Instituto Superior de Cincias do Trabalho e da Empresa

ESSAYS ON INTERNATIONAL EQUITY MARKETS

Paulo Miguel Gama

Dissertao submetida como requisito parcial para obteno do grau de

Doutor em Gesto Especialidade em Finanas

Orientador:

Prof. Doutor Miguel A. Ferreira

Fevereiro de 2005

Abstract

This dissertation consists of three papers on international equity markets. The first paper

uses a volatility decomposition method to study the time series of equity volatility at the

world, country and local industry levels. Between 1974 and 2001 there is no noticeable long-

term trend in any of the volatility measures. Then in the 1990s, there is a sharp increase

in local industry volatility compared to market and country volatility. Thus, correlations

among local industries have declined and more assets are needed to achieve a given level of

diversification.

The second paper studies the impact of sovereign debt rating news of one country on the

stock market returns of other countries between 1989 and 2003. The information spillover

effect is asymmetric and large. A one-notch credit ratings downgrade is associated with a

statistically significant negative two-day return spread of other countries relative to the US

stock market of 28 basis points, on average. Upgrades have no significant impact on return

spreads of countries abroad. Moreover, there is evidence of downgrades spillover effects at

the industry level.

The third paper investigates the time series of correlations between global industries and

aggregate world market over the 1979-2003 period. The behavior of industry correlations

is characterized by long-term swings, in particular with a period of low correlations in the

late 1990s. Small and value (low price-earnings ratio) industries have lower correlations.

Moreover, global industry correlations are counter-cyclical. Global industry correlations are

greater for downside moves than for upside moves. Correlation asymmetry is the largest

among small industries.

JEL classification: F30, G15

Keywords: Volatility, Correlation, Spillover effects, Asymmetries

ii

Resumo

Esta dissertacao engloba tres artigos sobre os mercados internacionais de accoes. O

primeiro artigo utiliza um metodo de decomposicao de variancia para estudar a evolucao

temporal da volatilidade ao nvel do mundo, do pas e da industria local. Entre 1974 e 2001,

nao ha evidencia de tendencias de longo prazo em qualquer nvel de volatilidade. No final

da decada de 90, observa-se um forte aumento do risco da industria local relativamente ao

risco do pas e do mercado mundial. Em conformidade, a correlacao entre industrias locais

decresce e mais activos sao necessarios para obter um dado nvel de diversificacao.

O segundo artigo estuda o impacto de alteracoes de ratings da dvida publica de um

pas nos mercados accionistas de outros pases entre 1989 e 2003. O efeito de spillover e

assimetrico e significativo. Em media, um ponto de downgrade do rating da dvida publica

de um pas esta associado a um diferencial de retorno face ao mercado dos EUA de 28

pontos base (em dois dias) nos mercados accionistas dos restantes pases. Os upgrades nao

tem um impacto significativo nos restantes pases. Adicionalmente, o efeito de spillover dos

downgrades manifesta-se ao nvel das industrias.

O terceiro artigo analisa as sucessoes cronologicas da correlacao entre industrias globais

e o mercado mundial entre 1979 e 2003. O comportamento das correlacoes e caracterizado

por flutuacoes longas, sendo o final da decada de 90 caracterizado por baixas correlacoes. A

correlacao e inferior nas industrias de menor dimensao e value (racio price-earnings baixo).

Os perodos de recessao caracterizam-se por um aumento das correlacoes industriais. As

correlacoes das industrias sao maiores para performances negativas do mercado do que para

performances positivas. Esta assimetria e maior nas industrias de menor dimensao.

Classificacao JEL: F30, G15

Palavras-chave: Volatilidade, Correlacao, Efeitos spillover, Assimetrias

iii

Acknowledgements

I am especially indebted to my advisor, Miguel Ferreira, for his kindness, support, and

exceptional guidance. His insightful ideas, helpful discussions and suggestions are invaluable

and greatly acknowledge. A very special thanks to Antonio Gomes Mota for encouragement

and support throughout my doctoral program.

