The Integration of Financial Markets

The objective of this study was to investigate the integration of stock market, foreign exchange market and money market in the context of Pakistan. The intra-country integration of these financial markets in the short and long-run are estimated using monthly data covering the period May 1994 to February 2011. To accomplish the objectives we use cointegration analysis and Vector Error Correction Method (VECM). The empirical results from both the techniques of cointegration i.e. the Engle-Granger and Johansen and Juselius (J-J), demonstrate that the Pakistani financial markets are cointegrated in the long-run. Results from VECM shows that in the short run, exchange rate and interest rate do not affect stock prices and similarly stock prices and interest rate do not affect exchange rate. However, exchange rate significantly affects interest rate in the short run. The findings based on impulse response functions and variance decomposition demonstrates that most of the variations in each market variable can be explained by its own lag. Thus, the Pakistani financial markets offer less opportunities of intra-country diversification of financial portfolio.