Return Comovement Research Articles

ROBUSTNESS OF THE HEADQUARTERS‐CITY EFFECT ON STOCK RETURNS

AbstractRecent studies report that U.S. firms headquartered near each other experience positive comovement in their stock returns, a finding suggestive of local biases in equity trading activity. We investigate the robustness of these findings and find that including additional pricing factors in models for monthly stock returns materially reduces the magnitude of the headquarters‐city effect in stock returns. Additionally, we find that an implicit null hypothesis of zero local return comovement is inappropriate as there is positive comovement between a stock's return and returns on portfolios of stocks from nonheadquarters cities, on average. Nevertheless, results benchmarked against estimates based on resampling methods indicate a significant and robust headquarters‐city effect in stock returns.

The MSCI-Canada index rebalancing and excess comovement

Major changes to the MSCI Canada Standard Country index were announced and implemented in May 2000. This rebalancing involved the addition of some 17 and deletion of 13 stocks and had the net effect of increasing the market capitalization by US$50 billions. We investigate the associated changes in stock return comovement around this event on the Toronto Stock Exchange, the third largest North American exchange. We find that the average beta of the added stocks increases by as much as a factor of 1.6 while the average R 2 increases by up to 5%. Robustness tests indicate the results are not driven by nonsynchronous trading.

The Determinants of Bank Stock Returns' Co-Movements in East Asia

We examine co-movements of bank stock returns in eight East Asian countries after the 1997 crisis and attempt to determine the factors that influence them. The return correlations among banks within each country are computed and used as a dependent variable in weighted least squares regressions. The factors were chosen from a wide range of accounting and market-based indicators using a stepwise procedure. The results show that the share of interbank activities in the balance sheet does not explain the level of correlations. However, a strong link is found between the bank return co-movements and bank default risk measured by a z-score. To a lesser extent, the share of loan activities in a bank's balance sheet, which is a proxy of opacity, is also a significant factor of the level of correlation.

Provincial co-movement in Chinese stock returns

Stock returns in China exhibit significant co-movement with provincial return indices after controlling for the industry effect, consistent with local co-movement findings in the United States. The magnitude of such co-movement increases with participation in trading by local investors. Trading activities of individual stocks also co-vary with provincial volume. The last two findings support the roles of investor behaviour in explaining the local return co-movement phenomenon.

Economic determinants of comovement across international stock markets: the example of Taiwan and its key trading partners

This study uses the multinomial logit model in which comovements are categorized into three outcomes, namely (i) negative comovements, (ii) positive comovements and (iii) no comovements, with the purpose of the empirical analysis being to investigate the economic determinants that affect the comovement relationships in the stock markets for Taiwan and four major trading partners (Mainland China, United States, Japan and Hong Kong) using daily data covering the period from 1994 to 2004. The period under study is further divided into three sub-periods, i.e. the period before the Asian financial crisis, that during the Asian financial crisis and that after the Asian financial crisis, in order to determine whether the factors influencing the comovements in the stock market returns of Taiwan and its trading partners actually change over time. In addition, this study differs from earlier studies that only emphasized the analysis of statistical significance in that it attaches importanace to analysing both the statistical and economic significance of the factors affecting comovements. The empirical results indicate that, regardless of whether it is the period during or after the financial crisis that is being considered, the volatility of stock market returns and the rate of change in the exchange rate are both important factors that affect comovement. In addition, interest rate differentials play an increasingly important role in the period after the financial crisis.

The nature of listed real estate companies: property or equity market?

This paper addresses the question of whether shares of public real estate companies should be treated as real estate or as equity investments. Because theoretical considerations do not suffice for making such a classification, we empirically investigate correlation structures and cointegration relationships of private and public real estate and equity markets for the United States and the United Kingdom. Our results suggest that public real estate stocks show similarities to the general stock market with regard to short-term return co-movements. For long-term investment horizons, the interdependence between direct and securitized real estate is much stronger. However, in the latter case, real estate stocks substantially lead the private property markets.

A change of focus: Stock market reclassification in the UK

This paper examines the impact of a change of focus by a firm, as signified by a firm's stock market reclassification. It distinguishes between a firm's sector reclassification motivated by information specific to that firm and one that results from the redefinition and reorganisation of a sector. The direction of the price effects following reclassification depends significantly upon this distinction. Furthermore, a stock's return comovement with the FTSE All-Share Index is affected by its reclassification into a new sector, consistent with the allocation of stocks into categories by investors. Reclassification can induce common factors in the returns to stocks in an index without there being any change in these stocks’ fundamental cash flows.

