Is the Swedish Market Becoming More Integrated with Those of Germany and France?

Abstract

We test for integration of the Swedish stock market with those of France and Germany. Sweden has a high degree of economic interaction with these two countries and thus, it is expected that the Swedish stock market will be integrated with those of France and Germany. Previous studies have shown that the more integrated economies are, the more integrated financial markets will be. We also investigate whether Sweden's entry into the EU in 1995 affected the level of equity market integration of Sweden with France and Germany. Since membership in the EU is supposed to result in Sweden's being more economically integrated with EU countries of which Germany and France had been early members, it is expected that the Swedish stock market will become more integrated after Sweden joined the EU. In this study, we examine whether indeed these expectations materialised. The issue of financial integration is one that is important theoretically, practically and policywise. Theoretically, integration is an important input to Mundell-Fleming models of open macroeconomy and to the international portfolio diversification models. Practically, the extent of integration between markets is important to investors in their pursuit of international iversification. As dictated by international portfolio theory, the level of portfolio diversification benefits depends on the extent of linkages between national markets. Policywise, knowledge about integration is important to financial market regulators. If national markets are integrated, then there is the possibility of spillover effects and financial contagion. Unfortunately, in spite of its importance, there is yet no clear conclusion as to the extent of integration between equity markets. Previous studies have come up with mixed results depending on the markets, methodology and time period used. Our study extends the literature on financial integration by new evidence put forward on this important issue in terms of a combination of markets previously little studied particularly in the context of the impact of the European Union membership. Furthermore, it is well-known that financial data are characterised by ARCH effects and non-normalities and, as a consequence, use of asymptotic methods leads to biased statistical inference when these characteristics are present. To circumvent these characteristics in this study, we make use of an econometric methodology that overcomes problems of non-normality and ARCH effects in the data which have beset previous studies. We perform a causality test between the Swedish market, on one hand, and the German and French equity markets, on the other hand, based on leveraged bootstrap procedures developed by Hacker and Hatemi-J (2006) which they demonstrated to be robust to ARCH effects and non-normalities. In the next section, we provide a brief review of the literature on equity market integration. Then, in Section 3 we provide a discussion of the leveraged bootstrap causality test. In Section 4, we provide some details to illustrate the level of economic interaction of Sweden with France and Germany based on trade. In this section, we also discuss how the EU can possibly impact the linkage between stock market prices. Section 5 presents the empirical results while section 6 provides the conclusion of the study.