21

CHAPTER III
RESEARCH METHOD

3.1

Data
Data that will be used in this research are daily exchange rates and composite

price index of equity markets for period January, 1999 through December, 2004 because
of providing more robust and updated results. The data sample will be divided into two
periods that are the pre-Euro period and the post-Euro period. The pre-Euro period of
time is started from January, 1 1999 to December, 31 2001. A reason chooses date for the
pre-Euro period because the Indonesians economy has become stable from Asian
financial crisis and has adopted the floating exchange rates. The post-Euro period of time
is started from January, 1 2002 to December, 31 2004. A reason chooses date for the postEuro period because the banknotes and coins of Euro firstly were introduced in the world
market in January, 1 2002.
Data of exchange rates that are employed for this research are daily closing
observations on the nominal exchange rate for US Dollar, and Japan Yen. Because US
Dollar and Yen are primary currencies in the world are used to the international trade.
And many Indonesian companies use debt services denominated in US Dollar. Besides
the debt, many subsidiaries of US and Japan companies are established in Indonesia
which have operating transaction by US Dollar and Yen, and local companies have
mainly exporting and importing activity to target countries such as US, and Japan.
Data of composite indices that are employed for this research is daily closing
observations for each of countries such as Indonesia, US, and Japan. For Indonesia,

22
employs LQ45 Index in Jakarta Stock Exchange. The US employs Standard&Poor500
Composite Price Index. According to Fratzscher (2001), the indices are denominated in
local currencies because using a common currency would mitigate the effect of exchange
rate changes and uncertainty. Finally, Japan employs Tokyo Nikkei225 Composite Price
Index. Reasons choose S&P500 Index and Nikkei225 Index because they are the largest
capital market in the world and have active transaction of share. In addition, almost
companies in US and Japan which are listed in their indices usually have subsidiary
company in Indonesia. Whereas a reason chooses LQ45 Index because the companies
which are listed in stock exchange have active transaction of share every day and almost
of companies are susceptible with US Dollar debt service.
There are at least two difficulties arise in investigating stock market
interdependencies across countries. The first one is the missing observation problem due
to different stock market holiday. Since the study extensively incorporates lags in the
regressions, missing data is particularly troublesome. Thus, it is desirable to fill in
estimate-based information from an adjacent day. Rather than using a sophisticated
interpolation, this study follows the studies of Jeon and Von (1990), and Hirayama and
Tsutsui (1998) by adopting the method of Occam's razor (just fill in with the previous
day's price). Simplistic as it may be, this study justifies this method on the premise that a
closed stock exchange does not produce any information on bank holidays. Since no new
information is revealed, the previous day's information is carried over to the subsequent
day. Method of collecting data is practiced in doing research that is library research. Data
that is used in this research is secondary data which is collected by Jakarta Stock
Exchange Daily Statistics.

23
3.2

Variable
Variables that will be used in this research are:
1.

Dependent variable is changes of Jakarta Composite Index for period

LQ 45t
.
LQ 45 t 1

1999-2004 that will be calculated with: R.LQ45 t = ln

2.

Independent variables are changes of abroad stock markets (S&P500

Index, and Nikkei225 Index) and changes of foreign exchange rates (US
Dollar, and Japan Yen) that are calculated with:
S & P500 t
Nikkeit
, R.Nikkei t = Ln
,
S & P500 t 1
Nikkeit 1

R.S&P500 t = Ln

US $ t
Yen t
, and R.Yen t = Ln
.
US
$
Yen
t 1
t 1

R.US$ t = Ln
3.3 Descriptive Statistics

Firstly, analysis that is practiced in this research is analyzing of data descriptive

statistics. Component of descriptive statistics are sample mean, deviation standard,
skewness coefficient, and kurtosis of data sample. Mean sample is used to know central
data, while standard deviation is used to spread data sample. From skewness and kurtosis,
describe about form of data distribution.

3.4 Unit Root Test of Time Series Data

Stationary is concept of data stability toward effects innovation of variable. In
time series, stability means that stable mean, and variance toward innovation of time.
Data of time series is collecting data that is ordered based on sequence specified time.