High Idiosyncratic Volatility and Low Returns: International and Further U.S. Evidence

Stocks with recent past high idiosyncratic volatility have low future average returns around the world. Across 23 developed markets, the difference in average returns between the extreme quintile portfolios sorted on idiosyncratic volatility is -1.31% per month, after controlling for world market, size, and value factors. The effect is individually significant in each G7 country. In the U.S., we rule out explanations based on trading frictions, information dissemination, and higher moments. There is strong comovement in the low returns to high idiosyncratic volatility stocks across countries, suggesting that broad, not easily diversifiable, factors may lie behind this phenomenon.

Changes in the international comovement of stock returns and asymmetric macroeconomic shocks

We study whether asymmetric macroeconomic shocks help to explain changes in the international comovement of monthly stock returns in major industrialized countries over the period 1975–2004. Based on a time-varying parameter model, we trace out how the pattern of international comovement of stock returns changed over time. In order to identify asymmetric macroeconomic shocks, we estimate vector-autoregressive models. The results of estimating time-series regression models and panel-data models indicate that changes in the international comovement of stock returns are not systematically linked to macroeconomic shocks.

Common Patterns in Commonality in Returns, Liquidity, and Turnover Around the World

We uncover similar cross-country and time-series patterns in co-movement or in stock returns, liquidity, and trading activity across 40 developed and emerging countries. The extent to which the liquidity and turnover of individual stocks within a country move together is related to the same institutional characteristics as is co-movement in stock returns. Commonality is greater in countries with weaker investor protection and a more opaque information environment. Monthly variation in commonality in returns, liquidity, and turnover is also driven by common determinants. Commonality increases during times of high market volatility, large market declines, and high interest rates, and is negatively related to capital market openness. Our results are consistent with theoretical models in which changes in the wealth and collateral value of traders and financial intermediaries endogenously affect liquidity, trading, and pricing.

International Stock Return Comovements

We examine international stock return comovements using country-industry and country-style portfolios. We first establish that parsimonious risk-based factor models capture the covariance structure of the data better than the popular Heston-Rouwenhorst (1994) model. We then establish the following stylized facts regarding stock return comovements. First, we do not find evidence for an upward trend in return correlations, excpet for the European stock markets. Second, the increasing imporatnce of industry factors relative to country factors was a short-lived, temporary phenomenon. Third, we find no evidence for a trend in idiosyncratic risk in any of the countries we examine.

Industry Classifications and Return Comovement

A company’s industry affiliation is commonly used to construct homogeneous stock groupings for portfolio risk management, relative valuation, and peer-group comparisons. A variety of industry classification systems have been adopted, however, creating disagreements as to companies’ industry assignments. This analysis of the Global Industry Classification System (GICS) and Fama–French system indicates that common movement in returns and operating performance resulting from industry effects is stronger for stocks of large companies than for those of small companies. Also, increasingly fine levels of disaggregation improve discrimination up to six-digit GICS codes, after which the benefits tail off. Stock groupings based on industry exhibit stronger out-of-sample homogeneity than groups formed from statistical cluster analysis.

Excess Comovement of Stock Returns: Evidence from Cross-Sectional Variation in Nikkei 225 Weights

Relative to their weights in a value-weighted index, a number of stocks in Japan's Nikkei 225 stock index are overweighted by a factor of 10 or more. I document a strong positive relation between overweighting and the comovement of a stock with other stocks in the Nikkei index, and a negative relationship between index overweighting and comovement with stocks outside of the index. The cross-sectional approach resolves endogeneity problems associated with event study demonstrations of excess comovement. A trading strategy that bets on the reversion of stock prices of overweighted stocks generates economic profits, confirming that the observed comovement patterns are excessive, and providing further evidence that comovement of stock returns can be a consequence of commonality in trading behavior.

Comovement in Investment

This paper examines the propensity of firms to comove in investment decisions. Although stock return comovement and herding among investors received considerable attention in existing work, little is known about correlated investment behavior of firms. After controlling for the similarity of firm characteristics, investments are expected to comove more when firms imitate other firms and rely on public information rather than on firm specific private information about investment opportunities. We consider the effects of agency conflicts on comovement and find evidence in support of managerial shirking of information acquisition effort. Weakly governed managers rely less on private information acquisition and comove more in their investment decisions. Our results also show that the effect is strongest for firms in industries with high information intensity and specialized assets. Further, comovement in investment is decreasing in shareholder rights and property rights protections and increasing in the degree of information asymmetry. The results are obtained after controlling for similarity in firm investment opportunities, correlation in cash flows, fraction of tangible assets, and industry concentration. Critically, we find that comovement in investment has a negative effect on firm and industry performance and productivity growth, after controlling for other factors.

