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Nonlinear Interdependence of the Chinese Stock Markets

Abdol S. SOOFI a , Zhe LI b, Xiaofeng HUI a b


b

University of Wisconsin-Platteville, Department of Economics School of Management, Harbin Institute of Technology

Abstract The methodologies and assumptions in nancial integration studies are problematic and may lead to spurious empirical results. Using surrogate data analysis and mutual prediction method of testing for nonlinear interdependence, it is feasible for an analyst, with a scant knowledge of the underlying dynamics of two dynamical systems, to show whether the systems are interdependent. This study applies these techniques in testing for synchronization of three Chinese stock markets: Shanghai, Shenzhen, and Hong Kong. The empirical results of the present study indicate that the stock markets series are nonlinear and that the Chinese stock exchanges are nonlinearly interdependent. Specically, the evidence indicates that Shanghai and Shenzhen markets are bi-directionally interdependent, while Shanghai and Hong Kong as well as Shenzhen and Hong Kong markets are unidirectionally interdependent, with the direction of interdependence going from the mainlands markets to the Hong Kong market.

Classication Code : C14, C22, F36 Keywords: Chinese stock markets, nancial integration, mutual prediction, nonlinear interdependence

We are grateful to Lianqyue Cao and anonymous referees for their helpful comments on the earlier drafts of this paper. This study was partially supported by a grant from The National Natural Science Foundation of China (70773028). Corresponding author : Abdol S. SOOFI. Address :University of Wisconsin-Platteville, Department of Economics, Platteville WI 53818, U.S.A. Tel.:608-342-1834; Fax : 608-342-1036. E-mail addresses: Soo@uwplatt.edu

Introduction

Measuring integration of nancial markets within a country or across national borders has been a subject of keen interest in nancial economics. However, economists rarely agree on denition of the term or the method of measurement of nancial integration. In this study, we give the term a more precise meaning by stating that the market for a nancial instrument is fully integrated if all potential participants in the market with the same characteristics face a single set of rules, have equal access to the nancial market, and are treated equally when they are active in the market(Baele, et al., 2004). This denition is qualitative in nature which is of little value in measuring the degree of integration of the nancial markets. Below we will provide an exact denition of nancial integration and use terms such as nancial integration, markets synchronization, and interdependence of nancial markets synonymously. In measuring nancial integration a number of methodological approaches have been utilized in the past. Many of these earlier studies that are based on international asset pricing models (IAPMs) use dichotomous integration-segmentation hypothesis, emphasizing that nancial markets are either fully integrated or totally segmented (Errunza, Losq, Padmanabham, 1992; Stulz, 1981). In addition to the problematic nature of the dichotomous assumption, (IAPMs) are based on rather restrictive assumption of purchasing power parity, a theorem that is based on holding of the law of one price. A newer methodology used in more recent capital markets integration studies is less restrictive, and proposes to measure nancial integration between two countries by quantifying the co-movements of innovations in future expected stock returns. Nevertheless, the method assumes that asset returns are conditionally multivariate normal concluding that capital asset pricing model holds (Henry, 2000; Phylakis and Ravazzolo, 2002). Moreover, these methods assume the underlying data generating processes of nancial data are linear and stochastic, while tests indicate that data generating processes of many nancial time series are nonlinear (e.g. Scheinkman and LeBaron, 1989; Hsieh, 1991; Soo and Cao, 2002; Soo and Galka, 2003), making the empirical results of such models questionable. Another strand of integration studies considers price-based, news-based, and quantity-based measures of integration that hinge on working of the law of one price. The price-based measures concentrate on discrepancies between assets of the same class created by geographic origin of the assets. While the news-based measures are based on the arguments that in a well-integrated nancial market news of local character would have little or no eect on the asset prices. However, news of global nature and signicance would impact the integrated nancial markets. The quantity-based measures focuses on cross-border holding of nancial assets by the institutional investors (see Baele, et. al., 2004, for details). To address some of the methodological diculties of the linear correlation and international asset pricing models with the latter method employing factor models, a number of approaches were adopted by researchers in the subsequent 2

studies. These methods include multivariate extreme value theory (Longgin and Solnik, 2001), asymmetric multivariate GARCH-M models ( Bekaert and Wu, 2000), Poisson jumps (Das and Uppal, 1999), regime-switching models (Ang and Bekaert, 2000). Recently, new approaches in measuring interdependence of nancial markets, mostly in the context of cross-country transmissions of nancial shocks and contagion of nancial crisis, have emerged (see for example, Pesaran and Pick, 2007; Dungey, et al., 2005; Bae, Karolyi, and Stulz, 2003). In contrast with the earlier contagion studies that focused on correlation of asset returns (see references to these earlier works in Bae, et al., 2003), the work by Bae et al., do away with correlation as a linear measure of association altogether, and adopt multinominal logistic regression in assessing probability of joint occurrences of large absolute value daily returns. It is important to point out that like many other researchers, Pesaran and Pick (2007), and Dungey al., 2005, distinguish interdependence of nancial markets during the normal times and during periods of high market volatility. These authors specify econometric models that are supposed to distinguish the two periods. However, as it is discussed below, specication and estimation of these models are wrought with a great deal of diculties. In this paper, we aim to introduce a new approach in testing for nonlinear dynamical interdependence between nancial markets. This new approach is readily applicable for testing for cross-country as well as domestic integration of nancial markets. We adopt mutual prediction method in measuring stock market integration (markets synchronization) and apply the method in testing for nonlinear interdependence of the Chinese stock markets: Shanghai, Shenzhen, and Hong Kong. We choose Chinese stock markets as a good example of a fully integrated nancial system, as the term is dened by Baele, et al. (2004) above. We would like to emphasis that the method we use, as it stands currently, does not dierentiate between contagion and regular nancial interdependence. However, for completeness of discussion of the topic of nancial integration, we nd it useful to discuss contagion as a special form of nancial interdependence in the present study. This paper is organized as follows. In section 2 we discuss a canonical model of interdependence (contagion) and review the problems that are associated in estimating the model (Pesaran and Pick, 2007). In section 3 we discuss surrogate data analysis and method of mutual prediction in detection of nonlinear interdependence between two dynamical systems (synchronization of oscillating systems). Section 4 deals with implementation of the methods discussed in section 3 on Chinese stock market data and presents the empirical results. Section 5 summarizes and concludes the paper.

