| EBS Business SchoolEBS Universität für Wirtschaft und Recht | Paper SubmissionIn requirements of the courseMultivariate Statistical Methods | Co movement of Global Stock Market Indices | | |

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Name: Abhisek Rathi
Matriculation Number: 22030512
Submitted To: Prof. Dr. Frank Brand
Submission Date: December 17, 2012

Contents Introduction 3 Stock Market Co-Movement 4 Causes 4 Data Analysis 6 Observations 9 Implications 10 References 12

Introduction
The global financial crisis of 2008 was the biggest economic crisis faced by the world since the great depression of 1929. The crisis started to brew in the US in 2007 and many believed it would be largely limited to the shores of the US. However, the collapse of Lehman Brothers in 2008 was sufficient to trigger a worldwide stock market collapse, the effects of which are felt to this day. The worldwide collapse of stock market can be understood by considering the world as a single big marketplace.
Analysing the co-movement of various financial markets has gained importance in the recent past both for policy makers, in terms of policy co-ordination, and portfolio managers, for portfolio diversification. For policy makers, high co-movement would facilitate transition in local currency areas resulting in potential efficiency gains from stock market merger activities. This, in turn, will result in greater financial stability across the regions. However, for portfolio managers, high correlation between international stock markets would reduce the benefits of portfolio diversification creating the need of searching other assets with lower correlation.
The past few decades have seen a continuous increase economic integration between countries as a result of greater impetus towards globalization. All the worlds developed countries are also major traders (imports and exports) with other developed countries as well as the developing countries of the world. With liberalization of capital flows across borders and rapid development of information and communication technology has fuelled the growth of globalization.
A better understanding of the co movement of global stock markets is essential for three reasons. Firstly, the global investors must understand the risks co movement of stock markets pose to their portfolios and hence how can they safeguard themselves against such risks. Secondly, the top management at global firms must understand the effects of global co movement of stock markets on their own firm’s stock returns. Lastly, the policy makers must understand these co movements if they wish to make their own stock markets more robust and safeguard their financial systems against global volatility.
Stock Market Co-Movement
Stock Market Co-movement is a situation where two or more stock markets move together with their indices’ movement being positively correlated.
When the global stock markets collapsed in 1987, economists were not able to explain its cause by the then contemporary financial markets understandings. Even though the crash started in Hong Kong, it spread very quickly throughout Europe and finally hit the United States. This led to a significant fall in stock markets across the globe. This was when the effect of co-movement of global stock markets was first felt.
Asian crisis of 1997 brought the topic of co-movement again under limelight. It was then that the need to understand international stock market co-movements and transmission mechanisms of shocks got intensified. This crisis started in Thailand as a currency crisis, spread to East Asia and Russia finally hitting Brazil. This crisis was due to the devaluation of Thai baht which led to foreign investors, who had invested in stocks and real estate of Thailand and neighbouring developing countries, selling their assets in Asia resulting in the collapse of local market.
Due to these crises, a need was felt for theoretical and empirical studies about international stock market co-movements and interdependence.
Causes
The price of stocks in a market is essentially driven by the investors’ expectations of the future growth and earnings prospects of the firm. These future growth prospects can be termed as the fundamental elements of a firm’s valuation. However, another factor which effects the valuation of shares on the stock market is the psychological or behavioural tendencies of the investors. As firms globalize the impacts of these factors also become global in nature. The causes include 1) innovating technologies, 2) real trade linkages, 3) financial linkages, {3) international nature of businesses,} and 4) common shocks.
