Bala Arshanapalli

International stock market linkages: Evidence from the pre- and post-October 1987 period

Abstract This paper uses recent developments in the theory of cointegration to provide new methods of testing the linkage and dynamic interactions among stock market movements. Our findings are in sharp contrast with previous research which discovered strong interdependence among national stock markets prior to October 1987. For the post-October 1987 period, however, our results show that the degree of international co-movements among stock price indices has increased substantially, with the Nikkei index the only exception. Furthermore, the US stock market is found to have a considerable impact on the French, German and UK markets in the post-crash period. We also find the response of the French, German and UK markets to US stock market innovations to be consistent with the view of cross-border informationally efficient stock markets. Finally, we find the Japanese equity market performance to have no links with both the US stock market and the stock markets in France, Germany and UK during the pre-and post-October crash period.

Pre and post-October 1987 stock market linkages between U.S. and Asian markets☆

Abstract This paper documents the presence of a common stochastic trend between the U.S. and the Asian stock market movements during the post-October 1987 period. The evidence suggests that the “cointegrating structure” that ties these stock market together has substantially increased since October 1987. The influence of the U.S. stock market innovations was also found to be greater during the post-October period. The results also indicate that the Asian equity markets are less integrated with Japans equity market than they are with the U.S. market.

Multifactor Asset Pricing Analysis of International Value Investment Strategies

Using a large international equity market database that has not been previously used for such a purpose, this paper documents that value (i.e., high book-to-market ) stocks outperform growth (i.e., low book-to-market ) stocks, on average, in most countries during the January 1975 December 1995 period, both absolutely and after adjusting for risk. The international evidence confirms the findings of previous work reported for the U.S.. For 1975-1995, the annual difference between the average returns on portfolios of high and low book-to-market stocks is 12.94% in North America, 10.42% in Europe, 17.26% in Pacific-Rim per year, and value stocks outperform growth stocks in 17 out of 18 national capital markets. Our analysis also shows that a three-factor model explains most of the cross-sectional variation in average returns on industry portfolios across countries and that the superior performance of the value investing strategy, documented in this study, is a manifestation of size and book-to-market effects. These results are consistent with those reported by Fama and French (1994, 1996) that show that the value-growth pattern in stock returns is largely explained by a three-factor asset pricing model. Our results suggest that the Fama and French (1996) three-factor asset pricing model is not limited to the U.S. stock market. Several recent studies have documented that value strategies (i.e., investing in stocks that have low prices relative to earnings, dividends, historical prices, book assets, or other measures of value) produce higher returns. Among these studies are Basu (1977), Rosenberg, Reid, and Lanstein (1985), De Bondt and Thaler (1985, 1987), Jaffe, Keim, and Westerfield (1989), Chan, Hamao, and Lakonishok (1991), Fama and French (1992), and Lakonishok, Shleifer, and Vishny (1994), all of which show that stocks with high earnings/price ratios or high book-to-market values of equity earn higher returns. A number of alternative explanations for the observed superior returns of value strategies exist. Fama and French (1992, 1993) argue that value strategies are fundamentally riskier and therefore the higher average returns associated with high book-to-market stocks reflect compensation for bearing this risk. A similar argument has been made by Chan (1988) and Ball and Kothari (1989). They suggest that the market overreaction (i.e., winner-loser effect) result of De Bondt and Thaler (1985) is due almost entirely to intertemporal changes in risks and expected returns. Lakonishok, Shleifer, and Vishny (1994), however, argue that value strategies yield higher returns because investors are able to identify mispriced stocks and not because they are fundamentally riskier. Ball, Kothari and Shanken (1995) report that the profitability of the value investing strategy is driven by performance measurement problems and microstructure effects. Kothari, Shanken and Sloan (1995) attribute the superior performance of value strategies to the research design and database used to conduct these studies [i.e., survivorship bias (see Davis (1994)], look-ahead bias [see Banz and Breen (1986)] and data snooping [see Lo and MacKinlay (1990)] in the selection of firms that are included in the CRSP and Compustat databases. Chan, Jagadeesh and Lakonishok (1995) show that this is not the case. Davis (1994) reports a value premium in U.S.stock returns prior to 1963 as well. In a recent study, Fama and French (1996) document that the superior performance of the value investing strategy is a manifestation of size and book-to-market effects. Empirical work has 3 discovered some stylized facts on the behavior of stock prices that cannot be explained by the capital asset pricing model (CAPM) of Sharpe (1964) and Lintner (1965). However, this evidence is largely based on firms in the U.S., and it is not at all clear how these facts relate to different countries. Without testing the robustness of these findings outside the environment in which they were found, it is hard to determine whether these empirical regularities are merely spurious correlations that may not be confirmed across capital markets. This study fills this gap in the literature. In addition, we document for the first time the cross-sectional relationship between beta, size (SMB), book-to-market (HML) and average industry portfolio returns in a sample of 2,629 stocks in 18 equity markets ( including the U.S.) over the 1975-1995 period. The first objective of this article is to examine the robustness of the value-investing strategy using monthly data for 18 equity markets and four regions of the world economy (i.e., North America, Europe, Pacific Basin and International) obtained from the Independence International Associates, Inc.