Methods of testing for interdependence of the nancial markets

For completeness of discussion of nancial integration, it is instructive to distinguish between the good nancial interdependence and the bad nancial interdependence (contagion), when the latter occurs during nancial crisis. Masson (1999) distinguishes normal interdependence of markets and nancial contagion by identifying three categories of cross-country transmissions of shocks: Monsoonal eect, spill-over eect, and pure contagion. Monsoonal eect occurs because correlation of economic fundamentals for two or more countries. The spill-over eect occurs because of external relationship such as trade between countries. Finally, pure contagion occurs because of presence of multi-equilibria of markets and movements of the markets from an optimal equilibrium to a suboptimal one. The rst two categories are considered normal interdependence, while the last one is contagion, a state of market(economy) that experiences higher correlation between the fundamentals. Accordingly, interdependence of nancial systems is the necessary but not the sucient condition for presence of contagion.

2.1

A canonical model of interdependence of nancial markets

To rigorously dene the terms nancial interdependence and contagion and differentiate between the two, we present the model by Pesaran and Pick (2007) developed a two-country canonical model, as follows : y1t = 1zt + 1 x1t + 1I (y2t c2 2,t1) + u1t y2t = 2zt + 2 x2t + 2I (y1t c1 1,t1) + u2t, (1) (2)

where yit , i = 1, 2; t = 1, , T is a performance indicator that could be an asset price, a market, or a country; u1t and u2t are serially uncorrelated errors with 2 2 zero means, conditional variances u and u , and a non-zero correlation 2,t1 1,t1 coecient . xit are (ki 1) country-specic observed common factors, are predetermined, and are distributed independently of ujt for all i and j . The (s 1) vector zt contains pre-determined observed common factors such as petroleum prices in international markets. I (.) is an indicator function and is dened as follows: I (yit ci i,t1 ) = 1 if (yit ci i,t1) > 0 0 otherwise

2 where i,t 1 = V ar (yit |t1 ), and t1 is the information set at time t 1. Using the simultaneous equations system (1) and (2) interdependence of the markets is measured by non-zero values of , and contagion is measured by nonzero values of i . These equations are nonlinear in the endogenous variables yt = (y1t, y2t) , and linear for the parameters under the simplifying assumption

that the threshold values of c1 and c2 are known. Furthermore, consistent, ecient estimation of the parameters of the model requires additional simplifying assumptions such as existence of one country-specic regressors in each equation. Furthermore, it is assumed that the regressors are stationary, strictly exogenous, and are distributed independently of the error terms u1t and u2t . These are highly restrictive assumptions that may lead to dubious empirical results in practice. Also, see, Pesaran and Pick (2007) for the problems associated with estimation of the model. Nevertheless, in spite of the above mentioned restrictive assumptions, Pesaran and Pick (2007), provide a formal framework for testing for nancial integration (interdependence) of two markets. This framework is consistent with the assumptions of linearity and normality that commonly appears in the nancial econometric literature. However, we provide another formal denition of nancial integration (interdependence) in the framework of nonlinear dynamical systems theories in section (3.1) below, which is non-parametric and does not pose any assumptions or restrictions on the data. The method works equally well on stationary and non-stationary series.

2.2

Volatility, nancial interdependence, and coupled nonlinear oscillators

We consider nancial markets as dynamical systems with varying degrees of volatility or oscillation. These oscillating systems could be nonlinear and in some instances chaotic. Nonlinear oscillators do not necessarily mean chaotic oscillators. Nonlinearity is the necessary condition for a chaotic system. A linear system cannot be chaotic. Study of coupled oscillators is an important, active eld of research in physics, which has many applications to communications and control. To have a synchronized set of nonlinear oscillators they must be coupled. We do know that nancial markets of developed, open economies are coupled. The coupling of these markets is due to free ow of news, money, and nancial assets across borders. What is not clear, however, is whether these coupled nancial markets with varying degrees of volatility are synchronized or become synchronized after passage of adequate time. The methodological problems in assessing the degree of nancial integration in one country or the degree of cross-country interdependence of the nancial markets, as stated in the previous section, lead us to search for powerful tools from nonlinear dynamical systems theories that were developed to test for the extent of synchronization of nonlinear systems with little a priori knowledge of their underlying dynamics. It turns out that a major strand of research on nonlinear dynamical systems of recent years deals with the issue of interdependence of dynamical systems, and asks the following important question: Given the time series data for two dynamical systems, and without a knowledge of the exact nature of their underlying dynamics, to what extent, if at all, does one system inuence the behavior of the second system? 5