I am also thankful to Geert Bekaert, John Campbell, Jens Jackwerth, Paul Laux, Francois

Longin, Tim Vogelsang, Robert Hodrick, Ana Paula Serra, Amar Gande, Yakov Amihud,

Andrew Ang, Peter Ritchken, for their comments and suggestions on earlier versions of the

papers. I have benefited from the comments of participants at the 2003 European FMA

meeting, the 2003 CEMAF/ISCTE conference, the 2003 North American FMA meeting, the

2004 AFA meeting, and the 2004 PFN meeting.

Any written acknowledgement is not enough for the love, patience, and understanding

of my wife and my two children. I hope that I have made you proud.

iv

Overview

This dissertation analyzes three empirical issues in international equity markets: volatil-

ity (Chapter 1), information spillover effects (Chapter 2), and correlation (Chapter 3). Each

chapter is written as an independent and self-contained paper. This brief overview provides

the motivation, methodology, and main findings of each paper.

The first paper primary goal is to describe the historical behavior of international equity

markets total volatility components and to study the implications for international diversi-

fication. We address three main research questions. First, have world, country, and local

industry risks changed over time? Second, has the power of international diversification to re-

duce risk decreased? Finally, given the recent evidence in the literature, we take another look

at the question of the relative efficiency of country versus industry diversification for global

equity investors. These are important questions for global portfolio managers. If the risk

that must be diversified away has increased, there are more opportunities for international

diversification, but more assets are needed to achieve a given level of diversification.

We extend the Campbell, Lettau Malkiel and Xu (2001) total risk decomposition method

to an international setting. This allows us to measure and study the time series behavior

of risk components without the need to keep track of covariances or estimate risk exposure

parameters for countries and industry portfolios. Moreover, the methodology measures in-

dustry risk on a country basis, which is an alternative to the Heston and Rouwenhorst (1994)

fixed-effects model assumption that asset exposures to global industry shocks are equal across

countries. We use local industry daily index return data, which include 21 developed markets

over the 1974-2001 period.

The paper major findings are the following. First, there is no evidence of a statistically

significant long-term trend in any of the volatility components, although local and global

v

industry volatility shows a sharp increase after 1995 (reaching an all-time peak in April

2000). Accordingly, the ratio of local industry to world risk experienced a considerable

increase during the late 1990s. The average ratio is 3.23 for the 1996-2001 period compared to

2.50 in the 1974-1995 period. This increase cannot be attributed solely to the new economy

bubble. Second, local industry risk dominates world and country risk, except during the

1990-1995 period, when country risk is on average the most important component. Third,

the October 1987 crash was felt at both world and country levels, but had less of an effect

on local industry risk. Fourth, lagged local industry risk is helpful in forecasting world and

country level volatility, while the converse is not true. Finally, the ratio of global industry

risks to country risk increased during the late 1990s. This ratio becomes greater than one in

the late 1990s.

Overall, the paper results show that risk components importance have changed over time,

and that global diversification opportunities using local industry portfolios have increased

after 1995. Moreover, the results support that global industry diversification has become

relatively more efficient than geographic diversification only in the late 1990s, although this

could be a temporary result. This is consistent with the early evidence in Heston and

Rouwenhorst (1994) and the recent evidence in Cavaglia, Brightman, and Aked (2000).

The second paper addresses the question: does sovereign debt ratings news in one country

impact other countries stock markets? Brooks, Faff, Hillier, and Hillier (2004) find that

sovereign ratings downgrades have a negative impact on the re-rated country stock market

returns. Kaminsky and Schmukler (2002) show that emerging market sovereign ratings news

is contagious to bond and stock markets of other emerging markets. Gande and Parsley

(2003) find that the international spillover effect on the sovereign debt market is asymmetric.

In fact, only downgrades abroad are associated with a significant increase in sovereign bond

spreads. Furthermore, there is a need for a through empirical investigation of the cross-

co