The evolution of risk premium as a measure for intra-regional equity market integration

We estimate and test the conditional version of an international capital asset pricing model using a parsimonious multivariate GARCH process and the multivariate nonlinear least squares method. Since our approaches are fully parametric, we can recover any quantity that is a function of the first two conditional moments. Our findings strongly support using a model that includes both regional market and foreign exchange risk. However, both sources of risk are detected only when their prices are allowed to change over time. Our empirical results show clear evidence of market integration to varying degrees, explained by the US term premium and the level of market openness. Though it reaches high values during turmoil periods and exhibits an upward trend toward the end of the estimation period, the Indonesian stock market remains partially integrated into the ASEAN-5 regional market. These results suggest that diversification into Indonesian market assets continues to produce substantial profits and that asset pricing rules should reflect a state of partial integration.