In answering this question, Schi et al. (1996) and Pecora et al. (1996) developed tests for dynamical interdependence in bivariate time-series data. These techniques have found many applications in natural and physical sciences, but their use in nancial economics is rare or nonexistent. In present study, we consider two stock markets as coupled nonlinear oscillators, and proceed to test for synchronization of the markets using the method proposed by Schi et al. (1996), which is called mutual prediction method. The study of dynamical interdependence of nonlinear oscillators, commonly known as synchronization in physics literature, has its origin in the works of Fujisaka and Yamada (1983), Afrainmovich, Verichev, and Rabinovich (1986), and Pecora and Carrol (1990). A variety of approaches to synchronization studies, including system-subsystem synchronization, synchronization in unidirectional and bidirectional coupled systems, anti-phase synchronization, partial synchronization, pulse-coupled synchronization, and generalized synchronization have been developed. The theoretical framework for generalized synchronization of coupled nonlinear oscillators where the form of coupling is unrestricted exists. However, the use of the model in practical applications involves considerable diculties (See Rulkov, et al., 1995). In present study, we assume forced synchronization, where the full coupled system consists of one market as an autonomous driving system and the second one as a response system. In communications or control systems, selection of an oscillator as autonomous driving system and the second one a response system may have material consequences; however, in this study it makes no dierence which market is a driver or response, since we test for forced synchronization by considering each market as autonomous (hence the second one as a response) system. By doing so, we cover all possibilities. In short, we are testing for presence of unidirectional synchronization between otherwise independent systems. This implies that identifying a system as endogenous or exogenous is not an issue here. Moreover, to be consistent with the terminology of nancial literature, instead of using synchronization of coupled oscillators, we use terminologies of nonlinear interdependence and nancial integration interchangeably.

Mutual prediction and surrogate data analysis for detection of dynamical interdependence

Before applying the methods and algorithms from nonlinear dynamical systems theories to the stock market data in this study, one should establish that the time series are nonlinear. We use the surrogate data technique (Theiler, et al., 1992) in testing for nonlinearity of the stock market indices. We give a more detailed discussion of this method in section 4.2 below; however, in the next section, we describe the algorithms for detection of dynamical interdependence.

3.1

Nonlinear mutual prediction and dynamical interdependence

Dynamical interdependence of two or more nancial markets implies that the observed time series originate from the dierent parts of the same dynamical system, nevertheless, in general, two or more coupled, completely independent systems could become synchronized also. For cross-country nancial integration studies the equity markets are part of the global economic system. In the present context, the stock markets are considered subsystems of Chinese nancial system. Moreover, presence of dynamical interdependence among the subsystems (the individual equity markets) implies that: 1. The subsystems communicate, that is, they are coupled together and information ows between them (news arrival in the nancial markets), and/or 2. They are coupled to a common driver, where in the case of the stock markets the driving force is prot motive. For coupled (interdependent) dynamical systems, it is possible that their temporal evolutions might become synchronized as one adjusts the coupling strength between them, even though their temporal evolution might not be identical. Dynamical interdependence, as described in Rulkov, Sushichik, Tsimring, and Abarbanel (1995), which adopts a generalized synchronization approach, implies predictability of the response systems behavior by the driving system. This is the starting point for testing for interdependence of two systems which assumes existence of function that projects values from the trajectories of the driving system D space into the trajectories in the response system R space. In practice, however, when the degrees and directions of the coupling between the systems are unknown, one aims to reconstruct the dynamics of the two systems by time-delay embedding method, and then estimates statistics for testing for dynamical interdependence between the reconstructed systems. This is the basis for the mutual prediction method for testing for interdependence of two dynamical systems. The method of mutual prediction tests for synchronization of completely independent, but coupled oscillating systems (stock markets in our case). Examples of synchronization of completely independent, yet coupled, oscillating systems from biological and physical realms include synchronized intermittent emissions of light by tens of thousand reies to random openings of ion channels in cell membranes, to organ pipes, just to name a few. In short, synchronization is interaction of dierent systems or subsystems with each other. This means that these coupled, dierent, and independent systems or subsystems adjust the time scales of their oscillations due to the interaction. We consider three Chinese stock markets as nonlinear dynamical oscillating systems. We further consider two indexes at a time for testing and take X(t) as the driver system and Y(t) as the response system. It is important to point out that in forced synchronization one may have oneway synchronization. This means that in a forced synchronization where one 7

oscillator is being inuenced by another one in a unidirectional manner without inuencing the inuencer. One can have bidirectional synchronization where both systems are mutually interacting and inuencing each other. Hence, in the forced synchronization case, if X is not inuencing Y, it does not necessarily mean that Y is not inuencing X. (For excellent discussions of synchronization, see Balanov, A. N. Janson, D. Postnov, and O. Sosnovtsev, 2009) . We search for evidence of coupling between these markets by considering their dynamics that are represented by the following dierential equations: dX = f (X(t)) dt dY = g (Y(t), hc (X(t), Y(t))) dt (3) (4)