(IIA) database for the 1975-1995 period. We note that in this study the term “international” refers to both the U.S. and non-U.S. stock markets. There are 1,554-2,629 stocks in this database that are tracked by Morgan Stanley Capital International (MSCI) throughout this period. For each country there is a set of five portfolio returns: market, value, growth, small and large. The sample covers more than 75 percent of each country’s market capitalization. There is no survivorship bias in the data set ( as defined by the MSCI database ) since each portfolio is calculated based on the companies that were actually in the MSCI database as of the Januaryrebalance date of each year. The use of such a broad international data set provides a unique opportunity for this analysis. By focusing on the 1975 to 1995 period, this paper studies the behavior of stock returns across countries using a large and updated database that has not been previously used for such a 4 purpose. To the extent that other countries are similar to the U.S., they provide an independent sample to reproduce the regularities found in the U.S. and compare the results to those reported in earlier studies . To the extent that our sample contains countries that are not similar to the U.S., it will increase our ability to shed additional light and help us understand the forces behind the superiority of value strategies. The second objective of the article is to investigate whether value stocks are riskier than growth stocks, since this issue remains controversial among researchers. We focus on betas, coefficients of variation and Sharpe ratios for value and growth strategies. Consistent with the empirical findings of Lakonishok, Shleifer, and Vishny (1994), our analysis provides evidence in support of (i) the superior performance of the value-investing strategy and (ii) the view that such strategies are not fundamentally riskier in 18 equity markets. However, this pattern in international stock returns cannot rule out the possibility that the superior performance of the value-investing strategy is a manifestation of size and book-to-market effects, as reported for the U.S. by Fama and French (1996). The third objective of this study is to examine whether the superior performance of valueinvesting in 18 capital markes is a CAPM related anomaly as argued by Fama and French (1996). This issue is addressed by implementing the Fama and French (1996) three-factor model internationally. However, our empirical investigation is based on portfolios that allow the slopes of the factors to vary over time as opposed to forming portfolios on size, book-to-market and other measures of value that result in factor loadings that are essentially non-time varying [ see Fama and French (1996 ) ]. Our evidence shows that the three-factor model explains most of the cross-sectional variation in average returns on industry portfolios across countries, and that the superior performance 5 of value investing documented in eighteen stock markets ( including the U.S.) is driven by relative size (SMB ) and distress (HML ) effects. Our results are consistent with those found for the U.S. by Fama (1994) and Fama and French (1996). Furthermore, the stock market evidence from around the world suggests that the Fama and French (1996) multi factor asset pricing model is not limited to the U.S. capital market. It holds across capital markets and regions of the world, although it does not uniformly explain portfolio returns in all markets. The rest of the paper is organized as follows. Section I describes the data used in this study. Section II presents annualized return spreads for value and growth strategies based on value and growth portfolios formed on an annual basis for three different investment horizons. Section III examines whether the superior performance of value stocks is related to the upward movements in stock markets. Section IV investigates whether the arbitrage portfolio formed by buying value stocks and selling growth stocks is associated with the effects of firm size. Section V analyzes the robustness of value investing strategies using the Fama and French (1996) three-factor asset pricing framework, and Section VI concludes the paper.

Common volatility in the industrial structure of global capital markets

This paper investigates the nature of the volatility process among security prices for US, Europe and the Pacific Rim capital markets using a new data set that removes the problem of disparate index composition associated with aggregate stock market index series. We use the common ARCH-feature testing methodology, recently developed by Engle and Kozicki (Journal of Business Economics 11, pp. 369–380, 1993), to examine the issue of a common volatility process among asset prices of nine industry groups from three economic regions of the world economy. It is found that industry-return series exhibit intra-industry common time-varying volatility process. The evidence is consistent with the view that world capital markets are related through their second moments implying that a world common time-varying variance specification seems to be appropriate in modeling asset prices. While our empirical evidence suggests that investors can form constant-variance portfolios by investing within an industry across regions, they will be better off if they invest across regions and industries rather than diversify within an industry across different geographical regions. That is, the industrial mix of global investment portfolios accounts for a substantial proportion of the international diversification benefits. Finally, our results appear to be consistent with Roll (Journal of Finance, 47, pp. 3–41, 1992) view that the industrial structure of national stock exchange indices is important for explaining cross-sectional return volatility differences.

