Time-Varying Energy and Stock Market Integration in Asia

Abstract

The degree of integration between energy and stock markets is critical for the diversification, risk management and funding decisions of global corporations and investors alike. We investigate the integration relation between ten major Asian stock markets and a diversified energy portfolio that comprises oil, coal and gas. Estimation of the relation in a time-varying asset pricing framework, which allows for regime switching, identifies two major regimes. The first regime represents periods of low energy-stock market integration, where markets tend to be segmented. It accounts for over two-thirds of the sample period during December 1992 to December 2015. The second regime represents periods of high integration, as characterized by limited diversification opportunities and increased levels of volatility. Also, corporate funding conditions are less favorable in the second regime. The two regimes differ in the way equity markets price energy risk. In addition to a positive energy-unrelated equity risk premium during the low integration regime, our results identify a significant positive energy-related equity risk premium during the high integration regime. Finally, we demonstrate that investors can use the conditional information of our integration model to outperform passive portfolio investment strategies in the stock and energy markets.