where functions f and g generate local dynamics, function h transmits the inuence of X(t) to Y(t), and constant c measures the strength of coupling. Let X and Y be two potentially coupled dynamical systems with the time series observations of xi and yi (i = 1, , N ), respectively. Often, in practice, the state variables are not directly observable, and one has no a priori knowledge of their individual dynamics or their dynamical interdependence. Instead, their evolutions are measured by the scalar variables xi (t) = k (X(t)) + 1 (t) yi (t) = k (Y(t)) + 2 (t) (5) (6)

where k is the measurement function (possibly nonlinear), and 1 and 2 are the error terms representing noise in the data. Because the time series data used in this study have values in a wide range (see table 2, below), we standardize each series by the following transformations: x i = y i xi x x yi y = y (7) (8)

where x , y , x , and y are the mean and standard deviation of the xi and yi series, respectively.

3.2

Time delay embedding and embedding dimension

Using time delay embedding (Takens,1981; Sauer, et al.,1991), reconstruct the phase spaces for xi in an embedding space X using the standardized time series {x i } with a suitable embedding dimension d and a time delay , such that xi = ( xi , x i+ , , x i+ (d1)). Similarly, reconstruct the phase space yi in an embedding space Y: yi = ( yi , y i+ , , y i+ (d1)). 8 (10) (9)

We select time delay by using mutual information approach (Fraser and Swinney,1986), see below. In practice, optimal determination of embedding dimension and time delay involves considerable diculties, and a large number of methods has been proposed for calculation of these parameters (see Soo and Cao, 2002). In this paper we choose the embedding dimension, d, and time delay, by Cao method (Cao,1997) which is discussed below.

3.3

Determining time delay and embedding dimension

Cao method of determining the embedding dimension is based on the concept of false neighbors. For a given dimension d, nd the nearest neighbor of each reconstructed time-delay embedding vector yi (d) and denote it yn(i,d)(d). Note that the n(i, d)th vector, yn(i,d) (d), is the closest vector to the ith vector, yi (d). Also note that notation n(i, d) implies that the nearest neighbor of any vector depends on the dimension d and the ith vector itself. Now increase d by 1, and then measure how the distance between these two nearest neighbors changes. This is quantied by a(i, d) = yi(d + 1) yn(i,d) (d + 1) . yi (d) yn(i,d) (d)

If a pair of nearest neighbors are true neighbors, a(i, d) should not be larger than some threshold value, otherwise, they are false neighbors. As there are many reconstructed vectors, a quantity measuring the average changes of all pairs of 1 N d nearest neighbors is dened as E (d) = N a(i, d) which depends only on i=1 d the dimension d, given the time delay . Clearly, given dierent values may lead to dierent embedding dimensions. See below for a discussion of a method of simultaneous determination of d and . Cao further dened E 1(d) = E (d +1)/E (d) for determination of the minimum embedding dimension. Increase d from 1 until E 1(d) stops changing at some d0 . Then d0 + 1 is the minimum embedding dimension according to Cao method. The algorithm of computing time delay with mutual information technique is based on Shannons entropy, and consists of rst constructing a histogram for the probability distribution of the data. Let denote the probability that the signal assumes a value inside the ith bin of the histogram. Moreover, let pij ( ) be the probability that x(t) is in the ith bin and x(t+ ) is in the j th bin. Then the mutual information for time delay is I ( ) =
i,j

pij ( ) ln pij ( ) 2
i

pi ln pi

(11)

The rst minimum of I ( ) marks the time lag where x(t+ ) adds maximum information to x(t). For an unfolding of a time series into a representative state space of a dynamical system, optimal embedding dimension d and time delay are required. The methods of computing embedding dimension and time delay presuppose prior 9

knowledge of one parameter before estimation of the other. Accordingly, calculating one parameter requires exogenous determination of the other. In this study, we adopt the method of simultaneous estimation of embedding dimensions and time delays and use these parameters in prediction of the original series. We select that combination of the embedding dimension and time delay that would lead to the minimum prediction error using nonlinear prediction method (see Soo and Cao, 2002 for a discussion of the method)1 . Specically, let i = f (dj , k , i ), [i = 1, , N ; j = k = 1, , M ], where i , dj , k , and i are the ith prediction error, the j th embedding dimension, the k th time delay, and the ith nearest neighbors, respectively. We used M = N = 30 on the stock market indexes and present the estimated parameters in table 1. We experimented with values of M = N > 30, but the prediction accuracy diminished with larger values of M and N . We also searched for the optimal embedding dimension and time delay for the standardized values and nd that the optimal dimension and time delay parameters for the series at level and standardized values are the same. Therefore, we only report the embedding dimension and time delay for the series at level. Shanghai 23 15 Shenzhen Hong Kong 16 18 15 26

Table 1: Optimal time delays and embedding dimensions for Chinese Stock market indices. We use d and for each stock market that is taken as a driver system for projection into the trajectories of the second stock market as the response system. For example, if we wish to unfold the Shanghai stock market index and project values from this index into the trajectory of the Shenzhen market, we use d = 23 and = 15 for unfolding of both indexes, even though d = 16 and = 15 for the Shenzhen market. We select the larger embedding dimensions to unfold the time series into the state spaces to avoid the problem of false nearest neighbors. Kennel et al. (1992) showed that if a time series is unfolded in a too small phase space, then the nearest neighbors falsely appear to be closer because of the small embedding space.

