Economic Determinants of the Correlation Structure Across International Equity Markets
Kevin Bracker and Paul D. Koch
This study investigates whether, how, and why the matrix of correlations across interna- tional equity markets changes over time. A theoretical model is proposed to specify
potential economic determinants of this correlation structure. The empirical validity of this economic model is investigated by employing daily returns for different national stock
indexes, from 1972 through 1993, to construct a quarterly time series of the correlation matrix. This quarterly time series is used to investigate the stability of the correlation
matrix over time, and to estimate the economic model. The model is then applied to generate out-of-sample forecasts of the correlation structure.
© 1999 Elsevier Science Inc. Keywords:
International market integration JEL classification:
F36, G15.
I. Introduction
The degree of capital market integration varies substantially across different pairs of national markets and over time. During some periods, there is less association between the
economic health of countries in different sectors of the world economy. At such times, national equity markets tend to follow their own paths, and experience less comovement
with other markets. At other times, there is greater association between the economic performance of different sectors of the world, especially across countries that are more
interdependent through trade, and we observe greater comovement across respective national equity markets. Recently, we have witnessed occasional contagion effects
whereby certain groups of national equity markets rally or crash together in response to economic andor political events, exhibiting correlations that are temporarily very high.
This discussion describes evolution in the nature and extent of global capital market integration, characterized by dramatic changes over time in the correlation matrix across
Economics, Finance, and Banking K.B., Pittsburg State University, Pittsburg, Kansas, School of Business P.D.K., University of Kansas, Lawrence, Kansas, USA
Address correspondence to: Dr. P. D. Koch, School of Business, University of Kansas, Lawrence, KS 66045.
Journal of Economics and Business 1999; 51:443– 471 0148-6195 99 –see front matter
© 1999 Elsevier Science Inc., New York, New York PII S0148-61959900021-1
national equity returns. This study focuses on understanding, modeling, and forecasting dynamic movements in the correlation structure.
1
We hypothesize that greater economic integration across countries should lead to greater capital market integration. Interdepen-
dence through trade and capital flows implies interdependence in investors’ valuation decisions across national equity markets. In this light, we suggest that pairs of countries
experiencing greater economic integration should also experience greater comovement in their respective capital markets. Furthermore, as the nature and extent of economic
integration across countries changes over time, we may expect concomitant changes in the degree of comovement across respective capital markets.
This study addresses whether, how, and why the correlation structure changes over time by testing the stability of the correlation matrix over different periods, and by
modeling potential economic determinants of the correlation structure. The economic model is then applied to generate out-of-sample forecasts of the correlation structure. A
better understanding of dynamic movements in the correlation structure is critical, given that this structure reflects the nature and extent of global market integration, and given its
impact on the risk-return performance of international equity portfolios. In light of the recent precarious situation in world financial markets, the ability to predict changes in
correlation patterns should be of interest to market participants, national policy makers, and regulatory bodies involved in monitoring and managing global market behavior.
2
This study employs daily returns on ten national stock indexes, from 1972 through 1993, to construct a quarterly time series of the correlation matrix. This time series
embodies any variation in the correlation structure experienced over the sample, and is used to test formally the hypothesis that the correlation matrix does not change over time.
Results reveal substantive changes over both short and long time horizons throughout this 22-year sample period. Augmented Dickey–Fuller tests indicate that almost all of these
time series of pairwise correlations contain no unit root. This outcome alleviates concern about possible spurious relationships with economic variables. This battery of stability
tests provides evidence of the dramatic evolution in the correlation matrix, and motivates the need to further analyze potential economic determinants of the correlation structure.
We seek to gain a better understanding of these dynamic changes in the correlation structure by modeling economic factors that may influence the degree of comovement
across equity markets. We hypothesize that the degree of integration across international capital markets at any point in time depends upon the degree of economic integration
1
Throughout this study, the term correlation structure refers to the matrix of correlations across returns in different national equity indexes. This correlation structure characterizes the nature and extent of integration
across different pairs of national equity markets. Dynamic changes in the correlation structure imply changes in the risk-return performance of international equity portfolios over time. For a summary of the role of the
correlation structure in international diversification, see Haugen 1990, pp. 134–136, Isimbabi 1992, and Hatch and Resnick 1993. For more related work on the nature and extent of international market integration,
see Arshanapalli and Doukas 1993, Bachman et al. 1996, Eun and Resnick 1984, Kasa 1992, and Longin and Solnik 1995.
2
Changes in the correlation matrix, along with changes in expected returns and variances across national equity markets, imply shifts in the international opportunities locus over time. The “optimal” international equity
portfolio is traditionally constructed from a given estimated opportunities locus as the portfolio with the highest Sharpe 1966 measure. Computation of both the opportunities locus and the Sharpe measure requires forecasts
of expected returns, variances, and correlations across national equity markets. As global capital markets evolve with changing economic conditions, these three dimensions of the international opportunity set should vary over
time, making this forecasting task a difficult endeavor. In this light, market participants and regulators should be interested in the ability to predict changes in the correlation structure.
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K. Bracker and P. D. Koch
across the countries involved.
3
We develop a theoretical model in which each time series of pairwise correlations may depend upon factors that characterize and influence the
extent of economic integration across the two markets in question. The set of all such pairwise equations is then estimated both as a pooled regression and as a system of
seemingly unrelated regressions that describes potential economic determinants of the correlation structure. This analysis is conducted on the subset of seven countries for which
complete economic data are available. Results indicate that the degree of international integration the magnitude of the correlations is positively associated with 1 world
market volatility and 2 a trend; while it is negatively related to 3 exchange rate volatility, 4 term structure differentials across markets, 5 real interest rate differentials,
and 6 the return on a world market index.
This analysis sheds light on the economic forces that influence the correlation structure over time, and thus the evolution in global capital market integration. For example, these
results corroborate a priori expectations that divergent macroeconomic behavior across countries tends to be associated with divergent behavior across national equity markets,
resulting in lower market correlations. In addition, the influence of economic factors 1 and 6 listed above indicate an increase in comovement across international equity
markets when world markets are more volatile andor falling. This outcome suggests a decline in the risk-reduction benefits of international diversification at the very time when
these benefits are needed most.
Finally, the economic model is employed to generate out-of-sample forecasts of the correlation structure. The forecast performance of this model dominates that of other
atheoretical models which ignore economic determinants of the correlation structure. This outcome adds credence to the validity of the theoretical economic model, and suggests that
modeling the correlation structure holds promise in assisting managers to exploit inter- national investment opportunities.
The paper proceeds as follows. Section II reviews the literature on stability in the correlation structure, discusses the data, and presents the stability tests. Section III
develops the theoretical model describing economic determinants of the correlation structure, and Section IV estimates the model. Section V compares the forecast perfor-
mance of this model with respect to alternative forecasting techniques. A final section summarizes and concludes.
II. Literature Review, Stock Market Data, and Stability Tests
