
included in those regions using US dollar returns. To simplify the estimation
procedure we conduct the tests separately for the two regions.
Panel A in Table 5 contains point estimates and robust standard errors for
the price of covariance risk, for both regions and for both levels of integration. 15
The results for the Asian markets are similar to those obtained under full
segmentation: the price of covariance risk is not statistically significant at
either the regional or global level. The evidence for the Latin American
markets is more encouraging. Under the hypothesis of regional integration the
price of market risk is equal to 10.04 and is statistically significant, at least at

572
 Stock returns and volatility in emerging financial markets: G D Santis and S [mrohoro,~lu
TABLE 5. The price of risk in integrated markets

Panel A: regional/global integration

Asia Latin America

Regional - 0.013 0.100

(0.034) (0.055)

Global 0.051 0.092

(0.119) (0.046)

Panel B: dynamic integration

India Taiwan Argentina Brazil Colombia Market

0.030 0.017 0.013 0.001 - 0.008 0.039

(0.074) (0.024) (0.023) (0.008) (0.012) (0.052)

Note: The table contains point estimates and robust standard errors (in parentheses) for the
price of market risk under different levels of market integration. Under regional integration,
a regional index from the FTA data base is used as a proxy of the market portfolio. Under
global integration, the FFA composite index is used instead. Under dynamic integration, the
market portfolio is approximated using the country-specific index before the liberalization
date and the FTA composite index thereafter.

the 10% level. The results are even stronger when we test the hypothesis of
global integration. In this case, the price of risk is slightly lower, 9.22, but
significant at the 5% level.
Our findings may reflect the higher level of competitiveness among Latin
American markets, in their recent attempt to attract foreign capital. As
documented in Table A1, the degree of openness to foreign investors is
considerably higher in Latin America than in Asia. In addition, although
formally open to foreigners, some Asian markets (e.g. India) are still domi-
nated by large institutions controlled by the government.
The final test on the pricing of market risk that we propose is based on a
combination of the two models discussed above: country-specific risk is the only
pricing factor before each market's liberalization and world-wide risk is the
pricing factor thereafter. We implicitly assume that when markets were closed
to foreign investors they also prevented residents from investing abroad. If this
was not the case, domestic assets would not necessarily be priced as if markets
were fully segmented, prior to the liberalization date that we use. Unfortu-
nately, the data currently available from the IFC do not allow us to determine
whether the liberalization for domestic investors occurred at a different date.
Given the relatively short time span covered by the IFC data set and the
recent phenomenon of international liberalization for most emerging markets,
we compute this test only for a subset of developing countries. Specifically, to
guarantee that each pricing regime is estimated using a sufficiently large
number of observations, we require that a minimum of 100 data points be

573
Stock returns and volatility in emerging financial markets: G D Santis and S imrohoro~lu

available for each regime. This limits our analysis to five markets: India and
Taiwan for Asia and Argentina, Brazil and Colombia for Latin America. The
FTA composite index is used as a proxy of the world portfolio.
Panel B in Table 5 contains point estimates and robust standard errors for
the price of domestic risk (c i) as well as the price of world risk (d) in equation
(7). None of the coefficients is individually significant at conventional levels.
We also computed two robust Wald test statistics. The first one to evaluate
whether all the prices are simultaneously equal to zero. The second one to
determine whether the country-specific prices (excluded the world price) are
equal to zero. Both tests fail to reject the null hypothesis.
These findings reinforce the evidence that country-specific risk does not play
any role in explaining conditional expected returns, even when this pricing
restriction is imposed only over the period when each market was legally
segmented. On the other hand, the finding that world-wide risk is not priced
after the liberalization date may be driven by the Asian markets, for which our
previous tests show no evidence of integration.