3.4

Algorithm for mutual prediction method


?

We write a possible functional relationship between X and Y as Y = (X) (12)

and aim at empirically verifying existence of the functional relationship between the two reconstructed systems X and Y. If such a relationship exists, then two
1 We are grateful to Dr. Liangyue Cao for suggesting this method and also for providing us his computer codes in simultaneous calculation of d and

10

close states in the phase space of the X system correspond to two close states in the phase space of the Y system. As was stated earlier, it does not matter which state variable we choose as autonomous or response variable. For measuring nonlinear interdependence what counts is hc function, and coupling strength coecient c. Existence of a continuous, dierentiable map , where in presence of synchronization creates a one-to-one correspondence between the orbits of X onto the orbits of Y in case of Y = (X), and maps Y onto X in case of X = (Y) is the important consideration. Select an arbitrary point x0 in the X space. Suppose the nearest neighbor of x0 has a time index of nnnd . Then if function exists, that is, if the two systems are coupled, then point y0 in the Y space will have point ynnnd as a close neighbor also. This means that the nearest neighbors of both points x0 and y0 share the same time indexes2. For example, if the nearest neighbor of point x0 is a three-dimensional vector with time indexes (1, 5, 8), then the vector that is the nearest neighbor of point y0 has the same time indexes (1, 5, 8). In implementing the mutual prediction method of testing for nonlinear interdependence of Chinese stock markets, we follow the method discussed by Breakpsear and Terry (2002) which is a modied, improved version of Schi et al.(1996) as discussed below. Construct in X a simplex around an arbitrary selected point x(ti) in time x t = ti with 2dx 1 vertices each consisting of another vector in X. d1 is the embedding dimension of X. Choose these embedding vectors (vertices) such that the size of the simplex is minimized3. Denote the points satisfying the criteria of being a vertex in the minimized simplex as xj (tij ), j = 1, . . . , 2dx 1 . Also denote the time indices of the vertices as tij , j = 1, . . . , 2dx . 1 Use the time indices tij of xj (tij ) to construct a simplex in the state space Y with vertices y (tij ), j = 1, . . . , 2dx 1. Take the weighted average of the vertices in y (tij ) to locate the vector y (tij ) that was predicted by the vector x(ti ) ypred. (ti) =
2dx 1 k=1 ik y (tik ) 2dx 1 k=1 ik

(13)

where the weighting factors ik , are determined by the distances of the vertices in X from x(ti), giving ik = (|x(tik ) x(ti)|)1 .
2 3

(14)

Note that we have unfolded the time series into d -dimensional space. A detailed discussion of how this is done is beyond the scope of this paper. Contact the corresponding author for the algorithm.

11

In this study, we choose the embedding dimension d of the driver system D. To calculate the mutual prediction error, take the dierence of the predicted vector and the actual vector
y ( x)

= |ypred (ti) y (ti)|.

(15)

To compare the prediction error y(x) with a prediction error based on a randomly selected element of the time series observations calculate
rand

= |yrand y (ti)|,

(16)

where yrand is calculated using the same procedure used in prediction of ypred. (ti), except that the simplex in X is a random combination of points on the orbit X weighted with respect to another randomly selected point. This corresponds to the null hypothesis of no interdependence between the markets. The normalized predicted y , y(x), as predicted by x, is calculated by y ( x) = < < >rms rand >rms
y ( x)

(17)

where <>rms is the root mean square. y(x)=1 implies no interdependence (no synchronization). y(x) = 0 implies complete synchronization. Calculate the vertices of simplex in Y as above and then iterate them H -step ahead on their respective orbits to obtain the vertices y (tij + H ), j = 1, . . . , 2dy i Compare the weighted predicted vector ypred. (ti + H ), j = 1, . . . , 2y i to the actual forward iterate y (ti + H ) to obtain future prediction errors. Normalize the H -step ahead prediction errors by a vector generated from random vertices in X to yield the normalized future prediction error: H y ( x) = < <
H y ( x) rand

>rms >rms

(18)

H y(x) = 1 implies no interdependence between the systems at H-step prediction. Note that in presence of generalized synchronization the error grows at a rate determined by the Lyapunov exponents(Wolf, Swift, Swinney and Vastano,1985), and is less than one for some time steps into the future. After generating a number of surrogates, which share the spectral density functions with the original time series use one-step ahead mutual prediction method 12

described above, and conduct H forecasts of the original time series and the surrogate time series separately. If the one-step ahead nonlinear prediction errors of the original series are smaller than those for any of the surrogates, predictions are signicant. A plot of H prediction errors as well as prediction interval for the original and surrogate series based on the above mentioned algorithm would aid in determining nonlinear interdependence of the markets. The deterministic interdependence is detected if the graph of the cross-prediction errors of the original series is below the graphs of cross-prediction errors for the surrogate sets, but above the lower bound of the 95% condence interval.