24
Ordered time in time series is very important because moment of data distribution always
is influenced by innovation of time. According to Mukherjee et al. (1998), moment of
data distribution is mean, variant, and other data distributions.
The study finds that all stock indices and exchange rates contain a unit root,
implying that the null- hypothesis of the presence of a unit root at level cannot be rejected
even at the 1% significance level. Since the indices and exchange rates are found to be
non-stationary at levels, the first differences for whole models are taken. The same tests
are applied to the first differences of the indices and the results show that all the indices
and exchange rates become stationary after differencing once. If the result indicates that
all index levels are integrated of order one, I(1) and, therefore, we can proceed to the
cointegration analysis and error correction model by two step Engle-Granger with these
indices and exchange rates because they are all integrated in the same order as required
for cointegration.
Co-integration test of two or more data that is proved non-stationary also is
necessary done. Two or more data is called cointegration if linear combination of both
data is stationer data. In bivariate analysis, two data must have same order of integration
that is called cointegration. Cointegration shows that non-stationary data has tendency to
move together convergent in long period. If data is used in regression model that is nonstationary data, and cointegration, the model should be repaired to catch dynamic in short
period.
Suppose { xt } and { yt } are time series I(1), and { yt } relation to y t 1 and
xt 1 is wanted to be analyzed. Because { xt } and { yt } are non-stationary, model can

be used to analysis this linkage is model using differential of { xt } and { yt }, are:

25

yt yt 1 xt 1 t , with t ~ IIDN 0, 2

But, if { xt } and { yt } is cointegrated, this above model is not accurate. Cointegration {

xt } of and { y t } is shown with linear combination yt xt that is stationer.

If { xt } and { yt } is cointegrated, the accurate model to analysis linkage yt

toward yt 1 and xt 1 is:

yt yt 1 xt 1 ECt 1 t , with t ~ IIDN 0, 2 , and ECt 1 is

first lag from error correction variable. ECt Variable is residual of yt regression to xt
regression. ECt = yt - A- B xt with A and B is coefficient yt regression to xt .
Unit root test is used to examine is a time series stationer toward time, or not. And
this test assumes that the errors are statistically independent and have a constant variance.
Unit root test that is used in this research is Dickey-Fuller Test.
Firstly, stationary of composite indices data will be tested by unit root DickeyFuller. Some steps that are necessary done in this testing are:
1. Regression IHSGt to IHSGt 1 uses ordinary least square (OLS) model, so

formed linear regression model is: IHSGt IHSGt 1 t . Taking estimation

of IHSGt 1 , and standard deviation of .
1

2. Calculate of DF statistics: DF

Value of DF is compared with critical value on level of

significant t DF , .

3. Using hypothesis of non-stationary H 0 : 1 and H A : 1 .If DF t DF , ,

hypothesis of data non-stationary can not be rejected on level of

significant. A

26
data is called stationer on level of

significant if DF t DF , . Critical value

of t DFD ,( 0, 05) 2,86 and t DFD ,( 0, 01) 3,43 .

Steps of testing hypothesis of non-stationary above also are used on other variables such
as Japan Yen, US Dollar, LQ45 Index, S&P500 Index, and Nikkei225 Index.
3.5

Analysis of Akaikes Final Prediction Error (FPE)

In this research, vector auto regression (VAR) model is used to examine

hypothesis of non-causality Granger. FPE analysis is used to determine lag optimum that
is number of lags minimize error caused by inconsistency and inefficient of parameter
estimation in VAR model. Standard recommendations for the selection of the appropriate
lag length is to choose the number of lags to be long enough to ensure that the residuals
are white noise, but not too long since the estimates can become imprecise. The lag
length is therefore often selected somewhat arbitrarily.
Linkage x variable Granger causes y variable will be tested with using VAR model
that is:

m*

n*

i1

j1

yt iyti j xt j t ,
With m * and n * are optimum lag for y and x variables. If y and x are non-stationer
variables and non-cointegration, variable that will be used in VAR model is differential
from y and x, are x and y .
Some steps determine optimum lag m * and n * with using FPE analysis
(Zhou,1997).
1.