III. C. Market liberalization and stock return volatility

The last issue that we investigate is whether the opening of emerging financial
markets to foreign investors has affected return volatility. In each subperiod we
estimate a model similar to that described in equations (1) and (2). The only

TABLE 6. Market liberalization and structural changes

ai bi wi ai ~i vi Wald
India 0.464*** 0.066 1.005" 0.170"** 0.788*** 1.320"** 0.011
-0.178 0.112 0.951 0.093 0.833*** 1.228"**

Taiwan 0.659 0.099 1.608 0.216"* 0.762*** 2.043 0.184

0.016 -0.009 3.603** 0.112" 0.665*** 1.324"**

Argentina 1.567"** 0.236 20.884* 0.255 0.669*** 1.124"** 0.000

0.348 0.092 1.785" 0.158"** 0.770*** 1.704"

Brazil 3.505** 0.361"** 16.548"* 0.057 0.756*** 1.289"** 0.086

2.085** 0.226*** -0.756 0.055* 0.957*** 1.879

Colombia 0.487*** 0.401"** 0.240 0.069 0.825*** 1.624" 0.044

0.169 0.254** 2.230 0.366** 0.540*** 1.089"**

Notes: The table contains parameter estimates for the model with a structural change at the
liberalization date. For each country, the first row corresponds to the pre-liberalization
period. The column labelled Wald contains p-values for the robust test of the hypothesis
that the two regimes are equal. *, ** and *** denote statistical significance at the 10%, 5%
and 1% levels, respectively. The test on the tail-thickness parameter v i is computed against
the alternative hypothesis that v i < 2.

574
 Stock returns and volatility in emerging financial markets: G D Santis and S [mrohorofi,lu

difference is that we omit the GARCH-in-Mean component, because our

previous tests suggest that country-specific risk is not priced. Also in this case
we require a minimum of 100 data points for each regime. Therefore this
analysis is again limited to: India, Taiwan, Argentina, Brazil and Colombia.
Table 6 contains quasi-maximum likelihood estimates for the two-regime
model. Overall, the results show that there is no obvious relation between
liberalization and market volatility. Contrary to the prediction that volatility
should increase after liberalization, the implied unconditional volatility, mea-
sured by to/(1 - o~-/3), is larger before the liberalization date for three of the
five countries.
The results also show that the estimated kurtosis of the conditional distribu-
tion is not affected by liberalization. In fact, although for some countries the
probability of observing big surprises increases in the second part of the
sample, the opposite is true for Argentina and Brazil. In four out of five cases
the robust Wald tests reported in Table 6 suggest that the difference between
the two regimes is statistically significant, at least at the 10% level.
The plots of the estimated volatility contained in Fig. 1 are a useful
complement to the results reported in the table. It is evident that the effect of
liberalization on volatility differs across countries. In fact, for all markets
except Colombia, the highest spikes in the estimated volatility are prior to
liberalization.
The reduction in volatility uncovered for some markets can have various
explanations. First, the number of securities included in the IFC indices has
increased over time and the higher degree of diversification in the last part of
the sample is likely to induce a decline in volatility, at least on average. Second,
Domowitz et al. (1996) show that liberalization can induce greater participation
by foreign investors, whose entry can reduce price volatility. Intuitively, new
investors broaden the market, dampening the effect of order flow shocks on
prices and may also make prices more efficient by increasing the precision of
public information regarding fundamental values.

IV. Conclusions
In this paper we analyze the dynamics of returns and volatility in emerging
financial markets. For almost all the countries included in our sample, we find
evidence of time-varying volatility which exhibits clustering, high persistence
and predictability. The level of volatility in emerging markets is considerably
higher than that of more mature markets, both at the conditional and uncondi-
tional level. We also find that the conditional probability of large price changes
is higher in emerging markets.
Although most of the markets that we analyze were legally segmented during
part of the sampling period, we find essentially no evidence of a relation
between expected returns and country-specific volatility. When we generalize
our model and assume regional or global international integration we find
support for a reward-to-risk relation in the Latin American markets but not in
the Asian markets.
Finally, contrary to the popular argument that liberalization would increase