4
4.1

Empirical results
The data

In this study, we use 3 Chinese stock indices to test for nonlinear interdependence among the markets. These are the major indexes for the stock markets of Hong Kong (Hang Seng Index, HSI), Shanghai (Stock Exchange Composite Index, SSI), and Shenzhen Stock Exchange (Component Index, SZI). The sampling time period for these series are the daily observations from 2 Jan 2000 to 6 June 2008. The log normalized graph of the series appear in gure 1. Table 2 shows the descriptive statistics for the stock markets series.
Time series of SSI,SZI and HSI SSI SZI HSI

1.5

series(log form)

0.5

0.5

200

400

600

800

1000 1200 observations

1400

1600

1800

2010

Figure 1: Normalized stock market series.

13

SSI mean 2025.3 variance 1.0e+006 * 1.139 skewness 2.0153 max 6092.1 min 1011.5

SZI 5363.9 1.0e+006 * 1.6635 2.1338 19531 2627

HSI 14999 1.0e+006 * 2.2079 1.1253 31638 8409

Table 2: Descriptive statistics for the stock markets series.

4.2

Test for nonlinearity of the stock market time series using surrogate data

Before testing for nonlinear interdependence of the three time series, evidence of nonlinearity for single series should be found. We use the surrogate data technique (Theiler, et al., 1992) in testing for nonlinearity of the stock market indices. By using surrogate data method of testing for nonlinearity of the series we aim to reject the null hypothesis that the data involve only temporal correlations and are random otherwise. It is known that noise and limited sample observations may point to nonlinearity of a stochastic time series when such nonlinearity does not exist(see for example, Osborne and Provencale, 1989). To exclude such misleading signals, surrogate data method is often used for testing nonlinearity of a series. The method generates a number of surrogates for the original series by preserving all the linear properties of the original data while destroying any nonlinear structure that may exist in the original series by randomizing the Fourier components. The strategy in surrogate analysis is nding an inadequate process that may have generated the original data and then using a statistical test in showing that the observed data are highly unlikely to have been generated by such inadequate process. The null hypothesis that the surrogate series are linear is tested. If the null is true, then surrogate procedure will not aect measures of nonlinear structure. However, if the measure of nonlinear structure is signicantly changed by the surrogate procedure, then null of linearity of the series is rejected. The hypothesis testing requires a test statistics, and a variety of test statistics have been used in surrogate data analysis. The most popular of these statistics are correlation dimension and some measure of predictability. In this study we use one step ahead prediction error as the statistics to test for nonlinearity of the series. We nd motivating the use of surrogate data analysis instead of traditional boostrap method that is commonly used in economic literature useful at this juncture. In determining the unknown probability distribution of measures of nonlinearity Monte Carlo re-sampling technique is used. The parametric bootstrap methods (Efron, 1982) use explicit models that must be extracted from the data. The validity of this approach hinges on successful extraction of the model from 14

the data. The main shortcoming of parametric bootstrap method is that one cannot be sure about the true underlying process by tting the data to any model. The surrogate data method, which could be considered constrained realization method, overcomes the weakness of parametric bootstrap method, which is typical realization method, by directly imposing the desired structure onto the randomized time series. To avoid spurious results it is essential that the correct structure (suitable null-hypothesis formulation) is imposed on the original series. One approach in ensuring validity of statistical test is determining the most likely linear model that might have generated the data, tting the model, and then test for the null hypothesis that the data have been generated by the specied model. (Schreiber, 1999, pp:42-43). Surrogate data analysis is the method of choice in physics and nonlinear dynamical systems analysis. Hence, the mutual prediction method of test for nonlinear interdependence uses this approach also. In this study we generate 35 surrogate data series and compute the prediction errors q 1, q 2, . . . q 35, as the discriminating statistics for each series. The choice of 35 surrogates is arbitrary but adequate for hypothesis testing. The surrogate series are consistent with the null hypothesis of a linear process. One may reject the null hypothesis either by rank ordering or hypothesis testing. The rank ordering involves deciding whether q 0 of the original series appears as the rst or last item in the sorted list of q 0, q 1, q 2, . . . q 35. If the q s are fairly normally distributed we may use signicance test. Under this method rejection of the null using the signicant test requires a t value of about 2, at the 95% condence level, where t is dened as: |q 0 < q > | t= q (19)

where < q > and q are the mean and standard deviation, respectively, of the series q 1, q 2, . . . q 35 (For an in-depth discussion of surrogate data analysis see Kugiumtzis, 2002). Note that we use two surrogate data generating programs, tsurr (fast Fourier transform surrogates) and ampsurr (amplitude adjusted surrogates) by Kaplan (2004). First, we generated 35 phase-randomized surrogate data using tsurr. The surrogate data generated by this program have the spectral density functions as the original time series. Next, we used the amplitude-adjusted surrogates ampsurr, where the amplitudes of the surrogates and the original data are identical. Note that the amplitude-adjusted surrogate method re-shues the original series in a way such that the power spectrum of the surrogates and the original series are almost identical, however, the actual values of the original and surrogates are dierent. Applying FFT to data with non-Gaussian distribution may result in spurious rejection of the null hypothesis. This result is due to dierence between the distributions of the surrogates and the original series. To remedy this problem one should distort the original data so that it is transformed to a series with 15