Continuously innovating technologies and communications have given the access to enormous amount of information very quickly, thus, accelerating all the processes in business and finance.
Real trade linkages refer to the effects of trade on a country and its companies; these can be classified into two types. The competitiveness effect refers to the effect of changes in relative prices of goods and services within a country on the country’s ability to compete abroad. The income effect refers to the dramatic fall in demand for imported goods within the affected countries due to reduced incomes in countries across the world. High level of trade linkages between countries can influence all national stock indices simultaneously.
Financial linkages mean the linkages in the financial account among countries connected to the international financial system. These linkages can be either direct, through foreign direct investment (FDI) or indirect, through capital market flows and foreign institutional investments (FII). Direct financial linkages are the direct financial exposures between the crisis-hit country and others. Indirect financial linkages involve actions of international investors, because of margin calls, changes in risk aversion, herding etc., which leads to co-movement across the various countries where they hold assets.
With a significant increase in international merger and acquisition deals, firms today have a large number of subsidiaries across the globe with each of these listed on the local stock markets. If a multinational firm receives a shock, it affects the prices of its subsidiaries across the world as well as stocks of its global associates.
Inter market co-movement might also happen because of new interpretation of existing information which results in learning and awareness. A crisis in one country may alert investors to potential dangers in other vulnerable countries.
The behavioural nature of investors across the world is a major contributor to volatility in the global stock markets as opposed to the traditional economic theory which assumes the investors to be rational in nature. Most large institutional investors today have a global portfolio, with an aim to diversify away country risk; however it is this global diversification that may lead to co movement of various stock markets.
Another possible explanation for the co-movements can be the liquidity problem of investors. An institutional investor incurring losses in one country might need to sell risky assets in other countries to meet certain customer demands. Thus, investors’ behaviour due to liquidity problems can explain the fall in stock prices in markets looking totally unrelated.
A possible cause can also be the herd behaviour and general loss of confidence. Herd behaviour arises from information asymmetry and is not always irrational. High costs of getting relevant information forces small and middle investors to rely on big players like large banks and multinational investment companies and emulate their actions. Thus, if a big player withdraws funds from a region, uninformed investors may follow them, causing co-movements. Investors may also lose confidence in institutions, sell risky stocks and invest in the safest and most liquid assets resulting in stock markets falling together.
Data Analysis
To measure the degree of co movement of stock market indices across the globe we selected some of the highly active indices such as S&P 500, FTSE, Nikkie, Dax, Hang Seng, ASX, Sensex, CAC 40, Ibovespa and RTSI. The data was collected for the historical records of the respective indices, which were chosen on the basis of the comprehensiveness of representation of their specific countries.
The following graph shows the historical movement of the selected stock market indices: Correlation between various stock market movements:
Table 1: Correlation 1984-1990 | S&P | FTSE | Nikkei | Dax | Hang Seng | Australia | CAC 40 | S&P | 1 | | | | | | | FTSE | 0.975 | 1 | | | | | | Nikkei | 0.875 | 0.819 | 1 | | | | | Dax | -0.585 | 0.009 | -0.661 | 1 | | | | Hang Seng | 0.001 | -0.009 | 0.103 | 0.552 | 1 | | | Australia | 0.818 | 0.861 | 0.551 | 0.037 | -0.338 | 1 | | CAC 40 | 0.527 | 0.604 | 0.300 | 0.502 | -0.647 | 0.762 | 1 |