575
Stock returns and volatility in emerging financial markets." G D Santis and S [mrohoro~lu

1990 1991 1992 199~, 1994 1995 1996 1997

A : "

?
o;
1989 1990 1991 1997 199,,~ 1994 1995 1996 1997

i"~qr
1989 1997

1989 1990 1991 1992 1993 1994 1995 1995 1997

, , ~ , , , ,
1989 1990 1991 Igg~ Igg3 1994 1905 I~ 1997

FIGURE 1. Estimated conditional volatilities (standard deviations). The vertical lines

correspond to the IFC liberalization date for each market.

market volatility the empirical evidence shows that volatility sometimes de-
creases with liberalization. We offer two explanations for this finding which
deserve further investigation, as more disaggregate data on emerging markets
become available.

Notes
1. See Box and Tiao (1973).

576
 Stock returns and volatility in emerging financial markets: G D Santis and S [mrohoro~lu
2. We replicated most of our tests using an MA(1) specification, as suggested by Scholes
and Williams (1977), and found essentially no difference.
3. See, for example Bollerslev (1987).
4. This feature of the model is dictated by the lack of a time series on a weekly risk-free
rate for the countries analyzed in this study.
5. For a review of different models of international asset pricing see Stulz (1995).
6. See Bollerslev and Wooldridge (1992).

TABLE A1. Regulation of emerging financial markets

Country Opening Degree of openness Stocks in index

date January October
1989 1993

Greece December 1988 Fully open 26 35

Turkey August 1989 Fully open 14 36

India November 1992 24% of issued share capital 40 108

Korea January 1992 10% of capital of listed companies 61 134

25% after July 1992

Malaysia December 1988 30% for banks and institutions 62 66

100% for remaining stocks

Philippines October 1989 Investable up to 40% 18 37

Taiwan January 1991 Investable up to 10% 62 78

Thailand December 1988 Investable up to 49% 29 58

Argentina October 1991 Fully open 24 31

Brazil May 1991 100% of non-voting preferred stock 56 70

49% of voting common stock

Chile December 1988 25% of shares of listed companies 26 35

Colombia February 1991 Fully open 21 20

Mexico May 1989 30% for banks 52 71

100% for other stocks

Venezuela January 1990 100% investable except bank stocks 13 17

Note: The table contains opening dates and legal arrangements for a number of emerging
markets included in the IFC data set. The last two columns contain the number of securities
included in the IFC index, for each country, at two different dates within the sampling
period. The information in the table is from the International Finance Corporation.

577
Stock returns and volatility in emergingfinancial markets: G D Santis and S [mrohoro~lu
7. Kroner and Ng (1995) discuss a number of multivariate G A R C H parameterizations.
8. For the first iteration H 0 is approximated with the unconditional covariance matrix of
the returns. Thereafter, the unconditional covariance matrix of the estimated residuals
can be updated at the end of each iteration (see De Santis and Gerard, 1997a,b).
9. Bekaert and Harvey (1995) allow for switching regimes and estimate the probability of
switching between the two regimes at any point in time. This implies that countries are
allowed to return to segmentation after they have been integrated.
10. See Table A1 for a description of the legal organization of the markets included in this
study.
11. Two recent studies that use monthly returns from emerging markets are Errunza et al.
(1994) and Bekaert and Harvey (1997).
12. This test is an alternative to the Lagrange Multiplier test proposed by Engle (1982) to
evaluate the specification of a G A R C H process. In a recent paper, Bollerslev and
Mikkelsen (1994) show that the LB test has considerable more power in detecting model
misspecifications.
13. Our results are confirmed by a Kolmogorov-Smirnov test, not reported here for reasons
of space.
14. We also used the conditional standard deviation instead of the conditional variance as
an explanatory variable. The results were essentially unaffected.
15. Compared to the univariate tests, we excluded one market for each region: Korea
because the univariate analysis reveals the absence of a G A R C H process, and Brazil
because the optimization algorithm failed to achieve a maximum when all the Latin
American markets were included into the system.
16. See Table A1.

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