Gaussian distribution. Then using the distorted original series, now a Gaussian series, with surrogate data generation using a method such as FFT, generate a new set of surrogates. Finally, the surrogates are transformed back to the same non-Gaussian distribution. This method is called amplitude-adjusted phase randomization (see Galka, 2000, chapter 11). It appears that the Chinese stock market data are non-Guassian, because of luptokurtic nature of the distribution. Therefore, we choose the results based on amplitude-adjusted phase randomization method. The root mean square prediction errors in the test are out-of-sample one step ahead prediction errors for the last 700 observations in the original and surrogate time series. In these prediction exercises, we divided the time series into two parts, with the rst half used as the training set and the last 700 observations were used as the test set. We used the training set to construct the phase space, then predicted one step ahead. We then used 701 observations as the training set, and predicted one step ahead, and continued the process by increasing the test set by one observation until the data is totally used. The null hypothesis is 0 , where 0 is the prediction error of the original series, while is the prediction error of the surrogate data. If t t (n 1) , the null hypothesis is rejected, which means the mean prediction error of the original time series is signicantly less than that of the surrogate data series. We calculated nonlinear prediction errors for 35 surrogate data we generated for each index. The mean square prediction errors, t-statistics, and the results of signicance tests for the series at levels are presented in Table 3. RMSE SSI 0.0854 SZI 0.1302 HSI 0.1334 Mean RMSE(t) 0.0747 0.1190 0.1289 t-statistics 4.5780 1.3560 0.7236 Mean RMSE(amp) 0.1487 0.2083 0.2059 t-statistics (2.4048) (2.0671) (2.2993)

Table 3: Testing for nonlinearity using two surrogate data generating methods. Mean RMSE(t) and RMSE(amp) means the mean RMSE of the surrogate data generated by fast Fourier transform and amplitude adjusted methods, respectively. RMSE means root mean square prediction errors. t-statistics appear in the parentheses. * implies signicant at 95% condence level. According to the t-statistics in Table 3, the prediction errors of the original series are smaller than the prediction errors of the amplitude adjusted surrogate data and are statistically signicant. Although, the prediction errors of the other original series are not signicantly less than those of the t surrogate data. For the t surrogate method the original data dont show nonlinearity, while for the amplitude surrogate method, the original data show signicant nonlinearity. The results point to nonlinearity of all three stock market indices: HSI , SSI, and SZI. Accordingly, we may apply the mutual prediction method for testing for nonlinear interdependence of the stock index time series. 16

4.3

Test for nonlinear interdependence of the Chinese stock markets

After the nonlinearity test of the single stock index series, we tested the nonlinear interdependence of the Chinese stock markets by the mutual prediction method that was discussed in section 3.4. In this part, we constructed 19 bivariate surrogate data with the same amplitude distribution, auto correlation function, and cross-spectral density function as the original data. However, non-linear structure contained within and between the surrogate series are destroyed. Thus the surrogate algorithm allows testing of the null hypothesis that the time series are produced by a cross-correlated stochastic system. Examples of the growth of the non-linear mutual prediction errors from Chinese stock indices appear in Figure 2 to Figure 4. Fig. 2 shows the test results of the standardized mutual prediction errors of SZI and HSI predicted by SSI. Values for the mutual prediction errors of the original series are shown as solid lines with circles. The entries on the vertical axis are the normalized predicted stock index of x, based on another stock index y using prediction errors based on a randomly selected point in the original series. For example, the term SZI (SSI ) means that we have used Shanghai stock market index (SSI) in predicting Shenzhen stock market index (SZI), and then compared the root mean square errors (RMSE) of these predictions with the RMSE of the predictions based on a randomly selected initial point in SZI. Furthermore, the term implies that we used the time indices of the nearest neighbors of this random point in the H -step prediction of Shanghai stock market series (SSI): H SZI (SSI ) = H SZI (SSI ) rms . H rand rms (20)

The dotted lines show the growth of the prediction errors calculated from the 19 surrogate data sets. In this study we calculated the lower bound by 1.96s , where as stated before, is the prediction error of the surrogate data, and s is the standard deviation of the surrogate errors.The line with x shows the lower bound of prediction interval at the 95% condence level. In Fig. 2, we see that the prediction errors of the original series are signicantly lower than the lower bound of the surrogates, which means the null hypothesis that the time series are produced by a cross-correlated stochastic systems is rejected. So the results show that the original series have nonlinear mutual predictability. The results in Fig. 2 and Fig. 3 indicate that there is nonlinear mutual (bidirectional) predictability between SSI and SZI. Moreover, there exists unidirectional predictability from SSI to HSI and from SZI to HSI. However, the results in Fig. 4 dont provide statistically signicant evidence that Hong Kong market predicts the stock markets in mainland China. See gure 5 for a schematic view of the direction of predictability, therefore, interdependence between the markets. Note that the direction of arrows shows 17

direction of predictability. For example, the arrow emerging from Shanghai and ending in Hong Kong indicates that Shanghai stock market predicts Hong Kong market, implying a unidirectional dependence of Shanghai market on Hong Kong market. Since the series are non-stationary, standardized series may distort the results. We tested the original data without data transformation, and discovered that the fundamental results concerning the market interdependence were intact, although the values of the statistics were changed. For economy of space we do not report results from the raw data. The presence of nonlinear interdependence is manifested by a more gradual increase in the cross-prediction error in the original series compared to the surrogate sets. Four of the six tests remain outside of the condence intervals for all 20 future iterates, corresponding to strong interdependence. We used both Schi et al. method as well as Breakspear and Terry simplex method on the data. The prediction errors based on Schi method are smaller than the prediction errors based on simplex method. The results in Fig. 2 to Fig. 4 are based on Schi technique.

