An Empirical Examination of International Diversification Benefits in Central European Emerging Equity Markets

International Journal of Business, Spring 2009 by Fadhlaoui, Kais, Bellalah, Makram, Dherry, Armand, Zouaouii, Mhamed

ABSTRACT

The objective of this paper is to examine the short and long-term relationships between the seven developed equity markets of United-States, Canada, United-Kingdom, France, Germany, Italy, Japan and three Central European emerging equity markets of Czech-Republic, Hungary and Poland in order to study their implications on the potential gains from international diversification in these emerging markets. The short-term relationships measured by the correlation matrix indicate a lower level of correlation between developed and emerging equity markets of Central Europe. In order to carry out the long-term relationships we resorted to Johansen cointegration techniques recently developed. The tests show that there is no long-term relationship between G7 developed equity markets and Central European emerging equity markets. Theses results indicate that the increase of financial integration degree and co-movement between equity markets has not significantly affected the expected benefits from international diversification in these emerging markets. These gains remain significantly important for the G7 industrial investors in the Central European emerging equity markets.

JEL Classification: G10; G11; G15; C10; C12; C15; C22

Keywords: International portfolio diversification; Financial integration; Central European emerging markets; Cointegration theory

(ProQuest: ... denotes formulae omitted.)

I. INTRODUCTION

International portfolio diversification was started in with the decision of Morgan Guaranty in 1974 to invest a part of its pension fund outside the United-States. At that time, the US market lived two successive decreases in 1973 and 1974, but outside the United-States, the returns had been very attractive. Accordingly, the investors have become increasingly more active in foreign capital markets. The investment in international financial market knows a spectacular increase. Recently, as a consequence of market liberalisation, financial markets tended to become more integrated. This integration process implies the increase of correlation between financial markets which can have negative effects on benefits from international diversification. This later depends on markets correlations. If the correlation coefficients between markets are higher, the gains from international diversification are low. On the other hand, if the market correlation is low the gain is very important.

The higher integration between developed markets led us to study the important potential of emerging markets for international portfolio diversification. However, the financial crises especially in Asia and Latin America emerging markets led investors to search for other emerging markets (Flight to quality phenomenon) like the Central Europe emerging markets. Those markets can provide more opportunities to increase benefits from international diversification. The endeavour to bring these economies into line with the western European economies gives them an important priority and led investors to study these investment opportunities.

This study examines the possible benefits from international diversification for the seven developed countries of United-States, Canada, United-Kingdom, France, Germany, Italy, and Japan in the three important emerging equity markets of Central Europe, those of the Czech Republic, Hungary and Poland.

The remainder of the paper is structured as follows; Section II discusses the relevant literature. Section III presents the methodology and the data. Section IV reports our empirical results and Section V contains our conclusions.

II. LITERATURE REVIEW

Advantages of International portfolio diversification are inversely related to the correlations between equity markets returns. The international diversification gains decline as the correlations between securities returns become increasingly positive. However, the existence of low correlations between national markets can provide significant benefits from international diversification. Numerous researches have recognized low correlation between international capital markets and highlight the substantial international diversification gains. The early literature in this field, like for example, Grubel (1968), Levy and Sarnat (1970), and Lessard (1973) finds that low correlation between developed and emerging equity markets proves that the benefits from international diversification is considerable for investors of industrial countries in emerging markets.

Other recent studies document the importance of low correlation between developed and emerging markets for generating substantial benefits from international diversification (Eun and Resnick, 1984; Errunza and Padmanabhan, 1988; Meric and Meric, 1989; Bailey and Stulz, 1990; Divecha et al., 1992; and Phylaktis et Ravazzolo, 2005). Many factors can explain the low correlations and consequently the importance of emerging markets in international portfolio diversification strategies: barriers to foreign investment flows on emerging markets in order to preserve the control of national companies; the asymmetric information on securities in emerging markets; strong controls of exchange and the lack in free trade of emerging markets with international markets.