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Instituto Superior de Ciências do Trabalho e da Empresa ESSAYS ON INTERNATIONAL EQUITY MARKETS Paulo Miguel Gama Dissertação submetida como requisito parcial para obtenção do grau de Doutor em Gestão Especialidade em Finanças Orientador: Prof. Doutor Miguel A. Ferreira Fevereiro de 2005

ESSAYS ON INTERNATIONAL EQUITY MARKETS · PDF fileInstituto Superior de Ciências do Trabalho e da Empresa ESSAYS ON INTERNATIONAL EQUITY MARKETS Paulo Miguel Gama Dissertação submetida

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  • Instituto Superior de Cincias do Trabalho e da Empresa


    Paulo Miguel Gama

    Dissertao submetida como requisito parcial para obteno do grau de

    Doutor em Gesto Especialidade em Finanas


    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


    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


  • 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


  • 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.


  • 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


  • 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-