The past several decades has witnessed immense change in the world’s financial markets, especially in the Pacific-Basin (PB) region. Changes have stemmed from the removal of capital restrictions, the floating of currencies, improvements in information technology, the enhanced level of investor education, the increased mobility of labour, the escalation, and participation in trade organisations and a general shift towards a global economy and community. These structural changes are likely to propagate a greater level of market linkage, which may reduce potential benefits garnered through international diversification. Moreover, Cooper and Kaplanis (2000) argue that the level of financial market linkage influences optimal corporate capital structure through differing costs of capital. Bekaert, Harvey and Lundblad (2002) show that equity market linkage resulted from the market liberalization helps spur real economic growth. Extensive research has been done on equity market linkage. However, three important questions in this area of research still remain inconclusive or unanswered.
The first question is: what are the right measures of equity market linkage? Ammer and Mei (1996) use the contemporaneous covariance, whereas Bekaert and Harvey (1995), among others, use the conditional covariance. Forbes and Rigobon (2002) and Hon, Strauss and Yong (2004) address the issue of short-term contagion following the East Asian currency crisis using the correlation coefficients corrected for heteroskedasticity. However, Kasa (1992) and Darrat and Zhong (2005) point out that contemporaneous correlation may not reflect genuine information on markets interrelationship and could be misleading if investors have long holding periods. Bracker, Docking and Koch (1999) use Geweke measures of feedback to measure the extent of financial market linkage for nine equity markets. These and other studies such as Dekker, Sen and Young (2001) and Johnson and Soenen (2002) all point to considerable linkage over the short run.
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We analyze the cross section of stock returns and liquidity of stocks traded in over-the-counter (OTC) markets. While hundreds of studies have investigated expected return patterns in listed stocks traded on the NYSE, Nasdaq, and AMEX, there are a substantial number of stocks—approximately one-fifth the number of stocks trading on the centralized exchanges—that trade in OTC markets. OTC stocks are traded on the over-the-counter bulletin board (OTCBB) or pink sheets (PS) markets, where at least one licensed broker-dealer agrees to make a market in each OTC stock. The OTC market data that we examine are a large sample. To our knowledge, it is the largest cross section and the longest time series of US stock prices to become available since the Center for Research on Security Prices (CRSP) added data on Nasdaq markets in 1984.