Table 2: Correlation 1991-1997 | S&P | FTSE | Nikkei | Dax | Hang Seng | Australia | Sensex | CAC 40 | Ibovespa | S&P | 1 | | | | | | | | | FTSE | 0.980 | 1 | | | | | | | | Nikkei | -0.473 | -0.544 | 1 | | | | | | | Dax | 0.968 | 0.962 | -0.278 | 1 | | | | | | Hang Seng | 0.898 | 0.932 | -0.611 | 0.870 | 1 | | | | | Australia | 0.909 | 0.954 | -0.557 | 0.904 | 0.930 | 1 | | | | Sensex | 0.501 | 0.561 | -0.311 | 0.493 | 0.654 | 0.565 | 1 | | | CAC 40 | 0.870 | 0.864 | -0.297 | 0.937 | 0.742 | 0.814 | 0.312 | 1 | | Ibovespa | 0.546 | 0.460 | 0.712 | -0.101 | 0.365 | -0.599 | 0.718 | 0.038 | 1 |

Table 3: Correlation 1998-2004 | S&P | FTSE | Nikkei | Dax | Hang Seng | Australia | Sensex | CAC 40 | Ibovespa | RTSI | S&P | 1 | | | | | | | | | | FTSE | 0.865 | 1 | | | | | | | | | Nikkei | 0.726 | 0.866 | 1 | | | | | | | | Dax | 0.872 | 0.906 | 0.843 | 1 | | | | | | | Hang Seng | 0.759 | 0.507 | 0.473 | 0.666 | 1 | | | | | | Australia | 0.182 | -0.162 | -0.312 | -0.022 | 0.455 | 1 | | | | | Sensex | 0.425 | 0.114 | 0.175 | 0.261 | 0.659 | 0.567 | 1 | | | | CAC 40 | 0.896 | 0.827 | 0.765 | 0.945 | 0.774 | 0.107 | 0.334 | 1 | | | Ibovespa | 0.167 | -0.180 | -0.136 | 0.006 | 0.543 | 0.773 | 0.786 | 0.116 | 1 | | RTSI | -0.206 | 0.122 | 0.100 | 0.076 | -0.512 | -0.296 | -0.011 | 0.009 | 0.444 | 1 |

Table 4: Correlation 2005-2011 | S&P | FTSE | Nikkei | Dax | Hang Seng | Australia | Sensex | CAC 40 | Ibovespa | RTSI | S&P | 1 | | | | | | | | | | FTSE | 0.951 | 1 | | | | | | | | | Nikkei | 0.756 | 0.703 | 1 | | | | | | | | Dax | 0.769 | 0.843 | 0.494 | 1 | | | | | | | Hang Seng | 0.523 | 0.610 | 0.189 | 0.826 | 1 | | | | | | Australia | 0.885 | 0.895 | 0.811 | 0.835 | 0.674 | 1 | | | | | Sensex | 0.215 | 0.357 | -0.12 | 0.657 | 0.851 | 0.350 | 1 | | | | CAC 40 | 0.826 | 0.792 | 0.923 | 0.593 | 0.252 | 0.846 | -0.114 | 1 | | | Ibovespa | 0.097 | 0.241 | -0.21 | 0.570 | 0.817 | 0.265 | 0.948 | -0.21 | 1 | | RTSI | 0.668 | 0.712 | 0.429 | 0.855 | 0.837 | 0.742 | 0.753 | 0.401 | 0.697 | 1 |
Observations
As is visible from the chart there is a good correlation visible between the major indices especially from the year 2000 onwards. The correlation has become very strong from the year 2006 onwards i.e. in the past six years.
If we look at the trends of indices of developing countries Brazil, Russia, India and China (BRIC countries) there is a very high correlation between these indices. This shows that the movement of indices in a developing country is closely affected by the movements of indices in other developing countries. So the stock market co-movement is high between developing countries as compared to others.
If we see the trends in all indices between the years 2008-09 all the indices have seen a major dip without an exception. This is a clear indication of the US born recession of 2008 hitting all the major indices of the world. It essentially validates the importance of co-movement of indices and the phenomenon of global integration of world markets. This makes the study of world stock markets co-movement an important topic for global investors.
From the study of table 1 to 4 it is discernible from the data that the correlation coefficients have seen a variation with time. So the correlation between pairs of countries has been changing over time. This implies that although the correlation is there between major stock indices, there cannot be full certainty as to the magnitude of this correlation. The macroeconomic and political conditions keep on changing and hence the correlation between major indices keeps on changing with time.
Considering the changing trends of this correlation with time (from the tables above) it is easily discernible that the stock markets co-movement has seen an increase in magnitude with time. This shows that there is a convergence between stock market correlations in recent times and hence the study of this topic is becoming more and more relevant and useful for the current scenario for global investors.

