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
Prof. Doutor Miguel A. Ferreira
Fevereiro de 2005
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
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
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.
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-