Abstract
This paper evaluates the influence of foreign or domestic stock market return and return of volatility shocks on dynamic conditional correlations (DCCs) between international stock markets and correlation volatility, respectively. The correlations between markets have implications for the gains from portfolio diversification, while correlation volatilities can be seen as risks to portfolio diversification. Meanwhile, domestic shocks are sourced from the return and return volatility from 24 developed, emerging, and frontier stock markets. The US stock market is the source of foreign shocks. The domestic and foreign shocks are derived using market-based returns and under bearish market conditions. We estimate multivariate exponential generalized autoregressive conditional heteroskedasticity (E-GARCH) models using daily and monthly MSCI based stock price data of selected developed, emerging, and frontier markets over 1993:1–2014:1. Our key results are as follows. Domestic market shocks were significant drivers of gains from portfolio diversification most of the time, although the US market effects were relatively stronger. On the other hand, the US, in terms of the number of significant cases as well as the size effects of shocks, dominated as a determinant of correlation volatility (or risks to portfolio diversification). Further, under bear market conditions, adjustments in correlations and correlation volatilities are found to be mostly US-induced. Bearish shocks, rather than market return based shocks, show strong evidence of the leverage effect. Signs of persistence of shocks are mainly noticed under bearish conditions.
Highlights
International stock market correlations are typically used to determine the gains or losses from diversifying risk internationally
The effects of US stock market return volatility shocks on correlation volatility are captured in columns 9 and 10 of Tables 2–5, while the country-specific volatility effects are captured in columns 7 and 8 of Tables 2–5
The second finding was a strong incidence of the leverage effect seen with US bear market volatility shocks, such that negative bear market innovations led to greater correlation volatility than positive bear market shocks
Summary
International stock market correlations are typically used to determine the gains or losses from diversifying risk internationally. Apart from examining the determinants of international stock market correlations, this study tests the influences of domestic and foreign shocks on the volatility of the correlations between the two markets. Apart from the US, the other markets examined over the period 1993:01 to 2014:01 are six developed markets (from Canada, France, Germany, Italy, Japan, and the UK), eight emerging markets (China, Brazil, India, Israel, Malaysia, Taiwan, Singapore, and South Korea), and 10 frontier markets (Argentina, Indonesia, Jordan, Mexico, Pakistan, Philippines, Sri Lanka, South Africa, Thailand, and Turkey). The developed markets of Canada, France, Germany, Italy, Japan, UK, and the US; the emerging markets of Brazil, China, India, Malaysia, Korea, Singapore, and Taiwan; and frontier markets of Indonesia, Jordan, Mexico, Pakistan, Philippines, Sri Lanka, South Africa, Turkey, and Thailand were examined.
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