Efficient Estimation of a Semiparametric Characteristic-Based Factor Model of Security Returns

This paper develops a new estimation procedure for characteristic-based factor models of security returns. We treat the factor model as a weighted additive nonparametric regression model, with the factor returns serving as time-varying weights, and a set of univariate non-parametric functions relating security characteristic to the associated factor betas. We use a time-series and cross-sectional pooled weighted additive nonparametric regression methodology to simultaneously estimate the factor returns and characteristic-beta functions. By avoiding the curse of dimensionality our methodology allows for a larger number of factors than existing semiparametric methods. We apply the technique to the three-factor Fama-French model, Carhart's four-factor extension of it adding a momentum factor, and a five-factor extension adding an own-volatility factor. We found that momentum and own-volatility factors are at least as important if not more important than size and value in explaining equity return comovements. We test the multifactor beta pricing theory against the Capital Asset Pricing model using a standard test, and against a general alternative using a new nonparametric test.

Trading Patterns and Excess Comovement of Stock Returns

In April 2000, 30 stocks were replaced in the Nikkei 225 Index. The unusually broad index redefinition allowed for a study of the effects of index-linked trading on the excess comovement of stock returns. A large increase occurred in the correlation of trading volume of stocks added to the index with the volume of stocks that remained in the index, and opposite results occurred for the deletions. Daily index return betas of the additions rose by an average of 0.45; index return betas of the deleted stocks fell by an average of 0.63. Theoretical predictions for changes in autocorrelations and cross-serial correlations of returns of index additions and deletions were confirmed. The results are consistent with the idea that trading patterns are associated with short-run excess comovement of stock returns.

Commonality in the time-variation of stock–stock and stock–bond return comovements

We jointly investigate time-varying comovements between stock returns across countries and between long-term government bond and stock returns within countries. Our focus is on how daily return comovements vary with stock uncertainty, as measured by the implied volatility (IV) from equity index options. Cross-country stock return comovements tend to be stronger (weaker) following high (low) IV days and on days with large (small) changes in IV. Stock-bond return comovements tend to be substantially positive (negative) following low (high) IV days and on days with small (large) changes in IV. A regime-switching analysis also indicates a striking temporal commonality in the stock?stock and stock-bond comovement variations. Our findings bear on understanding the influence of time-varying uncertainty on price formation and the diversification benefits of stock-bond and cross-country stock holdings.

Regime Shifts in the Stock–Bond Relation in Australia

Previous evidence suggests that the implied volatility from equity index options, as a measure of stock market uncertainty, can provide "forward-looking information" about the stock–bond return correlation. This paper uses an alternative regime-switching autoregressive model to characterize state-dependent stock–bond return comovement and to evaluate the contribution of implied volatility in understanding transition dynamics. We confirm that implied volatility provides information about transition dynamics which is not inherent in the stock and bond returns, notwithstanding several different features of our data set and methodological approach.

Provincial Co-Movement in Chinese Stock Returns

Stock returns in China exhibit significant co-movement with provincial return indices after controlling for the industry effect, consistent with local co-movement findings in the United States. The magnitude of such co-movement increases with participation in trading by local investors. Trading activities of individual stocks also co-vary with provincial volume. The last two findings support the roles of investor behavior in explaining the local return co-movement phenomenon.

Commonality in the time-variation of stock–stock and stock–bond return comovements

We jointly investigate time-varying comovements between stock returns across countries and between long-term government bond and stock returns within countries. Our focus is on how daily return comovements vary with stock uncertainty, as measured by the implied volatility (IV) from equity index options. Cross-country stock return comovements tend to be stronger (weaker) following high (low) IV days and on days with large (small) changes in IV. Stock–bond return comovements tend to be substantially positive (negative) following low (high) IV days and on days with small (large) changes in IV. A regime-switching analysis also indicates a striking temporal commonality in the stock–stock and stock–bond comovement variations. Our findings bear on understanding the influence of time-varying uncertainty on price formation and the diversification benefits of stock–bond and cross-country stock holdings.