Cyclical Comovement in World Indices

Carlos Pinho* and Mara Madaleno**May 8, 2009*

Carlos Pinho

E-mail: cpinho@ua.ptGOVCOPP / DEGEI – Departamento de Economia Gestão e EngenhariaIndustrialUniversidade de AveiroCampus Universitário de Santiago, 3810-193 Aveiro, PortugalFon: (+351) 234 370 361, Fax: (+351) 234 370 215**

Mara Madaleno

E-mail: maramadaleno@ua.ptDEGEI – Departamento de Economia Gestão e Engenharia IndustrialUniversidade de AveiroCampus Universitário de Santiago, 3810-193 Aveiro, PortugalFon: (+351) 234 370 361, Fax: (+351) 234 370 215Keywords: stock market indices; maximal overlap discrete wavelet trans-form; cross-wavelets; international comovement; diversi…cation

Abstract

In this paper we review the issue of international comovement of stock in-dices. The most powerful argument for cross-border investing is the risk re-duction due to low correlation of world’s stock markets. Diversifying risk hasbecome even more important as …nancial markets globalize, helped by advancedinformation technology which lowers the transaction costs. Systematic risk islowered through international diversi…cation in markets with low correlationwith domestic markets. Investors must be willing to take advantage of thesecorrelations to reduce volatility in their portfolios.The current work tries to analyze the relationship among eleven stock in-dices using wavelet theory, applying the MODWT and CWT techniques. The…ndings suggest that there is strong to moderate cointegration among manystock markets, and as such there is evidence of intra-continental relationships.The importance of historical transmissions is low for the period under analysis.

1 Introduction

Trade and …nancial liberalization since the nineties determined the process of globalization that has been further enhanced by the recent trend of the in-ternational stock market indices to become more and more integrated. As aconsequence of the increased integration, business cycles synchronization andstock returns correlations are expected to raise over time and across countries.1

The determination of diversi…cation strategies by an international investoralso depends on the nature and magnitude of the relationships existing betweendi¤erent stock markets. As such, it is important for international investors tounderstand the interrelations among the various markets to diversify risk andto derive high return. The present work tries to investigate the relationship,and to compare the daily dynamics of eleven stock market indices around theworld, namely the DAX30 of Germany, the CAC40 of France, the ATX20 of Austria, the IBEX35 of Spain, the FTSE100 of United Kingdom (comprisingthe …ve European markets considered), the MerVal of Argentina, the Bovespaof Brazil (the two Latin American indices), the Nikkei225 of Japan, the HangSeng of Hong Kong (the Asian indices sample), and from the United States theNasdaq Composite Index and the Dow Jones Industrial Average30 (DJIA30).Empirical studies investigating the interdependence and comovement be-tween international stock markets are based on the estimation of a correlationmatrix of stock market index returns and/or on multivariate analysis techniques,such as cointegration theory and principal component analysis (King, Sentanaand Sushil, 1994; Longin and Solnik, 1995, 2001; Karolyi and Stulz, 1996;Neaime, 2002; Da Costa et al., 2005; Brooks and Del Negro, 2005, 2006; Kizysand Pierdzioch, 2009). Most of these studies have found that the comovementof stock returns is not constant over time.Eun and Shim (1989) use the Vector Autoregressive (VAR) model to in-vestigate the relationship among nine major stock markets (Australia, Canada,France, Germany, Hong Kong, Japan, Switzerland, the UK and US) to con-clude that news beginning in the US market has the most in‡uence on the othermarkets. Lin, Engle and Ito (1994) explore the interdependence between thereturns and volatility of Japan and the US market indices using daytime andovernight returns. Ng (2000) found signi…cant spillover e¤ects from Japan andthe US stock market on six Paci…c-Basin markets, namely Hong Kong, Korea,Malaysia, Singapore, Taiwan and Thailand. With a di¤erent technique, Kimand Rogers (1995) use GARCH to study the comovement between the stockmarkets of Korea, Japan and the US. Results indicate that the spillovers fromJapan and the US have increased since the Korean market became open for out-siders to own shares. Brooks and Del Negro (2004) and Kizys and Pierdzioch(2009) found evidence of increasing international comovement of stock returnssince the mid-90’s among the major developed countries.Antoniou, Pescetto and Violaris (2003) applied a VAR-EGARCH model tostudy the relationship among three EU markets (UK, Germany and France)presenting some evidence of cointegration among those countries. In addition,Bessler and Yang (2003) employed an error correlation model and DirectedAcyclic Graphs to investigate the interdependence among nine mature mar-kets (Japan, US, UK, France, Switzerland, Hong Kong, Germany, Canada andAustralia, to show that both changes in European and Hong Kong markets in‡u-enced the US market, while this was also a¤ected by internal events. In studyingthe relationship between market cointegration and the degree to which com-panies operate internationally, Brooks and Del Negro (2006) considered threefactors (global, country-speci…c and industry speci…c) to found that the impor-2

