A Spatial Analysis of International Stock Market Linkages

Abstract:     
The severe global impacts of the recent financial crises have intensified the need to understand how country specific shocks are transmitted to other countries. Using spatial econometrics techniques, we analyze to what extent various linkages between countries affect the interdependence of their stock markets. We analyze a number of different linkages: geographical neighborhood, similarity in industrial structure, economic integration (measured by the degree of countries’ bilateral trade and bilateral foreign direct investment) and monetary integration (measured by the closeness of countries’ inflation rates and the stability of their bilateral exchange rate). We analyze both return and return volatility of country indexes for a large sample of 41 countries over a period of 16 years. Our empirical results indicate that economic factors affect the dependencies among financial markets to a greater extent than geographical neighborhood or monetary integration. In particular, we find that a country’s market return and volatility depend to a large degree on market returns and volatilities in countries that are similar in industrial structure and those that are important trading partners.

This is the first in-depth analysis of the underlying economic structure of financial markets interactions that relies on spatial econometrics techniques. A critical issue in risk management is to obtain precise estimates of the future correlation between markets. Our results can be used to improve correlation predictions when making investment decisions.

Number of Pages in PDF File: 37

Keywords: Spatial econometrics, risk spillover, integration

JEL Classification: F30, C49

working papers series