Determines maximum lag of M and N for y and x variables.

27
2.

With using model of OLS linear regression and sets N=0, regress y on lag 1 y,
lag 2 y,, lag m y, for m=1,2,3,,M.
m

Equation of regression is yt ( m ) ( m ) i yt i ( m ) t , for m=1,2,3,,M.

i 1

3.

Calculate FPE of VAR equation on second step as following:

FPE( m )

T m 1

SSR (m)
, for m=1,2,3,,M.
(T m 1)
T

(3.1)

SSR(m) is sum of squared residuals.

4.

Choosing m * that can minimize FPE(m), for m=1,2,3,,M.

So FPE( m * ) FPE(m), for all of m=1,2,3,M.

5.

Next, setting m = m * , doing linear regression (OLS) that fulfills linear

model:
m*

i 1

j 1

yt m* ,n m* ,n i yt i m* ,n j xt j m* ,n t , for

6.

Calculate FPE for VAR equation on fifth step as following:

FPE( m* ,n )

7.

n=1,2,3,,N.

T m

n 1 SSR (m * , n)

, for n=1,2,3,,N.
(T m n 1)
T

(3.2)

Choosing n * that can minimize FPE( m * ,n), for n=1,2,3,,N.

So FPE( m * , n * ) FPE( m * ,n), for all of n=1,2,3,,N.
Lag m * and n * that are obtained from step number of four and seven above,
are optimum lag used in VAR model. To test is x variable Granger cause y.

8.

If FPE( m * , n * ) FPE( m * ), This FPE analysis can detect that indicating x

variable Granger cause y variable.

28
Steps number 1-8 above will be used in all of couple of variables in this research.
After determining optimum lag that will be used to test Granger Causality in each of
couple variables, the next step is to test significant Granger Causality.
3.5.1

Testing of Non-Causality Granger Hypothesis

Granger causality is tool of causal test that always is used to two variables of time

series. According to Granger (1969), X granger causes Y if Y is better predicted using X

data history, compared with only using Y data history (Zhou, 1997). Formally, X granger
cause Y if mean square error (MSE) of Y prediction model uses X history data and Y is
smaller than MSE that comes from Y prediction model without X history data (Chen,
2001). Testing of non-causality Granger hypothesis in a couple variables is practiced
through vector auto regression (VAR) that represents linkage both variables.
Suppose will be practiced testing direct causality from time series variable X = {
xt } and Y = { y t }. Generally, VAR model that will be used to test direct Granger

causality is:
m

i 1

j 1

i 1

j 1

yt 1 1i y t i 1 j xt j ut
xt 1 2i xt i 2 j yt j vt

(3.1)

(3.2)

With residual of u t and vt of VAR model is not autocorrelation.

According Oxley (1998), equation (3.1) and (3.2) of VAR model can be used in
couple of xt and yt variables that are stationer, even couple of xt and yt variables are
non-stationer, and cointegration. If couple of xt and yt variables are non-stationer data
but no cointegration, couple of xt and yt variables must be differentiated first.

29
VAR model that is accurate used to test direct Granger causality in couple of xt
and yt variables is non-stationer and no cointegration:
m

i 1

j 1

i 1

j 1

yt 1 1i yt i 1 j xt j ut
xt 1 2i xt i 2 j yt j vt

(3.3a)

(3.4a)

Beside VAR (3.1) and (3.2) model, VAR (3.3b) and (3.4b) model also can be used
to test direct Granger causality of couples of xt and yt variables that are non-stationer,
and cointegration.
m

i 1

j 1

i 1

j 1

yt 1 1i yt i 1 j xt j 1 EC1t 1 ut
xt 1 2i xt i 2 j yt j 2 EC 2t 1 vt

(3.3b)

(3.4b)

