International Financial Linkages

K. Geert RouwenhorstYale School of Management

ECB-CFS workshop on“Capital Markets and Financial Integration in Europe”

Bank of Finland, March 12, 2003

Henry Lowenfeld, 1909

“It is significant to see how entirely all the rest of the Geographically Distributed stocks differ in their price movements from the British stock. It is this individuality of movement on the part of each security, included in a well-distributed Investment List, which ensures the first great essential of successful investment, namely, Capital Stability.”

From: Investment and Exact Science, 1909.

History of Diversification

• First Mutual Fund: Eendracht Maakt Magt (1774)• Danish and Viennese banks• Danish Tolls and Holstein• Russia and Sweden• Brunswick and Mecklenburg• Postal services of Saxony• Spanish Canals of Taouste and Imperial• British Colonies • Essequebo• Berbice• Danish American Islands

Diversification: 18th Century Mutual Funds

• In the portfolio construction the fund “will observe as much as possible an equal proportionality”

• “Because nothing is completely certain, but subject to fluctuations, it is dangerous to allocate all capital to a single security”

• “Nobody will have reason to believe that all securities will stop paying off at the same time thereby losing the entire invested capital”

Globalization and Financial Linkages

• Common wisdom is that globalization and integration of markets accentuates financial linkages (correlations)– Business cycle synchronization– Policy coordination– Coordination of institutions– Decrease in “home bias” of investors– Globalization of firms

• Globalization and integration also allows country specialization

Globalization and Financial Linkages

• Expansion of investment opportunities• Lowering of transactions costs

– Trade where costs are lowest

– Competition among exchanges

– Cross-listing / depository receipts / global shares

• Cost of capital / Expected returns• Change in covariance structure of returns affecting

portfolio risk / benefits of diversification

What is the overall effect?

• Decrease in expected returns• Higher correlation between asset markets• More markets for investment• Increase in the types of marketed securities• Potential synchronization of business cycles• Increased policy coordination

Net effect?

Average Correlation US UK Germany France

-0.2

0

0.2

0.4

0.6

1872

-89

1890

-14

1915

-18

1919

-39

1940

-45

1946

-71

1972

-00

segm

enta

tion

inte

grat

ion

full

Cor

rela

tion

The Role of Emerging Markets

• Expand the investment opportunity set

• Are imperfectly correlated with existing markets

• What is the relative contribution of changing correlations and evolution in the investment opportunity set for diversification benefits?

Decomposing the Benefits of International Diversificationequally-weighted portfolio variance / average market variance

0.0

0.2

0.4

0.6

0.8

1.0

1860 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

Rat

io p

ortf

olio

vol

atili

ty /

aver

age

mar

ket

vola

tilit

y

Core Countries (limited diversification)

Average four countries

All Countries (unlimited diversification)

Recent Benefits of International Diversificationvalue-weighted portfolio variance / market variance

0

0.2

0.4

0.6

0.8

1

1977 1980 1982 1985 1987 1990 1992 1995 1997 2000

Rat

io p

ortf

olio

vol

atili

ty /

aver

age

mar

ket

vol

atili

ty

Core Countries (limited diversification)

All Countries (unlimited diversification)

Globalization: How do Correlations Change?

• Does location of a firm matter?

• Industry membership may become more important

• What happens to residual risk?

European Equity Markets

• Increased industry importance

• Countries become less important– Why does it still matter?

• Residual risk is increasing: cost of not being diversified is going up

Global Linkages of Other Markets

• Bond markets– Interest rate correlations have increased in Europe

before EMU– Reduction of Bond market diversification

• Real estate markets– Non-tradable goods– But linked through

• business cycle correlations • Interest rate correlations• exchange rate correlations

International Financial Linkages- Summary -

• There is reason to believe that international financial linkages are becoming stronger.– World is not yet a global place

• Expansion of investment opportunity set should give some compensation for investors who seek diversification– Number of markets

– Expansion of tradable assets: new markets / securities