4.4

Comparing the results with the results based on a traditional linear method

We compared the results obtained in this study with the results from a linear method of testing for integration of nancial markets. Zhu, et al. (2003) have used cointegration, fractional cointegration, and Granger causality methods in testing for integration of Chinese stock markets. The tests in Zhu, et al. (2003) show no evidence of cointegration (either integrated or fractionally integrated) among the stock markets. They could not nd any evidence for presence of causality among the markets either. Hence, the mutual prediction method of testing for interdependence of Chinese stock markets data shows completely dierent results from those obtained by the traditional linear stochastic methods used in Zhu, el al.(2003) study. Since we have provided ample evidence that the stock market data are nonlinear series, it is reasonable to conclude that the linear models have failed to detect interdependence, while the mutual prediction method succeeded in nding the evidence of dynamical interdependence between the markets.

Summary and Conclusions

The methodological problems in assessing the degree of nancial integration of markets within a country or the degree of cross-country interdependence of the nancial markets point to the need for new tools of analysis. To test for presence and strength of interdependence of nonlinear systems with little a priori knowledge of their underlying dynamics, one could use methods from nonlinear dynamical systems theories that are readily available. We tested nonlinearity and nonlinear interdependence of Chinese stock markets using surrogate data analysis and mutual prediction method. The use of 18

Chinese stock markets data instead of data from stock markets of dierent countries in this study is motivated by two factors. First, the structure of Hong Kong economy and nancial markets are characteristically dierent from the economy and nancial markets of the mainland. Second, because of calendar eects, both trading days eects (number of business days in a week) and holiday eects (different holidays) between China and other countries, a uniform set of time series measurements for Chinese and other stock markets data does not exist. Even though, statistical methods for dealing with calendar eects exist (see, for example, Cleveland and Devlin, 1982), testing the data with calendar eects for synchronization would add one extra layer of complexity to an already complex problem. We used Chinese stock markets data to side step this issue. We used two surrogate data generating programs, tsurr and ampsurr in testing for nonlinearity of the series. First, we generated phase-randomized surrogate data using tsurr. The surrogate data generated by this program have the spectral density functions as the original time series. Next, we used the amplitudeadjusted surrogates ampsurr, where the amplitudes of the surrogates and the original data are identical, but the actual values of the original and surrogates are dierent. The method of mutual prediction is based on the notion that if two nonlinear systems are interdependent (synchronized), then there exists a function that maps values from the trajectories of one system into the trajectories of another one. Using the methods of surrogate data analysis and mutual prediction on Shanghai, Shenzhen, and Hong Kong stock market data, we showed that these series are nonlinear, and are nonlinearly dependent on each other. See gure 5 for a schematic view of the interdependencies. These results give additional credence to nonlinear methodologies that are used in nancial integration studies. However, it should be emphasized that the mutual prediction method, as it currently stands, cannot measure a change in coupling strength; therefore, it cannot test for contagion, which is often associated with a rise in cross-country interdependence during the nancial crisis. Nevertheless, we consider presence of nonlinear interdependence between two nancial systems as the necessary condition for presence of contagion. Accordingly, to test for contagion, one must rst establish nonlinear interdependence between two dynamical systems. The mutual prediction method is a suitable, ecient technique for testing for existence of the necessary condition for contagion. The method of mutual prediction that we use in this study does not address multi, m : n synchronization, where m and n are two arbitrary integers. Nevertheless, at it was discussed above, we are dealing with forced synchronization (unidirectional synchronization), and the test can determine whether one market is unidirectionally synchronized with another one. Therefore, it is immaterial whether the inuencing market is synchronized with or is inuenced by the other markets4. Currently we are not aware of a time series method that would test for synchronization of multi systems. This does not mean that such a method does not
4

We are grateful to an anonymous referee for raising this important, ne point.

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exist. Perhaps testing for an m : n synchronization could be the subject of another research paper if a methodology to test for simultaneous synchronization of a multi-system is attainable. Another important feature of the mutual prediction method is that in addition to demonstrating presence of integrated markets, it can show the direction of inuence by identifying a market as driver or a response system. In addition to extending the study for testing synchronization of an m : n system, it could be extended in two more directions. First, one could use this method in testing for nonlinear interdependence of cross-country equity or money markets, by rst adjusting the calendar eects in the data. Secondly, research is required to modify the mutual prediction method so that it can measure the strength of coupling. The increase in coupling coecient, then would be an indicator of rise in coupling strength during the period of nancial crisis.

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mutual prediction error of SZI by SSI and the surrogates 1 SZI predicted by SSI lower bound of surrogates 0.9

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Figure 2: Growth of mutual prediction errors H y(x) for original (solid with circles) versus surrogate data (broken lines). Solid line with x-marks shows 95 % condence intervals for the null hypothesis.

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Figure 3: Growth of mutual prediction errors H y(x) for original (solid with circles) versus surrogate data (broken lines). Solid line with x-marks shows 95 % condence intervals for the null hypothesis.

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Figure 4: Growth of mutual prediction errors H y(x) for original (solid with circles) versus surrogate data (broken lines). Solid line with x-marks shows 95 % condence intervals for the null hypothesis.

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Figure 5: Flow chart of the interdependencies of Chinas stock markets. The direction of arrows shows direction of predictability.

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