What Drives Equity Returns in Central and Eastern Europe

This paper investigates the apparent comovement of equity prices in the Czech Republic, Hungary and Poland. It argues that the main underlying forces moving stock prices in small open emerging markets are of exogenous nature. It models the main factor driving prices in the region as an unobservable variable labeled quot;the international investor sentimentquot;. This latent variable is represented as a two-state Markov chain and makes the stock returns switch from a high growth regime to a depression regime, or in the opposite direction. In such a framework, the stock return process comes from a mixture of two normal distributions with different means. This model is estimated using the vector Markov switching method of Hamilton (1989, 1990). The estimated process shows a significant correlation with a number of data series on capital flows as well as with emerging markets' benchmark indices, corroborating the main argument of the paper