Implications
The trend of globalization suggests that the correlations among international stock markets have grown over time. The recent global financial crisis which started in the United States in summer 2007 as credit market turmoil overgrew into serious threat to global financial stability and afterwards affected most of the economies around the world. And even though it ended in the U.S. in 2009, its affect on employment and economic growth rates can be felt in many countries till today.
According to McKinsey Global Institute, the biggest players before the crisis were: 1. Pension funds, 2. Mutual funds, 3. Insurance companies, 4. Petrodollar foreign investors, 5. Asian sovereign investors, 6. Hedge funds. The six groups of institutions managed almost 45% of total global financial assets in 2007. Because of this, during the time of the crisis the capital flow across the global economy reduced significantly and overseas investments virtually dried up.
One of the major implications of co movement of global stock markets is the validity of international diversification.
International portfolio diversification is considered as an effective way to achieve higher risk-adjusted returns than domestic investment alone. The premise behind this strategy is that international stocks have lower levels of co-movements than stocks trading on the same market. If the countries are subject to different shocks, international diversification facilitates risk sharing among global investors. However, if markets exhibit increased co movement, then the risk-sharing motive may fail to deliver the required benefits in the turbulent periods when they are most needed.
With financial linkages across economies and highly liquid flow of capital, stock markets exhibit greater co movement. It can be said that stock markets in countries with higher restrictions on banking activities and flow of capital will have lower co movement with stock markets of other countries.
When such crises hit stock markets around the world with increasing co movement, firms with weaker fundamentals are much more vulnerable. Hence high amount of corporate indebtedness will make the stock prices of firms more sensitive to global pressures. The result is an increasing pressure for firms to deleverage as a result of higher vulnerability.
In addition there are several macroeconomic and sectorial vulnerabilities as a result of higher co movement of stock markets. In particular current account balances and fiscal deficits play a big role.
These findings imply that there is a need for the countries to keep a check on banking and corporate vulnerabilities to limit the transmission of crisis. The results also highlight the negative side of financial integration and liquidity as the countries that are more integrated and have more liquid markets show greater co movement with US. However, countries should not stop financial integration completely. Rather they should manage the potential exposures arising from financially integrated and liquid markets through adequate regulations.

References
Didier T., Love I., & Peria M (May 2010). What Explains Stock Markets’ Vulnerability to the 2007–08 Crisis: The World Bank
Evans T., & McMillan D. (December 2006). Financial Co-Movement and Correlation. St. Andrews
Flavin T. J., & Panopoulou E. On the robustness of international portfolio diversification benefits to regime-switching volatility. Ireland
Peria M., & Love I (February 2011). What Explains Co movement in Stock Market Returns during the 2007–08 Crisis: The World Bank. Retrieved December 16, 2012 from http://blogs.worldbank.org/allaboutfinance/what-explains-comovement-in-stock-market-returns-during-the-2007-08-crisis
Poldauf P. (May 2011). International Stock Market Co-movements and the Global Financial Crisis. Prague: Charles University
Weber E. (October 2007), Correlation vs. Causality in Stock market co movement. Berlin: Freie Universitat Berlin

Yahoo! Finance. Retrieved December 10, 2012 from http://finance.yahoo.com

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[ 1 ]. Evans T., & McMillan D. (December 2006). Financial Co-Movement and Correlation. St. Andrews
[ 2 ]. Poldauf P. (May 2011). International Stock Market Co-movements and the Global Financial Crisis. Prague: Charles University
[ 3 ]. Poldauf P. (May 2011). International Stock Market Co-movements and the Global Financial Crisis. Prague: Charles University
[ 4 ]. Peria M., & Love I (February 2011). What Explains Co movement in Stock Market Returns during the 2007–08 Crisis: The World Bank. Retrieved December 16, 2012 from http://blogs.worldbank.org/allaboutfinance/what-explains-comovement-in-stock-market-returns-during-the-2007-08-crisis
[ 5 ]. Didier T., Love I., & Peria M (May 2010). What Explains Stock Markets’ Vulnerability to the 2007–08 Crisis: The World Bank
[ 6 ]. Poldauf P. (May 2011). International Stock Market Co-movements and the Global Financial Crisis. Prague: Charles University
[ 7 ]. Yahoo! Finance. Retrieved December 10, 2012 from http://finance.yahoo.com
[ 8 ]. Poldauf P. (May 2011). International Stock Market Co-movements and the Global Financial Crisis. Prague: Charles University
[ 9 ]. Flavin T. J., & Panopoulou E. On the robustness of international portfolio diversification benefits to regime-switching volatility. Ireland