Portfolio diversification effects of trading blocs: The case of NAFTA

Abstract

This study investigates the evolving nature of North American Free Trade Agreement (NAFTA) stock market interdependencies and their association with diversification gains from the perspective of US investors. The issues are addressed for both short- and long-run interdependencies through correlation of stock market returns and cointegration of stock market prices. The basic findings include: (1) the existence of a long-term relationship (a cointegration relation) which is time-varying and statistically unstable and (2) diversification gains with cointegration not consistently lower than without cointegration. Thus, per-unit-of-risk diversification gains to US investors from NAFTA stock markets are determined by return volatilities, return correlations and domestic market performance. Based on increased return volatilities and return correlations and the very small per-unit-of-risk diversification gains even when the US stock market performs poorly, US investors’ diversification gains have diminished since the implementation of NAFTA.