With EC1t 1 and EC 2 t 1 are first lag of error correction variable for each of VAR
models. Whereas is differential symbol. According to Granger (1969) show that if
both of time series { xt } and { yt } also cointegrated, causal relation will be existed in
one direct.
After determined through FPE analysis, optimum lag will be used in VAR model
to examine hypothesis of non-causality Granger in all of couple of variables. VAR model
that will be used to examine is x variable Granger cause y variable:

m*

n*

i1

j1

yt iyti j xt j t

30
With m * and n * are optimum lag for y and x variables. Lagrange Multiplier (LM) test
will be used to examine hypothesis of non-causality Granger in equation of VAR.
Statistic test of LM distributes chi-square and strong to heteroskedastial residual. In
testing hypothesis of non-causality Granger is assumed VAR model that does not consist
residual autocorrelation.
Some steps that are necessary done to test is x variable Granger cause y variable
significantly on level of
1.

significant:

With using optimum lag m * and n * from result of FPE analysis, determines
equation of OLS regression in VAR model applying backward method. Backward
method purposes to eliminate variable that is not significant based on OLS and to
exclude in VAR model.

m*

n*

i1

j1

yt (ur) (ur)yti (ur)xt j t

VAR model above is called unrestricted model that has been simplified. Backward
method only is used in unrestricted model. For other regressions, used OLS applies
selection method of enter. With using unrestricted model, hypothesis of non-causality
Granger:
2.

H 0 : ( ur )1 ( ur ) 2 ... ( ur ) n* 0

will be tested.

From unrestricted model, form of restricted VAR model as following:

m*

y t ( r ) ( r ) i y t i u t
i 1

31
yt i Variable that is included into restricted model is equal with included into

unrestricted model. OLS results with backward method. In this restricted model,
takes ut residual.
3.

Regression each of xt j variables that correspond with

to all of yt i

variables are corresponding with i .

m*

xt j j ji yt i rt j , for some j 1,2,3,..., n .

i 1

Takes rt j for some j 1,2,3,..., n . Notes, independent variable of xt j and yt i

are took from VAR unrestricted model on first step.
4.

Creates new variable, called a, with a( j ) t u t rt j , for some j 1,2,3,..., n .

5.

Regressing constant 1 to all of a( j ) t variables that are obtained from fourth step,
without using intercept constant in regression equation. Takes SSR1 is sum of
squared error that is obtained from this regression.

6.

Calculates LM T SSR1 based on Woolridge (2000). T is total of observations

that are analyzed. Under H 0 , LM distributes chi-square with degree freedom q
that is total of xt j variables in simplified unrestricted VAR model. Thus,
Pr ob LM H 0 can be calculated using Microsoft Excel. Statistic function of

Excel that is used to calculate Pr ob LM H 0 is CHIDIST (LM,q).

7.

Hypothesis of non-causality Granger is rejected on level of

Pr ob LM H 0 <

significant if

Step of 1-7 are implemented in all of couple of variables in this research that
examines linkage Granger causality.

32
3.5.2

Error Correction Model by Two Step Engle-Granger

Error correction model is used to examine whether relationship between stock

markets and exchange rate has short term. It means that the expectation from economic
analyst is not same with exist truly. So to repair this problem is needed the model which
corrects error in disequilibrium is called as Error Correction Model (ECM).
For instance, interaction between Y and X Variables that is Yt 0 1 X t . If Y
has equilibrium spot to X Variable, equilibrium between two variables X and Y can be
fulfilled based above equation. But in economic, generally equilibrium is seldom to be
found. If Yt has value which is different with equilibrium value, difference left and right
sides are ECt Yt 0 1 X t . This difference ECt is called as disequilibrium error.
Thus if ECt is null, surely Y and X have equilibrium condition.
Because Y and X Variables are seldom in equilibrium condition, they will only do
observation of short term relationship with including lag Y and lag X. To describe this
problem, we have an equation that is Yt b0 b1 X t b2 X t 1 Yt 1 et

0< <1.

In

this equation, Y value needs time to adjust fully toward X variant.

Error correction model describes that changes of Y variable today is influenced by
changes of X variable and error correction component in past period. Error correction
components were residual in past period. According to Engle-Granger, if two variables Y
and X are not stationer but cointegrated, interaction between both variables can be
described with ECM model. The ECM model is: Yt 0 1X 1 2 ECTt et . 1
Coefficient is coefficient of short term. Correction coefficient of disequilibrium 2 is
absolute value which describes how fast time needed to get equilibrium value.

