Are Correlations of Stock Returns Justified by Subsequent Changes in National Outputs?

Abstract:     
In an integrated world capital market, the same pricing kernel is applicable to all securities. We apply this idea to the stock returns of different countries. We investigate the underlying determinants of cross-country stock return correlations. First, we determine, for a given, measured degree of commonality of country outputs, what should be the degree of correlation of national stock returns. We propose a framework that contains a statistical model for output and an intertemporal financial market model for stock returns. We then attempt to match the correlations generated by the model with measured correlations. Our results show that under the hypothesis of market segmentation, the model correlations are much smaller than observed correlations. However, assuming world markets are integrated, our model correlations closely match observed correlations.

Number of Pages in PDF File: 44

Keywords: Industry correlations, market integration, market segmentation, stock correlation, output correlation

JEL Classification: G15, F36

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