Bruno H. Solnik

Is the correlation in international equity returns constant: 1960–1990?

We study the correlation of monthly excess returns for seven major countries over the period 1960-1990. We find that the international covariance and correlation matrices are unstable over time. A multivariate GARCH(1,1) modelling with constant conditional correlation helps capture some of the evolution in the conditional covariance structure. We include information variables in the mean and variance equations. The volatility of markets changed somewhat over the period 1960-1990 and the proposed GARCH modelling allows to capture this evolution in variances. However tests of specific deviations lead to a rejection of the hypothesis of a constant conditional correlation. An explicit modelling of the conditional correlation indicates an increase of the international correlation between markets over the past thirty years. We also find that the correlation rises in periods when the conditional volatility of markets is large. There is some preliminary evidence that economic variables such as the dividend yield and interest rates contain information about future volatility and correlation that is not contained in past returns alone. However, further theoretical work is required to provide a satisfactory model. The effects are not of great magnitude but are often statistically significant.

The performance of international asset allocation strategies using conditioning information

Abstract The existence of predictable components in conditional expected returns has been widely reported. We propose a test of the economic significance of this phenomenon by designing dynamic international allocation strategies based on a conditioning information set. We compare the performance of these dynamic strategies with some market portfolio benchmark and with unconditionally efficient portfolios (among the set of primitive assets). We find the performance of the dynamic strategies to be superior. The difference is not only statistically significant, it is economically large.

Day-of-the-week effect on the Paris Bourse

Abstract We present evidence on the day-of-the-week effect on a stock market with a particular settlement procedure: the Paris Bourse. A strong and persistent negative return is found on Tuesdays. A similar result was previously found for Japan and Australia. The settlement procedure is shown to have an effect on the distribution of daily returns consistent with forward pricing theory; it cannot explain the negative Tuesday return. After adjusting for this settlement effect, the mean return on Mondays is the largest in the week, a result at odds with the evidence in the U.S.A.

A Global Approach to Money Management

I n recent years a vast amount of empirical research has led scholars to believe that the capital market was efficient or nearly so. It simply recognized the intense competition between skillful analysts and investors and the rapidity of stock price adjustment to any new information. Similarly, some portfolio managers came to the conclusion that it was difficult and costly to beat the market consistently. This leads to the development of “index” funds or at least a change in portfolio management strategy where the short-term speculation attitude is replaced by a long-term perspective. Similarly, the risk-return, efficient market analysis coupled with recent dramatic swings in the market implied a shift of emphasis from the search for go-go return to improved risk diversificaltion and protection against inflation. The purpose of this paper is to present a global approach to money management and its application by the second largest private commercial bank in France. This bank has a century of experience in international investment and money management. The first part of the paper will briefly present some elements of empirical evidence and theoretical arguments, and what seems to be their operational implications. The application to an integrated system of financial analysis and money management is sketched in part 11. While the conclusions presented have been derived in the French environment, they apply to a highly diversified international portfolio and should be relevant for everyone; besides, comparable empirical results are presented for the American investor.

Dispersion as Cross-Sectional Correlation

We introduce the concept of cross-sectional dispersion of stock market returns as an alternative to the time-series approach to estimating the global correlation level of equity markets. Our objective is to derive a simple, instantaneous measure of the general level of global market correlation. Our cross-sectional method of estimating global correlation is dynamic and, using cross-sectional data, gives instantaneous information on the trend of global correlation. The traditional time-series method requires a long period of observations, and overlapping data have to be used to study the change in correlation. Both methods yield similar estimates for a “long” period, however, so a combination of the cross-sectional and time-series approaches should be of practical use to global asset managers. We introduce a new approach to estimating the global correlation of stock markets that has as the key ingredient the cross-sectional dispersion of stock market returns. The simple model of global market correlation is based on the postulate that each country has a beta of 1 relative to the world market. This model allows one, in a simple manner, to derive global correlation from the dispersion, and it also implies that global correlation is inversely proportional to dispersion. On the basis of the model, we show how to estimate the global market correlation by using cross-sectional (contemporaneous) short-term data. An important aspect is that the model allows derivation of an instantaneous measure of the general level and trend of global market correlation. The issue of changes in global correlations has strong practical relevance. Investment managers optimize their asset allocations partly on the basis of the international covariance of market returns. The level of global correlation affects the degree of diversification needed in investment portfolios. It also has a bearing on the extent of profit opportunities available to active asset allocators. What managers need is an indicator that will instantaneously track the time variation in global correlation—especially when market volatility is high, because the globalization of investments and the instantaneous flow of information have made crises contagious. By providing instantaneous detection of changes in correlation, our dispersion indicator and the global correlation measure derived from it are practical, even if partial, tools to meet this need. The traditional time-series method requires a long observation period and overlapping data (moving windows) in order for the change in correlation to be studied. Thus, it yields a slow-moving estimate of the level of global correlation that is poorly suited to rapid detection of changes in global correlations. Because our dispersion-based correlation uses only contemporaneous data, estimates at two successive points in time use independent data sets; therefore, changes in the global correlation level can be detected immediately. The two methods yield similar estimates when data over a long (five-year or more) period are used. We illustrate the concept of dispersion by reporting a study of its estimated values from January 1971 to September 1998 for a set of developed market indexes. We found that the dispersion was quite stable over the period, at an average of 4.5 percent a month or 15.6 percent annually but that the dispersion has had a tendency to decrease with time, which suggests more integrated equity markets. We then report results for using the model to derive the global correlation level from the dispersion for the same equity markets and period. We found that correlation has had a positive trend, increasing from 66 percent at the beginning of 1971 to 74 percent in September 1998, but that the slope of the regression is quite weak. These findings suggest that the developed equity markets have been becoming more integrated but at a slower pace than some analysts believe. We make no conclusions about whether global investment should be conducted along country lines or industry lines. But our approach could be extended to detect valid asset classes: groupings of stocks that have large covariance between them and small covariance within them.