tance of the international factor has increased since the 1980’s, while that of thecountry-speci…c factor has decreased on all markets.The comovement analysis should also consider the distinction between shortand long-term investor. Candelon, Piplack and Straetmans (2008) argue thatfrom a portfolio diversi…cation point of view, the short term investor is naturallymore interested in the comovement of stock returns at higher frequencies, thatis, short term ‡uctuations, but the long term investor focus on the relationshipat lower frequencies (long-term ‡uctuations). As such, one has to resort tothe frequency domain analysis to obtain insights about the comovement at thefrequency level (Lee, 2004; Pakko, 2004, Sharkasi, Ruskin and Crane, 2005; Ruae Nunes, 2009).In such a context, with both the time horizon of economic decisions and thestrength and direction of economic relationships between variables that maydi¤er according to the time scale of the analysis, a useful analytical tool maybe represented by Wavelet analysis. Wavelet analysis is a comparatively newand powerful mathematical tool for signal processing. The main advantage of wavelet analysis is its ability to decompose macroeconomic time series, anddata in general, into their time scale components. Moreover, because of thetranslation and scale properties, nonstationarity in the data is not a problemwhen using wavelets and pre…ltering is not needed.Several applications of wavelet analysis in economics and …nance have beenrecently provided by Ramsay and Lampart (1998a, 1998b), Ramsay (2002), Kimand In (2003) and In and Kim (2006), among others. More recent applicationsof Wavelet theory for the international comovement of stock indices have beenapplied by Lee (2004), Sharkasi, Ruskin and Crane (2005) and Rua e Nunes(2009).Lee (2004) developed a new testing technique based on the Wavelet trans-form to study international transmission e¤ects. He applies this technique toUS, Germany and Japan (developed markets) and two emerging markets in theMiddle East and North Africa (MENA) region, namely Egypt and Turkey. Hereports that movements from the developed markets a¤ected the developingmarkets but not vice versa. Sharkasi, Ruskin and Crane (2005) use a new test-ing method, based on the wavelet transform to reconstruct the data series, toinvestigate the price interdependence between seven international stock mar-kets (Ireland, UK, Portugal, US, Brazil, Japan and Hong Kong). They …ndevidence of intra-European market comovement with the US market, while USmarkets impact Asian markets, which in turn in‡uence European markets. Insum, intra-continental relationships are evident and they also …nd an increasein importance of international spillover e¤ects since the mid 1990’s, while theimportance of historical transmissions has decreased since the beginning of thiscentury. In a similar fashion, Rua and Nunes (2009) also tested the stylizedfact that the degree of comovement has changed over time using Wavelet tech-niques applied to four major markets, namely, Germany, Japan, UK and US.The analysis is done both at the aggregate and sectorial levels. Following theirresults, the degree of comovement of the German market with the US and UKmarkets is characterized by some permanent changes over time: a gradual but3