International stock market correlations
IN PRINT ARCHIVE CIR Summer 2001
|International stock market correlations|
|Until researchers know more about the importance of global return correlations and contagion, tread carefully|
By G. Andrew Karolyi, Professor of Finance, Fisher College of Business, Ohio State University
An understanding of the magnitude and dynamics of return correlations among international stock markets is critical for a sound global asset management program. How low these correlations are among different markets, of course, limits the potential benefits to global investors of portfolio risk diversification strategies. But, knowing how they change over time can also be an important ingredient of a successful strategic or tactical global asset allocation program. The objective of this article is to survey briefly the most recent evidence on measuring international stock return correlations. I outline a series of facts that researchers have uncovered. I also address a genuine concern expressed by market regulators, policymakers, issuers and investors alike: do recent increases in equity market correlations reflect contagion effects?
Research on international stock market correlations and its usefulness in making the case for the benefits of international diversification of risk has its beginnings in the 1970s. For a number of years, studies attempted to understand the factors underlying the low international correlations by focusing on institutional factors and, specifically, the fact that national market indexes have a very different industrial composition. After all, risk diversification by investing in the Australian and Canadian market for U.S. investors may not stem from their economic growth rates, monetary/fiscal policies or exchange rate movements, but from the fact that they are heavily resource-based markets. The early evidence had clearly documented that country factors were more important than industry factors, but the debate was sparked again in the 1990s by a series of papers that re-established the growing importance of industry factors. No doubt this is an intuitive outcome with the growing integration of international equity markets through the growth in cross-border listings, international mutual and closed-end country funds and the introduction of new currency blocs. Researchers have learned three key facts.
FACT 1: COUNTRY FACTORS STILL DRIVE INTERNATIONAL
STOCK RETURN CORRELATIONS, BUT INDUSTRY FACTORS ARE GROWING IN IMPORTANCE.
FACT 2: STOCK MARKET CORRELATIONS VARY
OVER TIME, BUT IN A WAY ONLY WEAKLY RELATED TO FUNDAMENTAL MACROECONOMIC
AND CAPITAL MARKET FACTORS.
FACT 3: INTERNATIONAL CORRELATIONS OF
LARGE STOCK RETURNS, ESPECIALLY NEGATIVE ONES, ARE HIGHER THAN THOSE
FOR USUAL RETURNS.
"Contagion, in general, is used to refer to the spread of market disturbances--mostly on the downside--from one country to the other, a process observed through co-movements in exchange rates, stock prices, sovereign spreads and capital flows."
Some researchers caution that inferences about contagion effects from time-varying correlations may be flawed because of natural statistical biases due to time-varying volatilities, omitted variables and endogeneity. Still others propose a new framework of analysis for contagion that draws on co-incidences of extreme returns in international markets, but, more importantly, explicitly does not draw on traditional measures of stock return correlations. Their results also suggest that their measures of international financial contagion may not be as large as what others may have perceived. Until researchers get a better handle on the economic importance of global stock returns correlations and, especially, the association with contagion, caution is advised. Stay tuned.
Cavaglia, S., C. Brightman, and M. Aked, 2000, "The increasing importance of industry factors," Financial Analyst Journal, September/October, 41-54.
Forbes, K. and R. Rigobon, 2000, "No contagion, only interdependence: Measuring stock market comovements," MIT working paper.
Griffin, J. and G. A. Karolyi, 1998, "Another look at the role of the industrial structure of markets for international diversification strategies," Journal of Financial Economics 50, 351-373.
Longin, F. M., and B. Solnik, 2000, "Correlation structure of international equity markets during extremely volatile periods," Journal of Finance, forthcoming.