Common stochastic trends in a system of Eurocurrency rates

Abstract This paper investigates the temporal relationship between interest rates on Eurodeposit instruments ranging in maturity from seven days to one year for seven different currency denominations over the 1986–1992 period. Multivariate tests of cointegration reveal strong evidence in favor of the presence of common factors in the univariate time-series representation of each Eurocurrency term structure. Specifically, the hypothesis of noncointegration was rejected in all seven Eurocurrency term structures of interest rates examined in this study. This is consistent with the hypothesis that each Eurocurrency term structure of interest rates possesses a cointegrating structure that prevents these rates from drifting too far apart from equilibrium so that profitable opportunities do not persist. The estimation of an error-correction model, which used this information (i.e., the cointegrating equilibrium error term), produced interest rate forecasts that outperformed the forecasts of a naive and a VAR model that ignore the cointegration of Eurodeposit rates. Finally, we examined the extent of interdependence among five maturities of seven-dimensional intercurrency Eurodeposit rate series and found a strong cointegrating structure across intercurrency Eurodeposit rates that forces convergence among these rates.

Macroeconomic news effects on conditional volatilities in the bond and stock markets

This paper investigates the sources of time-varying risk for the US stock and bond markets. The model captures the change in the risk premium due to each markets own volatility risk and the covariance risk. We test for the effects of macroeconomic news on time-varying volatility as well as time-varying covariance, and whether such news induces time-varying risk premia in either of the markets. We find that stocks and bonds have higher volatility on the day of macroeconomic announcements. This higher volatility is transitory but because it can be anticipated, it induces increases in the risk premium in both markets.

THE DIMENSIONS OF INTERNATIONAL EQUITY STYLE

his article provides a comprehensive summary of the dunensions of international equity style in the developed world from T January 1975 through December 1996. It describes eight dunensions of equity style using twenty-two years of returns on twenty countries grouped into four time periods and s i x geographc regions. Other studies have looked at various aspects of international equity style for smaller samples of countries and shorter time periods. See, e.g., Capaul, Rowley, and Sharpe [1993], Umstead [1993a, 1993b, 1995, 19971, and Sinquefield [1996]. To our knowledge, ours is the first study to present such a comprehensive overview of international equity style.

Estimating the Demand for Risky Assets via the Indirect Expected Utility Function

This article obtains demand functions for risky assets without making a priori assumptions about the form of the utility function. In a simple portfolio model, the envelope theorem is applied to the indirect expected utility function to derive estimating equations. Tests for the existence of constant absolute or constant relative risk aversion are also developed. Empirical estimation of the demand for financial assets held by U.S. households for the period 1946–1985 indicates that aggregate household behavior is consistent with the existence of constant relative risk aversion, with the coefficient of risk aversion having a value of approximately 1.3.

The linkages of S & P 500 stock index and S & P 500 stock index futures prices during October 1987

Abstract Intraday minute-by-minute data for the entire month of October 1987, were used to investigate the linkages between the S & P 500 index futures market and the underlying cash market before and after the crash. This study used cointegration and error-correction estimation techniques, and found, with the exception of October 16 and 19, that the two markets were highly cointegrated and operated as one market for most trading days in the month of October. Further, the results show that the stock and futures markets converged immediately after the crash and that the price-discovery process originated in the futures market instead of the stock market, as the two markets are linked by index arbitrage. Finally, the evidence also suggests that the delinkage of the futures market from its underlying stock market started on Friday, October 16, implying that the crash originated in the United States and not in Asia as suggested by Roll (1988)

The basics of financial econometrics : tools, concepts, and asset management applications

Description: The Basics of FINANCIAL ECONOMETRICS With the growth in quantitative finance, financial econometrics has emerged as a vitally important field, providing the analytical models to address complex financial product structures, valuation, and risk assessment. The Basics of Financial Econometrics covers the commonly used techniques in the field without using unnecessary mathematical or statistical proofs and derivations, and with a clear emphasis on basic ideas and how to apply them. Financial econometrics is an indispensable component to modern finance and a crucial body of knowledge for financial professionals. The Basics of Financial Econometrics addresses the key relationship between econometrics and quantitative finance, and provides practical examples that use real–world financial data. Areas covered include: Building financial models Asset pricing Derivative pricing Portfolio allocation Hedging strategies Model selection Strategy development Written for both seasoned financial professionals and advanced students of finance, The Basics of Financial Econometrics provides a complete, real–world overview that provides a strong foundation in financial econometrics.