33
3.6

Cointegration Analysis
Cointegration analysis is able to detect whether the integrated markets exist or not

in the sense that there is a tendency among the markets to move together in the long run,
while in the short run deviations from the equilibrium is also permissible.
To test for cointegration Jakarta Stock Exchange vis--vis the US stock market,
the Japan stock market, US Dollar, and Japan Yen. The maximum likelihood approach of
the Johansen cointegration approach is adopted. Some steps that are necessary done to
Johansen test is cointegration model with a Vector Autoregressive [VAR(k)] model:
1.

Yt = A1Yt-1 + A2Yt-2 + + AkYt-k + t where Yt = (Y1t, Y2t, .Ynt)'.

2.

Subtracting Yt-1 from both sides of the Equation above to have: Y t = (A1 I)Yt-1 +
A2Yt-2 + AkYt-k + t

3.

Then adding and subtracting (A1- I)Yt-2 from both sides to get:
Yt = (A1 I) Yt-1 + (A2 + A1 I )Yt-2 + AkYt-k + t

4.

Again, adding and subtracting (A2 + A1 - I)Yt-3 from both sides to obtain:
Yt = (A1I) Yt-1 + (A2+A1- I) Yt-2 + (A3+A2+A1I)Yt-3 +AkYt-k + t

5.

Repeating addition and subtraction in this fashion, the JJ cointegration model can
therefore, be formulated as follows:
Yt = + iYt-1 + .+ kYt-k + Yt-k + t , where Yt is an n x 1 vector of
variables and is an n x 1 vector of constant, respectively. is an n x n matrix
(coefficients of the short run dynamics), = where is an n x 1 column
vector (the matrix of loadings) represents the speed of short run adjustment to
disequilibrium and is an 1 x n cointegrating row vector (the matrix of

34
cointegrating vectors) indicates the matrix of long run coefficients such that Yt
converge in their long run equilibrium.
Finally, t is an n x 1 vector of white noise error term and k is the order of
autoregression. As my study investigates market integration among Jakarta Composite
Price Index, S&P500 Index, and Nikkei225 Index also their interdependencies from the
US Dollar, and Yen therefore our n is equal to five.
The above process from a VAR model to fifth step is called the cointegrating
transformation. The long run information matrix in this equation is the key to
Johansen's cointegration test because its rank r determines the number of cointegrating
vectors. If rank () = 0, equation (2) returns to a VAR(k) model in the first differences
and the components in Yt are not cointegrated. On the other hand, if is a full rank n, all
component in Yt are stationary.
In a more general case when 1 < rank () < n, the number of cointegrating vectors
is equal to r, the rank of matrix . Since the rank of a matrix is equal to the number of
eigenvalues i (or characteristic unit roots) that are significantly different from zero,
Johansen proposed two statistics to test the rank of the long run information , namely:
trace (r) = -T

...(1)

max (r, r + 1) = -T ..(2)

Where i are estimated eigenvalues (characteristic roots) ranked from largest to smallest.
The trace in the equation (1) is called the Trace statistics, which is a likelihood ratio
test statistics for the hypotheses that are at most r cointegrating vectors. The max in the
equation (2) is called the Maximal Eigenvalue statistic that tests the hypothesis of r
cointegrating vectors against the hypothesis of r 1 cointegrating vectors. The rank of

35
is equal to the number of eigenvalues that are different from zero. If eigenvalues i's are
all zero, then the trace and max will be zero. To test for the number of cointegrating vectors,
this study employs the Johansen and Juseliuss (1990) and Osterwald-Lenums (1992)
trace and max statistics that are adjusted for the degree of freedom.
Additionally, an important requirement for implementing the JJ cointegration test
is that the variables are non-stationary integrated of the same order. Accordingly, prior to
the JJ test, henceforth ADF unit root tests are conducted to determine the order of
integration for each national stock price and each foreign exchange rate.