International Factor Linkages

Abstract

Griffin (2002) shows that Fama-French stock market factors are local, rather than global. In an integrated world financial market, however, local factors may be interrelated across countries. In this paper, we investigate the international linkages among local, country-specific stock market factors in order to better understand the structure of increasingly integrated world financial markets. In particular, the focus of our study is on (i) the cointegrating relationship and equilibrium dynamics among local factors and (ii) the pattern of international transmission of local factor innovations. In addressing these issues, we use daily returns to Fama-French three factors plus the momentum factor for each of the six major markets in our sample, during the period January 2000 - December 2005, and utilize the 'factor indices' constructed from the cumulative factor returns. The key findings of the paper are as follows. First, local factor indices are internationally cointegrated for each factor class, supporting the view that international stock markets are integrated at the factor level. This means that although stock market factors may be local, rather than global, these local factors are globally bound to each other through the long run equilibrium relationship. Furthermore, industrial outputs of our six sample economies also form a cointegrative system, implying that the cointegrating relations among local stock market factors may reflect, at least in part, international integration of the real economies. Second, following a system-wide shock to the cointegrating relations, the market and size factors revert to the equilibrium state much faster than the value and momentum factors, implying that international markets are more strongly integrated for the former than for the latter. Interestingly, the momentum factors initially 'overshoot' following a shock, drifting farther away from the equilibrium, before they begin to adjust toward the equilibrium, whereas other factors immediately embark on the adjustment processes. Third, the U.S. plays the dominant role in the market factor system, with its innovations eliciting clear global responses. However, the U.K. emerges as the most influential market in both the size and momentum factor systems. No single market plays a leadership role in the value factor system.