High Return Correlations in Emerging Markets: Are They Symptoms of Exploitable Arbitrage and Massive Market Inefficiency? Evidence from Germany, Mexico, Thailand and Turkey

Abstract

In some emerging financial markets, high cross sectional return correlations limit the risk reduction benefits of diversification. The dominant explanation for these high correlations in the literature is that they result from shortages of information (c.f. Grossman, 1976, Roll, 1992, Stulz, 1999). We present evidence for the opposite case here. It appears that the covariance matrices one uses to estimate correlation coefficients have a more productive use. We provide evidence that these covariance matrices also may be used to produce buy and sell signals, information investors can use to arbitrage markets. They signal investors that markets are in disequilibrium, with resources being massively misallocated. This article documents the link between high asset return correlations and arbitrage profits in an examination of four financial markets: Germany, Mexico Thailand and Turkey. We provide evidence that Turkey's financial markets were in disequilibrium throughout our six year data sample period, as was Thailand for the six years prior to the Asian crisis. We identify arbitrage portfolios and the economic rents associated with them. If our results turn out to be characteristic of most financial and currency crises, much of the previous emerging markets research needs another look and policies based upon it need reconsideration.