The Market Model Applied to European Common Stocks: Some Empirical Results

The stock price literature abounds with applications of the Markowitz [16] – Sharpe [18] market model to American stock price data. There is a lack of corresponding studies for non-American securities, due primarily to the absence of generally available machine readable data bases (see, however, [1], [2], [8, Section 9.5], [11], [17], and [20]. The purpose of this paper is to present the results of some initial tests of the market model for a broad cross-section of the European common stocks. Our data base consists of daily price and dividend data for 229 stocks from seven European countries. In addition, for comparison purposes we have included a sample of 65 American securities.

A Pure Foreign Exchange Asset Pricing Model

Abstract If consumption tastes differ among countries, a position in foreign-denominated nominally riskless bonds is risky in real terms. Risk averse and rational consumer-investors facing such a situation would generally seek a diversified portfolio of foreign bonds. They would demand risk premia in accordance with portfolio (covariance) risk. A model is specified to portray this behavior and it is tested with data from eight countries. The results indicate that the actual premia earned in foreign risky positions are positively related on average to portfolio risk measures; but the premia deviate significantly from those predicted by the model.

Global Pricing of Equity

Global equity management has historically been structured around country asset allocation. This approach was supported by the observations that the country factor is the major source of influence on stock-price behavior and that the correlation between equity and currency is close to zero and unstable. If a corporation is regarded as a portfolio of international activities, however, its stock price should be influenced by international factors in relation to the geographical breakdown of its activities rather than where its headquarters is located or its stock is traded. We examined a large cross-section of security prices and found that regional factors and currency factors have a strong influence on asset returns beyond that of domestic factors. Moreover, the sensitivity of individual company returns to nondomestic factors is closely related to the extent of their international activities, as proxied by the relative importance of foreign sales to total sales. We review the implications of these findings for the asset management profession. Global equity management has historically been structured primarily around country asset allocation. This approach was supported by the common observations that the country factor is the major influence on stock-price behavior and that the correlation between equity and currency is close to zero and unstable, so country exposure matches currency exposure. This logic breaks down, however, in a world where companies work and compete on a global basis and are recognized as doing so by investors when they price securities. As companies expand and diversify their international activities, the relative importance of domestic factors for the companies should decline. If a corporation is regarded as a portfolio of international activities, its stock price should be influenced by international factors in relation to the geographical breakdown of its activities. Similarly, the currency exposure should be influenced by the geographical distribution of the companys activities, rather than by the domicile of incorporation or by where the stock is mainly traded. In such integrated or “global” pricing, the market recognizes the value and changes to value of the foreign activities of the company. In essence, a French company with foreign activities can expect investors to value each stream of “national” earnings at the relevant national discount rate adjusted for the companys specific risk characteristics. We examined a large cross-section of security prices for companies in eight developed countries from mid-1989 through 1998 and found that regional factors and currency factors have a strong influence on asset returns beyond the influence of domestic factors. We found a relationship between the degree of domestic (international) stock exposure, as inferred from return data, and the companys domestic (international) sales. This finding corroborates our theoretical model of the value of the company: The greater the proportion of international sales, the greater the likelihood that the stock responds to foreign stock-price movements. (These results were less pronounced for U.S. companies.) We also found that foreign stock market exposures exceed foreign currency exposures, which suggests that some currency hedging takes place within the companies. Because the stock prices of some international companies are exposed to foreign currencies, when investors fully hedge their accounting currency exposures back to their home currencies, they risk overhedging. Our findings suggest that conventional methods of market and currency allocation used in asset management are problematic and biased. For instance, our analytical framework, in contrast to the traditional accounting-based portfolio measures of market exposure, demonstrates that a portfolio of the constituents of the Swiss market provides significant exposure to foreign factors. More importantly, this portfolio illustrates how home-biased allocations are poorly diversified from a global perspective; the lack of exposure to several major global industries is noteworthy. Global asset management has become a more complex task than in the past—and a task that cannot be addressed through simple shortcuts, such as stratifying the world into multinational and national companies. Analysis of the individual company and its diversity is critical; thus, analysts need a sound understanding of the geographical breakdown and currency practices of the company as well as the country and industry factors that affect its performance. This complexity provides opportunities to those with a good understanding of the global and domestic influences on stock pricing to achieve superior return and risk management.

An International Market Model of Security Price Behavior

The Markowitz-Sharpe market model has been extensively applied to the study of price behavior of American common stocks. In this paper an international market model will be used assuming that the return on any security is a linear function of the return on the world market portfolio. A justification for this approach lies in the International Asset Pricing Model (IAPM) proposed by Solnik [14] and [15]. This market model is by no means the only stochastic process of security returns consistent with the IAPM, but it is the most simple and straightforward extension of the traditional approach to domestic markets.

A multi-country test of the Fisher model for stock returns

Abstract This article provides a test of the Fisher model, linking expected stock returns and inflation, based on international data. Since the Fisher model is ‘universal’ and calls for a slope of 1 in any country, we improve the testing power by conducting a joint test over eight countries. The pooling of data for several countries seems to reduce the small-sample bias. We test the Fisher model, using an instrumental variable approach, for holding-period horizons ranging from 1–12 months. The Fisher model is not rejected at any horizon: however, the magnitude of the slope coefficient lends stronger support at long horizons. This study using multi-country panel data provides evidence corroborating the finding of Boudoukh and Richardson (1993) that the Fisher model holds at long horizons (5 years), using 180 years of US data.